Is Real Tax Reform Realistic?

Plus Changes in Pension Accounting Economic Substance Doctrine Questions on Outsourcing

C O N T E N T S october 2012

24 Accounting & Auditing

Accounting

A New Reality Ahead for Pension Accounting?: The Recessions Aftermath and IAS 19R Prompt Changes in Accounting Practices By James M. Fornaro

Auditing

Audit Fee Patterns of Big Four and NonBig Four Firms: A Study of the Potential Effects of Auditing Standard 5 By H. Leon Chan, David G. DeBoskey, and Kevin Hee

Financial Reporting

Disclosures on Derivatives and Hedging Transactions: A Review of Best Practices By Ira G. Kawaller

24

ESSENTIALS
56 Management

40 Taxation

Compliance & Enforcement

Corporate Management

The Economic Substance Doctrine: Understanding the IRSs Guidance on its Proper Application By Karyn Bybee Friske, Karen M. Cooley, and Darlene Pulliam

A Potential Resurgence of Outsourcing: Essential Questions Answered By Charles E. Davis and Elizabeth Davis

State & Local Taxation

62 Responsibilities & Leadership

Marriage Equality in New York and Beyond: To Love, Cherish, and Tax By David Spaulding and Jay Freeberg

Education

50 Finance

Multiple Financial Accounting Standards Intensify the Dilemma of What to Teach: Stalled Convergence Presents Challenges for Educators By Heather M. Lively and Nicholas J. Mastracchio, Jr.

Personal Financial Planning

Education

Transfers for Valuable Consideration: Tax Issues when Transferring a Life Insurance Policy By Andrew I. Shapiro

Multiple Auditing Standards Intensify the Dilemma of What to Teach: Diverging Guidance Presents Challenges for Educators By Nicholas J. Mastracchio, Jr., and Heather M. Lively

68 Technology

IT Management

10 Questions Audit Committees Should Ask: Managing Information Technology Risks By Jeff Krull and Kevin Rich

What to Bookmark

Website of the Month: Tax Foundation By Susan B. Anders

vol. LXXXII/no.10

PERSPECTIVES
6 Perspectives

18

IN FOCUS

Improving Governance and Internal Control: An Interview with COSO Chairman David L. Landsittel Publishers Column: Truth and Accuracy in Words and Numbers A Case-Based Approach to Intermediate Accounting Courses: New Hires Ready to Hit the Ground Running Five Tips to Reduce the Risk of Internal Fraud: Keeping Controls Current Inbox: Letters to the Editor

18 In Focus: Is Real Tax Reform Realistic? The Election Season Raises a Familiar Question
By Michael E. Roach and William G. Jens, Jr. The concept of reforming the current tax code has gained traction in recent years. The current economic climate and the election campaign season, in particular, have provoked discussion about the fairness and equity of the existing tax code. The question is whether the current system should indeed be reformed and how. The concept of tax reform might be desirable, but the reality of accomplishing it less so, both for Congress and taxpayers. The authors look at some of the issues involved in reforming the present tax code and offer some insight as to the feasibility of real tax reform.

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E R S P E C T I V E S

viewpoint

Improving Governance and Internal Control

An Interview with COSO Chairman David L. Landsittel
By Donald E. Tidrick

avid L. Landsittel was appointed chairman of the Committee of Sponsoring Organizations of the Treadway Commission (COSO) as of June 1, 2009. Landsittel was selected for the position after an extensive, four-month search, according to a COSO press release announcing his appointment. Landsittel was lauded for his leadership skills, knowledge of risk management and control, his previous service as Chairman of the Auditing

Standards Board [ASB] ... [and] his leadership in the development of the external auditors responsibility for detecting fraud ([Statement of Accounting Standards] SAS 99 [Consideration of Fraud in a Financial Statement Audit]). Prior to his appointment to COSO, Landsittel spent 34 years with Arthur Andersen, and he has an extensive record of professional service. He is also a former chair of the Illinois CPA Society. This interview took place during Landsittels visit to Northern Illinois University, on April 25, 2012, to speak at the universitys Beta Alpha Psi (Gamma Pi Chapter) spring initiation banquet.

COSOs Mission and Board Members

Donald E. Tidrick for The CPA Journal: Would you share a historical summary of COSO? David L. Landsittel: COSO [www.coso.org] was formed in 1985, in connection with the National Commission on Fraudulent Financial Reportingbetter known as the Treadway Commission, named for James C. Treadway, Jr., a former SEC Commissioner who chaired it. In the 1970s, there were several instances of improper corporate payments that were inappropriately accounted for, which led to the passage of the Foreign Corrupt Practices Act [1977]. In the 1980s, there were several additional conspicuous instances of outright fraud as some companies engaged in fraudulent finan-

cial reporting to manipulate their stock prices. In 1985, five private-sector organizations that had a stake in the credibility of financial reporting came together to establish the National Commission on Fraudulent Financial Reporting. These five sponsoring organizations were 1) the American Accounting Association [AAA]; 2) the AICPA; 3) the former Financial Executives Institute, now the Financial Executives International [FEI]; 4) the Institute of Internal Auditors [IIA]; and 5) the former National Association of Accountants, now the Institute of Management Accountants [IMA]. Collectively, these organizations represent about half-a-million members, including many outside the United States. In October 1987, the Treadway Commission issued its report, which detailed 49 specific recommendations designed to improve the integrity of financial reporting. These recommendations were directed at a variety of stakeholders, including public companies, independent auditors, the SEC and other regulators, and even educators. Over time, these sponsoring organizations have seen the benefits of cooperation, and they have continued to believe in the merits of working together. One of the Treadway Commissions recommendations emphasized the need to study internal control in a comprehensive manner, which gave the group a specific project to pursue. With the support of Coopers & Lybrand as the project manager, COSO published the Internal ControlIntegrated Framework in 1992. There have also been other projects to make the control framework more robust, including (Continues on page 8)
OCTOBER 2012 / THE CPA JOURNAL

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

Truth and Accuracy in Words and Numbers

J
ournalism is in trouble. In the past five years, more than 39,800 newspaper jobs have been eliminated in the United States, according to the Paper Cuts blog (http://newspaperlayoffs.com/), a website that has kept track of the shrinking newspaper industry since 2007. Already weakened by taking on huge amounts of debt in a drive for higher profit margins and struggling against an emerging digital mediumwhere according to a Federal Communications Commission (FCC) report, The Information Needs of Communities, digital ad sales bring in only four cents out of every print advertising dollarnewspapers were devastated when the recession hit, leaving the reporters who work for them jobless and the coverage that the public depends upon them to provide absent. Ive been struck more than a few times by some of the similarities between CPAsnamely in the role of auditorand journalists, and how the current economic environment is having an impact on these roles as protectors of the public trust. Both auditors and journalists require a high level of professional skepticism; both work the fairness and accuracy beat: one may attest to it, the other must provide it. Both are public watchdogs; whose roles in society are considered necessary in order for our democracy to thrive. Of course, there are important differences that set them far apartnamely, that certified public accounting is a profession and journalism is not. CPAs are licensed and bound by enforceable ethical standards; those who fail to meet those standards risk losing their license and the ability to practice. There are established rules for CPAs, shaped and issued by federal and state regulators; journalists have none. Journalists, long defined as practitioners of a trade that required no formal education, face no real penalty for failing to meet the publics expectations of objectivity in their work; the only standards they must meet are the codes of conduct enforced by their employers or professional associations. As we watch newspapers fold across the country, its hard not to wonder what type of long-term impact a diminished fourth estate will have on the ability of our democracy to function and thrive. Thomas Jefferson said no less in 1799: Our citizens may be deceived for awhile, and have been deceived; but as long as the presses can combination of the auditor payment model and independence rules, even coupled with individual audit partner rotation requirements, is adequate to deal with the potential conflict of interest that appear[s] to be inherent in the auditor payment model (Lewis H. Ferguson, PCAOB Open Board Meeting, August 16, 2011). The PCAOB continued its exploration of this issue through a concept release published last year and roundtable discussions conducted across the country. (See the May 2012 CPA Journal for a variety of perspectives on the topic.) The NYSSCPA has also issued a comment letter on this release; although it agrees with the PCAOB that auditor independence and objectivity is an important factor that should be strengthened and encouraged wherever possible, the Society believes that mandating audit firm rotation is not the optimal way to address this problem because it could have the unintended effect of reducing overall audit efficacy. Engagement partners, particularly those in smaller firms, need time to develop and maintain the necessary skill set to properly audit SEC-registered issuers; this often becomes an industry-specific specialization that successor firms would find difficult to pick up. Regardless of your position on the PCOABs proposal, this is the right conversation to be having right now. The CPA profession is not journalism, but for more than 100 years, the profession has shared its highest aim with that of journalists: to provide a service that protects the public. As our economic and business environments evolve (or diminish, in the case of the press), it is necessary for CPAs, not only as a profession, but as Americans, to defend and protect the democratic institutions that have for so long protected us. Joanne S. Barry Publisher, The CPA Journal Executive Director, NYSSCPA jbarry@nysscpa.org

Auditors also balance two interests, and they always have.

be protected, we may trust to them for light. The presses are not being protected; in fact, theyre literally being sold as scrap metal, relics of a bygone era in our new, more selfcontained digital environment. On top of that, more and more journalists and editors are being asked to cross what used to be a very well-defined line between editorial and advertising. Reporters are now concerned with search engine optimization (SEO), increasing page views, and feeding the 24hour news cycle that the Internet has created. They rely on press releases issued by government entities and special interest groups to fill the news hole left by the layoffs of thousands of colleagues. This leaves the public uninformed and unawarea dangerous place for a democracy.

Shared Obligations and Aims

Auditors also balance two interests, and they always have: they are charged with meeting the CPAs professional and independence standards, as well as those of the client, who pays them for their services. The Public Company Accounting Oversight Board (PCAOB) has taken a greater interest in auditor independence recently, stating that in this environment of quickly evolving accounting standards due to new economic realities it is reasonable to ask again whether the current

OCTOBER 2012 / THE CPA JOURNAL

(Continued from page 6) Internal Control Issues in Derivatives Usage, which was published in 1996. In 2004, we published a separate framework on enterprise risk management [ERM; Enterprise Risk ManagementIntegrated Framework]. Some people might confuse the two frameworks or misperceive that the ERM framework supersedes the internal control framework, but in our view, they stand on their own as separate documents. In addition to the ERM framework, we sponsored two significant research studies to investigate fraudulent financial reporting. In recent years, we have published a series of thought papers that have focused on important issues related to ERM in order to help stakeholders move along the maturity curve. CPAJ: How would you characterize COSOs mission today? Landsittel: COSO is a thought leader, not a standards setter. Our thought leadership focuses specifically on three interrelated subjects: internal control, risk management, and fraud deterrence. Basically, we view ourselves as a think tank in those three areas. CPAJ: Who are the other current board members of COSO? Do they bring any unique or institution-specific perspectives to the board? Landsittel: The AAA is represented by Douglas F. Prawitt [PhD, CPA], who is a respected auditing professor at Brigham Young University and remains active in the AAA and its auditing section. He has experience on a couple of COSO task forces that involved internal control in smaller public companies and ERM, as well as with the ASB. The AICPA is represented by Charles Landes [CPA]. He is the vice president of the AICPAs Professional Standards and Services Group. In that role, he oversees the technical activities of the AICPAs audit and attest standards team, among many other responsibilities. Prior to joining the AICPA in 2000, Chuck had extensive public accounting experience. The FEI is represented by Marie N. Hollein [CTP(CD)], who has served as its president and CEO since 2009. She has more than 30 years of extensive corporate and financial services experience as a

senior financial executive at organizations including Citibank and Westinghouse Electric Corporation, as well as at KPMG, where she was a managing director of financial risk management. The IMA is represented by Sandra Richtermeyer [PhD, CMA, CPA]. She is a former IMA chair [20102011], a respected accounting professor, and chair of the department of accountancy and business law at Xavier University. In addition to having specific institutional knowledge of the IMA and being grounded in an academic perspective, she also has public accounting experience. The IIA is represented by Richard F. Chambers [CIA, CCSA, CGAP], who has served as the IIAs president and CEO since 2009. He has more than 30 years of extensive internal audit, accounting, and financial management leadership experience in both the private and public sectors. He has worked with the U.S. Government Accountability Office (GAO), served as the chief audit executive for several large federal governmental entities, and worked with PricewaterhouseCoopers, where he led the firms internal audit advisory services practice before taking the helm of the IIA. These are all extremely capable and collegial individuals, and it is a pleasure to work with them. They bring a wide range of informed perspectives to our discussions, but always focus on the broad mission of COSO and meeting the collective interests of our many stakeholders without limiting their perspectives to that of any specific organization. CPAJ: How did you come to be appointed COSO chairman? What are your responsibilities in that role? Landsittel: I served on the advisory council for the 1992 internal control framework without further involvement with COSO until I served on a focus group involving audit committee chairs in 2008. A few months later, I was contacted about my willingness to be considered for this position. Although I am retired, I do like to be professionally engaged, and I thought that this would be very interesting work. One thing led to another, and I was appointed as COSO chair in May 2009. The chairs fundamental responsibility is to carry out the mission of COSO. Other

responsibilities include managing relationships and assessing how COSO can best serve our stakeholders' interests with respect to internal control, ERM, and fraud deterrence. Because COSO is a virtual organization without employees or its own resources, projects are largely outsourced. Consequently, the chair is also responsible for finding opportunities for interested organizations to help us make progress on our projects. I am fortunate to have a very helpful part-time research assistant, Joanna Dabrowska, supported by COSO and DePaul University. CPAJ: How long do you plan to serve as COSO chair? Landsittel: Originally, I had a three-year term, which expired in May 2012, but I have agreed to an additional one-year extension in order to see current work to completion. During this next year, we will be looking for someone to take on the role of the next COSO chair. CPAJ: You described COSO as a virtual organization. How is COSOs business conducted? Landsittel: Normally, we meet face-toface four times per year [for one day], with additional meetings by phone on an asneeded basis. Although different points of view are expressed in our discussions, they tend to result in consensus. On those occasions where we need to take votes, to approve certain documents related to projects, the votes tend to be unanimous. Most of our revenues are generated through our publications. Although the individual thought papers are available for free on our website, the frameworks and related documents have generated sufficient revenues to fund our activities. The five sponsoring organizations are extremely supportive of COSOs activities and provide essential support services. For example, the AICPA naturally handles the accounting function for COSO. The AICPAs involvement with CPA2Biz [a subsidiary that markets AICPA products and services] helps with the marketing and sale of COSO publications. The IIA is very helpful with public relations and our interface with the media. We engage various parties to author materials published by COSO. Twenty years ago, Coopers & Lybrand was the project manager for the original internal control framework,
OCTOBER 2012 / THE CPA JOURNAL

and the contract stipulated that they had the right of first refusal on any updates to that framework. We approached PricewaterhouseCoopers first, and they accepted the project. In other instances, we might solicit authors through an invitation to bid. For some of our more recent thought papers, we might target individual authors based on their interests and expertise. COSO oversees and approves the final products and addresses any issues that might arise, but someone else actually authors those products. It is important to note that, for the update of the internal control framework, COSO reimburses PricewaterhouseCooperss direct, out-ofpocket expenses, but the significant amount of time that their professionals devote to a project such as this is pro bono. This virtual organization model has worked very well for COSO for several decades and, in my view, is unlikely to change going forward.

Updating COSOs Internal Control Framework

CPAJ: Although not a standards-setting body itself, how does COSO interface with regulators and standards setters, such as the Public Company Accounting Oversight Board (PCAOB) and the SEC? Landsittel: Although there is not much interaction with those organizations when it comes to the thought papers, there has been a lot of interface with regulators and standards setters related to our update of the internal control framework. For this update, COSO has formed an advisory council that consists of about 15 members. There are also five observers, primarily having a regulatory orientation: the SEC, the PCAOB, the FDIC [Federal Deposit Insurance Corporation], the GAO, and IFAC [the International Federation of Accountants]. Although the individuals representing these organizations are designated observers, they do have the right to the floor and they do participate. In addition, we welcome their feedback outside of the advisory council meetings. Their input has been highly constructive and very helpful, and we are grateful for their support of our goal of developing high-quality frameworks. CPAJ: What motivated the refresh of the original internal control framework,
OCTOBER 2012 / THE CPA JOURNAL

and how would you characterize the results of that initiative to date? Were there any surprises that have surfaced in comments received during the exposure period? Landsittel: The environment in which the 1992 framework was developed was very different from todays environment. The basic structure of the framework including the definition, the three objectives, and the five componentsremains relevant and effective, but we needed to update the framework to address significant changes in governance; in how business is conducted, including a lot more outsourcing and joint ventures; and information technology. The Internet and e-mail were relatively unknown in 1992, whereas they are ubiquitous today. Beyond those considerations, there were other reasons to update the original framework. For example, we have a document that addresses the application of controls for smaller businesses and identifies a series of principles supporting the components; we believed that such principles were applicable to the entire framework itself. The proposed updated framework identifies explicit principles that support the applicable components. Those principles were implicit in the 1992 framework, but making them explicit should be helpful to stakeholders in understanding the assessment of the components. In addition, we wanted to make the commentary dealing specifically with the objectives

involving operations and compliance more robust. As for comments, we received almost 100 comment letters; I was pleased that those letters were very thorough and thoughtful. Interestingly, there was a wide diversity of viewpoints expressed in those letters, some of which advocated opposite positions. That makes it incumbent on us to really think through a lot of issues that were identified in those letters. We decided to extend the target date for delivery to the first quarter of 2013 because we have a lot to do. We are also contemplating whether it might be beneficial to make an update of the document publicly available to obtain further input on specific issues of interest. CPAJ: How do you envision the transition from the 1992 framework to the updated framework? Landsittel: We get a lot of questions about transition, and they generally fall into two basic categories. First, when we thought we might be able to release the finished document before year-end, we received a lot of questions as to whether users would have to apply that 2012 framework. Of course, we never envisioned that there would be instantaneous implementation of the refreshed internal control framework. Extending that delivery to the first quarter of 2013 should alleviate some of those anxieties. Second, it is important to remember that COSO is a thought leader, not a standards setter. We are not in a position to tell users when to transition. The only thing we can control is when we stop selling our documentsand I assure you that we will continue to sell the 1992 framework until the marketplace moves on. The 1992 document is still effective, but we think the new control framework will be even better, so we hope that stakeholders will transition as quickly as possible. Ultimately, as it relates to SEC registrant application of the framework in response to the section 404 requirements of the Sarbanes-Oxley Act of 2002 [SOX], the regulatory authorities might perhaps provide guidance regarding when the transition must be made. CPAJ: COSO has indicated its intention to release guidance on implementing

the revised framework for external reporting. Are there any plans to issue additional guidance on other aspects of the revised framework? Landsittel: We do indeed plan to have a separate document that provides approaches and examples related to financial reporting that would be relevant to SOX issues, and we plan to expose that document for public comment this fall. We have also discussed the longer-term possibility of developing a specific document that addresses compliance-related internal control issues. And, although not currently under active consideration, we might eventually develop a separate document to focus on applying controls in an operations setting.

The ERM Framework

CPAJ: Everyone seems to be talking about risk management these days. How would you assess the impact of the 2004 ERM framework? Landsittel: There are a number of differences affecting user application of our ERM and internal control frameworks. The internal control reporting requirements mandated by SOX obviously spurred the visibility and use of the internal control framework, but that has not been a factor for the ERM framework. The U.S. auditing profession has probably had standards related to internal control for more than 60 years, whereas risk management is a relatively recent construct. There is still a significant subset of companies that does not really embrace the value proposition of ERM, and there is another group that has

taken steps toward ERM, but has not fully embraced our entire ERM framework. Of course, there are other risk-related frameworks that users might consider too, including ISO [International Organization for Standardization] 31000. CPAJ: Is there a sense of competition among these various frameworks for acceptance in the marketplace? Landsittel: We do not view this as a competition because COSOs role is that of a thought leader. The fact that there is an ISO-level framework adds credibility to the validity of the whole topic of ERM, which is helpful in making progress. ERM is young, and we still have a ways to go; it is an evolving environment, within which these concepts will continue to develop. CPAJ: Do you envision future efforts to either combine the internal control and ERM frameworks, or perhaps to conduct a separate refresh of Enterprise Risk ManagementIntegrated Framework? Landsittel: In my personal view, COSO should support the development of a standalone document that clearly explains the differences between the two frameworks; how they fit together; and how they fit into the broader view of governance, organizational strategy, and operational processes. Some people, particularly those outside the United States, advocate merging the two frameworks into one overarching framework for purposes of coordination. In the United States, we have some unique circumstances associated with SOX, and there are practical advantages to having a separate framework that focuses exclusively on internal control. I would not be surprised if COSO refreshes the ERM framework someday, but we have no specific plans to do that at the present time.

Preventing and Detecting Fraud

CPAJ: In your previous role as chair of the AICPAs Auditing Standards Board (ASB), you were closely involved in the development of SAS 99, Consideration of Fraud in a Financial Statement Audit. Fraud continues to be a significant challenge for the CPA profession. What more can the profession do to provide greater assurance of detecting fraud? Landsittel: It might be hard to implement, but I think it would be helpful if we had bet-

ter communications about fraud risk and lessons learned from prior frauds that have occurred. For example, whenever there is an airplane crash, the National Transportation Safety Board does a thorough investigation to identify causes and insights that can be broadly communicated in order to reduce such risks going forward. Having a process for systematically investigating instances of fraudulent financial reporting, with the purpose of sharing information more freely, would be a distinct improvement; however, there are many obstacles, not the least of which are confidentiality and legal liability issues. With the support of regulatory authorities, it would be constructive if we could get some sort of safe harbor to focus on the underlying causes of a fraud and ways it could have been prevented or detected without focusing on placing blame on the individuals and organizations involved. CPAJ: In 2008, two of the sponsoring organizationsthe IIA and AICPA along with the Association of Certified Fraud Examiners (ACFE), jointly issued conceptual guidance related to fraud issues, Managing the Business Risk of Fraud: A Practical Guide. That sounds similar to COSOs core focus. Would you expect such non-COSO collaborations involving a subset of sponsoring organizations to increasingly occur when there is mutual interest? Do you envision that the organizational affiliations represented by COSO might expand beyond the present five? Landsittel: COSO does not exclude other organizations from contributing their thoughts that can be helpful to us. We want to have a healthy working relationship with a lot of other organizations, and I have tried to facilitate those relationships during my term. I do not anticipate expanding the number of organizations comprising COSO, because there is clearly some legacy associated with the five existing sponsoring organizations. It is important to COSOs progress, however, to further develop and maintain close working relationships with other organizations who can help us better address our missionfor example, with respect to issues like board governance and IT, as well as global issues that relate to internal control, ERM, and fraud deterrence.
OCTOBER 2012 / THE CPA JOURNAL

10

Thought Papers and Future Projects

CPAJ: Since 2010, COSO has periodically issued thought papers, such as Enterprise Risk Management Understanding and Communicating Risk Appetite and Enhancing Board Oversight by Avoiding and Challenging Traps and Biases in Professional Judgment in 2012. Going forward, is COSO likely to release additional thought papers? Landsittel: Our primary purpose in issuing those thought papers has been to help organizations implement ERM processes. They are available for free, and they have been well received. They address issues such as how to get started; achieving proper oversight, both from a management and a board perspective; establishing appropriate risk appetites; and developing key risk indicators. A couple of new thought papers are in process, and we will continue to follow this approach to address specific issues of the dayfor example, application of our ERM framework to risks and opportunities related to cloud computing and sustainability. CPAJ: You and your predecessor, Larry Rittenberg, commented that COSOs agenda of potential future projects has never been larger (COSO: Working with the Academic Community, Accounting Horizons, September 2010). Aside from the internal control refresh, what projects are in process now or envisioned for the future? Landsittel: Other than the thought paper strategy I just outlined, COSO is limited in the activities we can work on at this time by the all-encompassing nature of the internal control refresh. I also mentioned earlier the possibility of supporting the development of products dealing with the application of our internal control framework specific to compliance and operational objectivesas well as the possibility of developing a document discussing how our internal control and ERM frameworks relate to one another and fit into a broader view of governance, organizational strategy, and processes. Longer term, I believe that COSO should focus more on behavioral issues that are very important, but difficult to define precisely. Think about issues like
OCTOBER 2012 / THE CPA JOURNAL

overconfidence. I have talked with corporate board members about the risk of management override of controls. The usual response is, Well, I know that is prevalent among entities that commit fraudulent financial reporting, but it would never happen at this company, because I wouldn't be associated with this company if anyone were untrustworthy. And there may be a different kind of overconfidence in ERM, where there may be a tendency to systematically underestimate the likelihood of significant risksthat is, the black swan issue. In the fraud research area, I think it would be interesting to look at the impact of SOX on the occurrence of fraud. So, there are a lot of possibilities for future projects. CPAJ: Given COSOs focus on internal control, risk management, and governance, have recent events involving apparent failures of such processes in some major companies caused COSO to consider the need for further study or guidance? Landsittel: Not in a way that is identifiable to any specific failure. But, for example, our ERM thought papers have addressed a board of directors responsibility for oversight of the risks that organizations have assumeda frequent criticism associated with the financial crisis. We certainly link our thought papers to the environment within which our projects are conducted, and that environment including the recent financial crisishas contributed to the visibility of COSO, underscored the relevance of our ERM and internal control frameworks, and increased our level of activity.

Ethical Standards and International Impact

CPAJ: In the 1990s, COSO highlighted three topics of emphasis: corporate governance, internal controls, and ethical standards. The emphasis on ethics seems to have faded into the background. Do you foresee a renewed emphasis on ethics in the future? Landsittel: It is true that the Treadway Commission Report in 1987 included several recommendations specifically related to ethical issues. Perhaps it has not been as explicit as it should be, but

ethics is an integral part of the internal control, risk management, and fraud deterrence topics that COSO emphasizes. For example, an entitys control environmentthe tone at the tophas a pervasive effect on each of the other components of internal control. Ethics continues to be an essential thread that is woven throughout the fabric of all of COSOs broader projects. CPAJ: What impact has COSO had outside of the United States? Landsittel: This is actually something that has surprised me. A large amount of the hits and downloads of the recent exposure draft on internal control occurred in countries other than the United States. I have spoken outside the United States on a number of occasions in my role as COSO chairman, and I have been pleasantly surprised by the level of interest projected by audiences. Our internal control framework has been translated into seven languages, with requests for additional translations. The concepts of effective control and governance are relevant around the world. IFAC has been particularly helpful to us in extending our relationships with others internationally, which we very much appreciate. From an international perspective, COSO is indeed widely known and, I think, well respected. With that said, we need to continue to focus on developing and maintaining relationships that facilitate a global focus. CPAJ: In closing, is there anything else that you want to say to CPA Journal readers? Landsittel: The opportunity to chair COSO has been a very rewarding experience, and I feel very fortunate to have had the chance to interact with so many outstanding individuals. We have a fundamental principle stating that effective internal control and risk management are essential to the success of organizations I believe that. It makes me feel good that I have been privileged to chair a group whose mission is so committed to the success of organizations. Donald E. Tidrick, PhD, CPA, CMA, CIA, is the Deloitte Professor of Accountancy at Northern Illinois University, DeKalb, Ill.

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future of the profession

A Case-Based Approach to Intermediate Accounting Courses

New Hires Ready to Hit the Ground Running
By Robert P. Derstine, James M. Emig, Thomas J. Grant, and Kenneth Hiltebeitel

ould you be pleased if your new hires, straight out of college, were ready to be productive their first day on the jobalready possessing seven years of experience providing review, audit, tax, and consulting services for a CPA firm? An intensive, case-based, twosemester intermediate accounting course, which also integrates components from both corporate tax and auditing classes, can provide the profession with such new hires (Connie Esmond-Kiger, Business Activity Model for Teaching Intermediate Accounting, 5th ed., 2009 [with continual updates]). Both accounting graduates and their employers can benefit from this course, described in further detail below.

financial statements, the student teams research accounting issues; question the clients controller (played by the professor) in order to obtain additional information; develop necessary adjusting entries; draft corrected financial statements and required note disclosures; and, finally, present the clients corrected financial statements at the annual stockholders meeting. This learning experience more closely aligns with the skill set new hires need to hit the ground running, when compared to the traditional pedagogy of reading a chapter in a textbook, listening to a lecture, attempting homework problems, and then parroting back the information on exam day.

Case Content
Students are exposed to a variety of accounting topics and issues during the course. The following sections describe some of the critical topics and issues addressed. Financial accounting. The first several weeks of intermediate accounting are spent reviewing financial accounting (including the four financial statements). Students also are introduced to U.S. GAAP, FASBs conceptual framework and Accounting Standards Codification (ASC), and International Financial Reporting Standards (IFRS). Financial statements and balance sheets. For each of the seven years in the case study, students must analyze clientprepared income/retained earnings statements and balance sheets, correct for errors and omissions (i.e., determine any required adjustments), and explain the financial statements at the clients annual stockholders meeting. Cash flow statements (both direct and indirect method for operating activities) must be prepared by the students from scratch because the client appears unable to do so. Accounts receivable. This becomes an issue in the first year, when students must realize that they need to ask the controller: Are all receivables collectible? Do they require an allowance for bad debts? Each year, students must evaluate the clients response; propose an appropriate adjusting entry, if necessary (and defend it); and again explain the receivables presentation at the annual stockholders meeting. The very limited number of customers in the early years of the case (e.g., only six

in the first year) exemplifies the need to remain alert for risk situations requiring disclosure. Merchandise inventory. This requires students to deal with first-in, first-out (FIFO) and last-in, first-out (LIFO) costing; lower of cost or market; and shipping/receiving cut-off issues. A consulting engagement on the FIFO/LIFO choice requires students to make a presentation to the client addressing the advantages and disadvantages of each choice under various inflationary scenarios. Property, plant, and equipment. Equipment, vehicles, land, and buildings are acquired throughout the case via cash purchase, bank loan financing, capital lease, or part of net assets acquired in purchase of

This case-based approach enables students to learn how to learn.

another company. Students need to determine whether expenditures should be recorded as repairs and maintenance expense or capitalizedincluding self-construction costs and any related interest cost. Varied lives and depreciation methods on the books versus tax return require students to generate workpaper documentation to support clients book and tax depreciation amounts. Students can use these workpapers (and other workpapers created throughout the case) when they are explaining the clients financial statements and disclosure notes at the annual stockholders meeting. In addition, by requiring workpaper documentation each year, students become familiar with utilizing the prior years workpapers while maintaining a constant vigil for changing circumstances. Consulting engagements requested by the client require students to research and then make presentations on alternative financing opportunities available for asset acquisitions and for nonmonetary exchanges. Intangible assets and goodwill. Intangible assets are introduced as the result
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Course Overview
In this course, students work for a fictitious CPA firm and are assigned one client to advise for the first seven years of its existencefrom the start-up to public company. Working in teams, students learn how to identify opportunities and problems encountered by the client; research possible solutions; determine when and if it is appropriate to ask for help; make accounting and financial suggestions; and effectively communicate their findings, both verbally and in writing. The teams perform review engagements for the first three years, followed by audits during the last four years of the case study. New topics are introduced each year, with critical accounting issues repeated until the students feel comfortable dealing with them. This case-based approach enables students to learn how to learn. Provided only with a partial set of client-prepared

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of licensing costs and the clients incorrect capitalization of start-up costs. Students need to account for goodwill resulting from an acquisition of the remaining net assets of an equity method investee. Liabilities. Accounting for and disclosure of typical current liabilities are encountered throughout the case. Long-term liabilities include bank loan payables (with associated loan covenants), capital lease liabilities, and accrued pension liabilities. Retroactive adjustment. Students need to recognize that a prior-period error correction is necessary to retroactively adjust for the warranty costs of an acquired company. These previously unrecorded costs require an adjustment to warranties payable and previously recorded goodwill. Pension plans. A defined benefit pension plan (including prior service cost) requires students to learn about pension plans in general and how to handle the accounting, funding, and disclosure issues of the clients pension plan, specifically. Students continually need to enquire about other post-retirement benefits being offered to employees. Earnings per share. Common stock is issued by the client both to raise cash and to acquire another company. Accounting for accumulated other comprehensive income is required, due to unamortized prior service costs. Basic earnings per share (EPS)or, rather, loss per share in the first yearis required for the first four years of the case. As the client does not appear to know how to calculate EPS, students must research the topic, perform the calculations, put EPS on the face of the income statement, and draft the associated footnote disclosure. Diluted EPS is required beginning in the fifth year, with the issuance of convertible preferred stock. Investments. The client ultimately makes several investments in the case study. In addition to the portfolio of trading securities, students need to analyze other investments to determine whether the cost or the equity method of accounting is appropriate. Changing circumstances require altering the accounting treatment in subsequent years. Revenue recognition. Such issues are introduced early in the case as some of the clients customers pay for contracted services in advance. Students also encounter revenue
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recognition for long-term construction projects in the last part of the case. They need to revise three years of financial statements (and prepare correcting entries) due to the client improperly accounting for longterm construction contracts. Tax. Accounting for income tax issues starts in the first year of the case, with a net operating loss and the determination of whether a valuation allowance is necessary. By the fifth year, students must document (via workpapers) 10 temporary differences that impact deferred income taxes. This is another instance where students refine their skills in workpaper preparation. Assignments requiring corporate tax return preparation (and documentation linking audit work with the clients corporate tax return) are required in the later years of the case. Disclosure notes. Students draft all required note disclosures for each year and explain them at the annual stockholders meeting. As an example, the fifth year requires students to draft 12 separate disclosure notes. The first note of the 12 significant accounting policieshas 10 individual disclosures.

in the real world, as opposed to having a professor lecture about a particular topic and then asking students to simply recite back what they learned. The application of the principles in a real world setting is very beneficial. It shows you how to put the principles into practice, whereas in a traditional classroom setting you would just need to know how to apply them on a test. The CPA exam is much easier to tackle some of this ease is attributable to having learned and worked with the tough accounting issues in more depth in this case-based method.

An Innovative Learning Style

We echo the above observations about this case-based learning approach. We believe students will have increased motivation for the accounting profession; enter the profession with technical competency in financial accounting (with integrated audit and corporate tax skills); and will have developed critical-thinking, communication, and research skills relevant to real-world situations. It is not the topical coverage of this case-based approach that differs from the traditional pedagogyit is the learning style. Students are required to learn just as they would on the job. As a result, they should be well prepared for their first day on the job. Robert P. Derstine, PhD, CPA, is a professor of accounting at Kutztown University, Kutztown, Pa. James M. Emig, PhD, CPA, is an associate professor of accountancy and information systems and Villanova University, Villanova, Pa. Thomas J. Grant, CMA, is an associate professor of accounting, also at Kutztown University. Kenneth Hiltebeitel, PhD, CPA, is also an associate professor of accountancy and information systems at Villanova University. Further information on how the authors use this case approach in their intermediate accounting courses can be obtained by contacting the authors at derstine@kutztown.edu, james.emig@villanova.edu, grant@ kutztown.edu, or kenneth.hiltebeitel@ villanova.edu.

CPAs Comment on Case Approach

In order to determine if this case-based approach is actually working, the authors contacted CPAs at both large and medium-sized accounting firms. Open-ended questions were asked concerning how students exposed to this case-based learning approach are performing once they enter the real world. The responses were overwhelmingly positive: Once youve had this case-based learning approach, you already have one client experience under your belt. One of the biggest adjustments that students must make in practice is to learn to identify the issues theyre facing. They must also learn to ask the right questions rather than simply be given answers. This casebased approach fulfills all of these criteria! This approach really allows the students to get a better understanding of real-life scenariosit helps them understand and apply what they learned both in the classroom and later on the job. This approach gives students experience in addressing new accounting problems in the manner in which they occur

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fraud

Five Tips to Reduce the Risk of Internal Fraud

Keeping Controls Current
By Ernie Rossi

avvy business owners know the value of internal controls and the critical importance of reviewing those controls on a regular basis. Effective internal control systems must be adapted to changes in business practices and the global economy. How do todays businesses keep up? The answers to the five questions below can help companies strengthen their controls and prevent fraud.

petrator meets poorly designed or poorly implemented internal controls and little or no monitoring of those controls. An employee that perpetrates a fraud generally rationalizes the behavior. For example, the perpetrator might say, The owner makes way too much money, or, I work really hard, and the business doesnt properly reward me for my efforts. It is possible to distinguish between businesses that have poorly designed internal controls and those where the controls are poorly monitored. Internal controls might be in place, but sometimes the businesss culture evolves to a point where controls are allowed to be ignored. One common example is an increasingly busy workplace where checks are signed without thorough review of supporting invoices.

1. Which Businesses Need to Protect Against Fraud?

No company is completely immune to fraud; however, certain types of companies are at greater risk. Small companies tend to have limited resources, meaning that employees perform multiple duties. This is a problem because small businesses cannot easily separate what a good internal control structure would call conflicting tasks. Properly separating tasks requires perpetrators to conspire in order to stealand collusion is more difficult than acting alone. Larger businesses might be more capable of separating tasks simply because they have more staff, but their fraud risk can potentially increase over time if they become lax in pinpointing loopholes in their systems; given time, people can find weaknesses and exploit them. One common denominator among companies is that few believe they are susceptible to internal fraud. But the statistics in this area are clear: fraud is often perpetrated by a long-term employee or friend. It is best to have well-designed and implemented internal controls that reduce, as much as possible, the opportunities to commit fraud in the first place.

Increased awareness, along with the knowledge that internal controls are a priority, will serve as a strong deterrent to employees who might otherwise commit fraud.
Companies should not only design proper controls but also remain vigilant and monitor their effectiveness.

nize the risk of fraud, they are often unsure about the steps required to prevent it. Companies should start small; the first step is to leverage a third party to review the business and uncover potential problems through an assessment of internal controls. This will help identify the areas of biggest riskalso known as the lowhanging fruit. The second step is to implement controls, such as a separation of duties of employees, in order to shore up vulnerabilities uncovered in the assessment. Next, periodic reviews by internal managers and external assessors will help to keep controls sharp. Its also important that companies educate employees about the purpose of the controls. Increased awareness, along with the knowledge that internal controls are a priority, will serve as a strong deterrent to employees who might otherwise commit fraud. Businesses should communicate that internal controls will ultimately protect employees if and when a fraud is committed by allowing them to quickly be eliminated from suspicion. Financial audits can be helpful, but audits alone cannot replace internal controls or a thorough risk assessment. Although an audit might catch errors, there is no guarantee that such errors are the result of fraud.

4. What Qualifies an Individual or a Firm to Assess Risk?

Businesses should consider hiring CPAs with fraud-related experience, such as auditing. They need not specialize in fraud, although that it helpful, but they should have lengthy experience in public accounting. Generally, CPAs with significant public accounting experience are well suited to evaluate existing controls and assist in developing additional or more effective controls. Basic assessments can be conducted over a few days or weeks, depending upon the size of the business and the amount of time needed to document the businesss day-to-day practices. The assessment does not need to be done all at once. A business owner should meet with the selected professionals, perform a general assessment, and then design a plan over time to develop and implement a comprehensive internal control system. After conOCTOBER 2012 / THE CPA JOURNAL

3. How Can Companies Prevent Internal Fraud?

Companies led by a management team that sets the tone at the top by modeling the greatest degree of integrity might exhibit less risk for internal fraud. Business owners who play fast and loose with tax laws, and company assets can expect employees to feel comfortable doing the same. While some business owners recog-

2. Under What Conditions Does Internal Fraud Occur?

Internal fraud can be compared to a perfect stormthat is, a motivated per-

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trols are implemented, periodic maintenance should be performed. Over time, even good controls will become less effective; eventually people find their way around the controls, especially if they know they are not monitored regularly.

5. How Can a Service Provider Help?

Any service provider should talk with its clients about controls frequentlynot

just during an annual audit or when preparing the annual financial statements. In every meeting, a service provider should listen for key phrases or changes to the business; for example, the phrase, Were having cash flow problems, might indicate a control issue. In order to truly reduce the likelihood of fraud, education and communication should be top priorities on both sides of the table.

Ernie Rossi is an audit partner at Sensiba San Filippo, Pleasanton, Calif.

This article has been adapted from the authors article, How to Reduce the Risk of Fraud by Keeping Internal Controls Current, published in Smart Business (Northern California edition), April 1, 2012.

inbox: letters to the editor

Debating Auditors and Fraud

read with interest Auditors Responsibility for Detecting Fraud: Putting Ethics and Morality First, by Richard H. Kravitz, and Auditors Responsibility for Detecting Fraud: Applying Professional Judgment and Maintaining Integrity, by Vincent J. Love (The CPA Journal, June 2012). I congratulate the authors on an excellent analysis of Generally Accepted Auditing Standards (GAAS) vis--vis consideration of fraud. When it comes to non-GAAS fraud examinations, however, some clarifications should be made. First, the objective of a fraud examination (Exhibit 2 in Loves article) is not to determine whether fraud has or is occurring; this task can only be adjudicated by a judge and jury. Rather, the objective of a fraud examination is to provide all the relevant, reliable, and available information, so that the legal process can make its determination. As certified fraud examiners (CFE) and CPAs, we are precluded from rendering an opinion on whether a fraud has occurred. Rendering such an opinion would be paramount to a legal opinion. Second, the authors somewhat loosely use the word auditor to mean the person who performs a fraud examination. Performance of an audit implies performance of procedures that include a risk assessment, audit procedures, and arriving at an opinion that can be relied upon. Accordingly, an auditor is someone who performs an audit; in contrast, a fraud

examiner is someone who takes all necessary steps to provide the information for the legal process. Third, a fraud examiner does different work than an auditor. A fraud examiners approach is less of a risk-based approach and more of a methodical discovery based on a theory of how a fraud occurred. Accordingly, the fraud examinations costbenefit analysis also differs from that of an auditand it is often much more expensive. Taking a look at the big picture, the term audit, in relation to fraud-related procedures, should be used strictly within the GAAS framework. The use in other contexts might confuse the general public, who could hear the word audit or auditor in connection with fraud and understand a level of opining and reliance that is simply not there. Yigal Rechtman, CPA, CFE, CITP, CISM Director for technology assurance and forensic services Buchbinder Tunick & Company LLP

The Authors Respond

greatly appreciate the writers interest in the articles and that he took the time to closely read and comment on them; however, his comments are close to, but off of, the mark. Both the AICPA and the Association of Certified Fraud Examiners (ACFE), when addressing the objective of a fraud examination, use the phrase determine or determining. For example, the 2012 edition of the Fraud Examiners Manual states: The fraud

examinations goal is to determine whether fraud has/is occurring and to determine who is responsible (ACFE, p. I-2). (See also, Considering Fraud in a Financial Statement Audit: Practical Guidance in Applying SAS No. 82, AICPA, p. 43; An Audit Versus a Fraud Examination, by Annette Stalker and Mike Ueltzen, CPA Expert, Winter 2009, p. 4.) This describes the object of the examination and not the type of report rendered by the auditor or examiner on the existence of a fraud. This is the point that I believe the writer is trying to make, and it is a good one. While the auditor or examiners objective may be to determine if fraud has or is occurring, the auditor or examiner usually does not give an opinion that a fraud has occurred because one element of fraud is intent, and that determination is better left to a trier-of-fact in a legal proceeding. Moreover, the auditors or examiners report is beyond the scope of the articles. I have scanned the articles and have not found any instance where the auditor or examiner designation is inappropriately used. Forensic audit and forensic auditor are perfectly proper designations, as are fraud audit or fraud auditor. The fraud audit and fraud auditor terms have been around long before Joe Wells established the CFE designation; the designation is a great one, but CPAs have conducted audits to find fraud and testified on the results in courts of law since the beginning of the profession, and they continue to do so today. The articles address auditing of financial statements and

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the auditors responsibility for detecting fraud; consequently, any such audit, whether based on GAAS or a more intensive set of standards to detect fraud, will be performed by an auditor in all instances. The cost-benefit analysis discussed in the articles is related to the cost and benefit of performing a GAAS audit versus a fraud examination (or fraud audit, because there would not be any predication) in all instances when audited financial statements are presented. Kravitzs position is that the cost, when compared to the enormous losses that have occurred in the past, is justified. My position is that the cost and other attendant issues make auditing for fraud, in all instances, uneconomical. The risk-based approach in a GAAS audit and the predication and focus of a fraud examination are beyond the scope of the article, but they are understood to exist and are at the heart of the point/ counterpoint discussion. Vincent J. Love, CPA/CFF, CFE Managing director of VJL Consulting LLC New York, N.Y. am thankful to Rechtman for his constructive comments. Although I do agree with Loves response, I would also like to add my own comments: Rechtman states, As a CPA and CFE, we are precluded from rendering an opinion on whether a fraud has occurred. He stands behind semantics. My definition of fraud is broader, and I assert that Rechtmans preclusion is, in fact, our principal obligation. As CPAs, in our professional judgment, we certify that, in rendering an unqualified opinion, the financial statements are free of material misstatement, free of false and misleading (i.e., fraudulent) financials, and fairly represent the condition of the enterprise. There can be no compromise in our responsibility to detect and report on misleading or fraudulent financials, regardless of whether they are intentional or unintentional. The Public Company Accounting Oversight Board (PCAOB) seems to be leaning in this direction as well; it requires auditors to identify risk of material misstatement regardless of error or fraud (see Auditing Standard [AS] 15, Audit Evidence, par. 12).

Rechtman comments that I use the term auditor somewhat loosely in contrast to a fraud examiner. That is correct; my thesis is that public accountantswho are sanctioned; licensed; and provided legitimacy, autonomy, self-regulation, and certification by the publichave a responsibility to protect the public against fraud. As Nassim Taleb (author of The Black Swan) argues, fail early and fail often in a capitalistic society is far more beneficial or desirable than creating enterprises too big to fail (and ultimately too big to bail), with adverse effects that are felt for years. We have the responsibility to detect and uncover fraud, and to allow enterprises to fail early and often as a result. Rechtman argues that the fraud examinations cost-benefit analysis also differs from that of an audit, and is more expensive. I have argued that the added cost of an enhanced audit, the purpose of which is to uncover fraud and disclose systemic risk, is a small price to pay when compared to a crippled financial industry with a meltdown cost of $30 trillionand even this cost might be small compared to the loss of the publics trust in our auditors, our financial institutions, and our government regulators. (See Richard H. Kravitz, Socially Responsible Accounting: Protecting the Public Interest, The CPA Journal, November 2009.) Moreover, the cost of adding forensic techniques to financial audits is insignificant if, as a result, hidden or systemic risk is uncoveredwhether from off-balancesheet financing, credit default swaps, special purpose entities, repo 105 sales, or collateralized debt obligation (CDO) bundles. Federal backstopping of financial institutions under an emergency act dating from the Great Depression is not a substitute, nor is it desirable in a free and open democratic capitalist societynot when CPAs, as the largest independent observers of corporate behavior, have the tools, techniques, and leadership skills to protect the public against fraud.

When Strategic Concepts Meet Practical Realities

Richard H. Kravitz, MBA, CPA Founding director of Center for Socially Responsible Accounting Managing director of R H Kravitz and Company Island Park, N.Y.

homas Presslys article, Linking Strategic and Project Concepts to Enhance Management Advisory Services (July 2012) was an excellent overview of how to implement a project. Unlike many articles, it offered a step-by-step-approach, with all of the applicable templates for a successful project implementation. Being a CPA, a college instructor, and a six sigmacertified professional, I could relate very easily to all of the points that the author presented on what makes a project successful. Unfortunately, the one item not included in the article was the intention of the participants. Senior managements or employees intentions are usually not communicated to management consultants. They are usually very agreeable to change when it does not affect them, and they are usually very logical when plans are in a theoretical state. But when it actually comes into play, all bets are off. At this point, a persons more primal nature tends to come out, and instead of a coherent, successful project, implementation becomes a dysfunctional, failed project. This has been proven over and over again since CPAs became a licensed profession. It is very rarely a problem of not knowing what to do or not following templates that makes a project fail; the individuals performing the tasks are more than qualified to do that. The issue is the desire to make things better when it has a direct impact on a persons external or intrinsic needs. This problem is not limited to project plans; it is present even among members of a department working together. Well-run companies are now implementing the 10% rulethat is, 10% of employees are assessed every year based on performance evaluations. Companies human resources (HR) departments now direct supervisors on how to adjust evaluations so that it appears legal and proper that 10% of employees can be let go. This has no bearing on how competent or how diligently one tries to follow the template of being a good corporate citizen. The key premise that we are all in this together, which is the basis of project management, is a fallacyjust like the notion
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that Enron had fairly presented financial statements. In addition, because we live in an employment-at-will state [New York], a manger can lie in performance evaluations and get away with it. The HR manual has a disclaimer in it that it is not to be followed if the company so deems. Thus, the rules of conduct or behavior that employees desire has been replaced by profits at all costs; employees are rewarded based not on whether they work hard, but on the number of hours that they slave away at the company. Sadly, the templates that are used for successful implementation are a tease that has no bearing on the reality of the unforgiving business jungle that CPAs, along with many other Americans, find themselves in. I think a good place to start, with respect to a companys project, is to have a more

open mission statement. The companys role is to make money and employees role is to support itall the rest is mere commentary that does not much need to be adhered to. Larry Stack, CPA New York, N.Y.

The Author Responds

he context of my article was to introduce basic strategic and project procedural issues to those CPAs who are interested in becoming more actively involved in their clients business operations. Certainly, the general guidelines of the template presented must be adjusted in practice to meet specific purposes and clients needs. Stacks constructive comments improve the practical usefulness of my article for

CPAs working with independent clients. I believe that the issues he identified can be included in the early stages of negotiations with senior management during the development of a common mission statement, followed by specific mutually agreeable performance goals and measures in the strategic formulation stage, and subsequently reinforced with data retrieval and analysis in the project implementation and control phase. The incorporation of his insight of practical realities into the procedural framework of the article represents the kind of thoughtful dialogue that has made The CPA Journal such a genuine service to accounting practitioners. Thomas R. Pressly, PhD, CPA Penn State UniversityShenango Campus Sharon, Pa.

OCTOBER 2012 / THE CPA JOURNAL

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In Focus

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OCTOBER 2012 / THE CPA JOURNAL

Is Real Tax Reform Realistic?

The Election Season Raises a Familiar Question

T
Background

By Michael E. Roach and William G. Jens, Jr.

he concept of reforming the current tax code has gained traction in recent years. Every potential challenger in the present presidential campaign has offered a tax reform proposal as part of their platform. President Obama put forth his own Buffett Rule, spurred by an acknowledgement that one of the worlds richest men pays a lower tax rate than his secretary. The current economic climate and the election campaign season have gotten people thinking about the concept of fairness and equity within the existing tax code. The following discussion looks at some of the issues involved in reforming the present tax code and offers some insight as to the feasibility of significant tax reform, defined as more than just the periodic code revisions that happen regularly.

Because most of the calls for reform center on a desire for economic stimulus and parity, it is necessary to look at both corporate and personal taxes. The U. S. corporate income tax rate, a combination of both federal and state taxes, is one of the highest among members of the Organization for Economic Cooperation and Development (OECD), which comprises the worlds industrialized nations. But at the same time, U.S. corporate tax revenue as a percentage of GDP is well below the OECD average, in part because the U.S. tax code is full of deductions, credits, and exemptions. In addition, the United States is among a handful of countries that tries to tax multinational companies on their foreign earnings while allowing them to avoid these taxes by keeping these profits overseas. While the primary purpose of any countrys tax
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code is to raise sufficient revenues to fund government expenditures, a reasonable assumption would be that this process should not be detrimental to the countrys economic development. Personal tax reform is no less complex and confusing than corporate tax reform. Anyone filing more than a Form 1040EZ faces a plethora of forms, regulations, and requirements so complex that most surrender and seek professional help. Options to address this complexity include commercial electronic filing packages, such as TurboTax; professional preparers like H&R Block; or CPAs and tax attorneys specializing in tax return preparation. The Internal Revenue Code (IRC) even allows a deduction for the cost of preparing a tax return by allowing it as a business expense for businesses and as an itemized deduction for individuals, even though the tax code is so complex that most taxpayers do not realize that the individual deductions rarely produce tax savings. The IRC has become so complex that, in most instances, it can only be managed and interpreted by those who can afford to pay experts to chart their course through the maze of law and regulations. For this and other reasons that will be explained in further detail below, making a case for substantial revision to the present tax code is not difficult. Before changing it, however, it is important to have some understanding of how the present tax structure arose, including congressional intent.

U.S. Tax History

Income taxes were first constitutionally sanctioned by the ratification of the Sixteenth Amendment to the United States Constitution in 1913. Prior to this amendment, direct taxation was permitted by

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Article I of the Constitution (in particular, sections 2, 8, and 9). The Constitution provided that any direct taxes had to be apportioned among the various states based on census data and uniformly applied. Thus, while the concept of direct taxation has been with us since the countrys beginning, the taxes assessed were either a direct tax on property or a capitation tax, the most common of which was the poll tax. Prior to 1913, Congress had only imposed a direct tax on income during the Civil War (Ch.173, sec. 116, 13 Stat. 223, 281 [1864]), and again 30 years later when Congress imposed a 2% tax on any income in excess of $4,000 (Ch.349, sec. 27, 28 Stat. 509, 553 [1894], also known as the WilsonGorman Tariff). The assessment of income taxes in 1894 was constitutionally challenged on the basis that direct taxation was unconstitutional. The U.S. Supreme Court agreed with the assertion, and it held in the landmark case of Pollock v. Farmers Loan & Trust Co. (157 U.S. 429 [1895]; 158 U.S. 601 [1895]) that the taxes collected had to be apportioned according to the Constitution to the states based on the census. (It should be noted that most tax protestors rely on this case in order to assert that income taxes are unconstitutional.) The Court concluded that because the taxes were collected on income on various property (including salary, dividends, interest, rents), the income must be apportioned. As stated in Penn Mutual Indemnity Co. v. Commr (277 F.2d 16, 3rd Cir. [1960]), [Pollock] only held that a tax on the income derived from real or personal property was so close to a tax on that property that it could not be imposed without apportionment. As this proved to be administratively unfeasible, the Supreme Court ruled, in a divided opinion, that this form of taxation was unconstitutional. In the intervening years between Pollock and the passage of the Sixteenth Amendment, there were various attempts to continue some form of taxation by such means as revenue stamps (Nicol v. Ames, 173 US 509, 19 S. Ct. 522, 43 L. Ed. 786 [1899]), a war revenue tax on tobacco (Patton v. Brady, 184 US 608, 22 S. Ct. 493, 46 L. Ed. 713 [1902]), and an inheritance tax (Knowlton v. Moore, 178 US 41, 20 S. Ct. 747, 44 L. Ed. 969 [1900]). An expansion of excise taxes and tariffs was used in an attempt to collect revenue from U.S. taxpayers. Congress decided to allow

a direct form of taxation by constitutional amendment, which was originally proposed by President William Howard Taft and ratified by Congress four years later in 1909. With the passage of the Sixteenth Amendment, the limitation on direct taxes and the required apportionment ended, and the federal government was entitled to tax all income from all sources, with only minor exceptions (e.g., state and municipal interest). The tax code further evolved when the United States Supreme Court stated, Unquestionably Congress has power to condition, limit, or deny deductions from gross income in order to arrive at the net that it chooses to tax ( Helvering v. Independent Life Ins. Co., 292 U.S. 371, 381 [1934]). This congressional authority has resulted in what is arguably one of the most complex tax systems in the world.

ets. On the other hand, there were only two brackets from 1988 to 1991. The marginal income tax rate has varied from a low of 7% from 1913 to 1916 (the more recent low was 28% from 1988 to 1991) to a high of 94% in 1944 and 1945. These brackets and marginal rates have provided Congress with a constant source of adjustment and manipulation to allow it to achieve the desired tax impact.

Economic Tax Theories

There are three primary economic theories related to the impact of taxation on the individual taxpayer. The progressive tax system is based on taxing income at a higher marginal rate as a taxpayers income increases; thus, the more income one makes, the greater the tax burden. This approach is reflected in the tax tables used for calculation of individual and corporate taxation. While the tables represent a true progressive tax, the determination of taxable income prevents this system from being a true progressive tax (discussed below). The second theory is the regressive form of income taxation, stipulating that tax rates should stay the same irrespective of the level of income; as a person generates more income, the tax rate represents a lesser burden. The most common example of this is the sales tax. Whether a person earns $10,000 or $100,000, a $500 purchase with a 5% sales tax still results in a tax burden of $25 for each; however, this tax has a greater economic impact on the person making $10,000 because it represents a greater portion of his income. Many states have attempted to reduce this regressive nature by exempting food, pharmaceuticals, and other necessities from taxation. The third economic approach is the proportional tax, under which the tax rate is static but the amount to be taxed increases. In other words, the burden that each taxpayer pays is calculated in the same ratio as their property bears to the total of property to be taxed; the higher the value of an individuals property, the higher the tax bill, but all taxpayers are taxed at an equal tax rate. Most excise taxes fit this description. For example, tax on the use of diesel remains .244 per gallon for 2011, but this number is determined by the number of gallons used (Form 720, Quarterly Federal Excise Tax Return); thus, the tax is the same within its class, but as the volume of diesel increases, so does the tax burden. Another
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Identification of the inequities is the easy part. The desire to change them, however, is almost certainly going to be uneven.

The 1913 Revenue Act assessed all married taxpayers who made over $4,000 ($3,000 for single individuals) a normal 1% tax. In addition to this tax, there were six additional brackets with a maximum marginal tax rate of 7% (the 1% normal rate, plus an additional tax of up to 6% on all income over $500,000). Other than the exemption of income, there were no other offsets or deductions allowed. Since 1913, the income tax brackets have been expanded and contracted on numerous occasions. In nearly half of the years that the income tax has been in existence, there have been 24 or more separate tax brackets; from 1933 to 1935, there were an incredible 55 brack-

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example would be the assessment of real estate taxes. The millage remains the same, but as the value of property increases, so does the tax amount.

The U.S. Tax System

The U.S. tax system utilizes a hybrid format that applies various elements of the progressive, regressive, and proportional approaches. In certain circumstances, the tax application may be a hybrid format on the same tax. For example, payroll taxes are assessed on the first $110,100 of earned income. The first dollar of wages earned is assessed at 7.65% (currently 5.65% for the employee) and this continues in a regressive format until the upper limit is achieved. For an employee in the lower salary ranges, the tax operates as a regressive tax; the employee will have fewer dollars to consume, while paying the same proportionate tax as an employee with a higher salary. When the $110,100 salary level (6.2% of the total 7.65%) is achieved, the portion assigned to Social Security is capped, and only the remaining 1.45% related to Medicare continues to be assessed. This tax is a proportional tax, but it becomes a regressive tax once the upper limit is reached. A person with a salary of $1 million pays the same Social Security tax as an individual making $110,100. So even though the taxs regressive nature occurs at a higher rate, it is still regressive in nature. The U.S. tax system professes to adopt a progressive format as it pertains to the assessment of income taxes, estate taxes, and gift taxation. All of these forms of taxation utilize a rate schedule in which the tax rate increases as the amount to be taxed increases. But the facts suggest that this is not a truly progressive tax system, due to the existence of various tax incentives within the tax code.

Tax Incentives
Most tax incentives are designed to encourage taxpayers to undertake certain activities that they might not necessarily be normally inclined to do. Sometimes, the tax incentive is to encourage a taxpayer not to take some action. By rewarding behavior by allowing either a special deduction or tax credit, the federal government can encourage certain types of investments or social behaviors. The granting of tax incentives is not generally intended to be a revenueraising activity. Instead, such incentives rediOCTOBER 2012 / THE CPA JOURNAL

rect what would be normal government resources into other areas that the government does not want to directly fund. These incentives represent a waiver of normal tax rules and allow the government to direct the types of activities to be undertaken. Social considerations. Probably the best example of how the IRC provides tax incentives to encourage investment in areas that the government believes should be funded by the general public rather than by the government lies in the area of charitable giving. From a purely economic view, there is no rational reason to exempt the taxation of charitable organizations. (Please note that this article is not about the separation of church and state; the discussion is purely about possible sources of tax revenue.) Almost all charities have the same goal as any for-profit organizationnamely, to accomplish their stated mission by maximizing revenues and minimizing expenses. Such charities might, in fact, be as well organized and efficiently run as any Fortune 500 organization. Internal Revenue Code (IRC) section 501(c)3 specifies, however, that if certain charitable goalsreligious, charitable, scientific, public safety, literary, educational, amateur sports competition, promotion of the arts, or prevention of cruelty to children or animalsare achieved, then the entity will not be taxed on its gross receipts. There is an exception when the organization enters into direct competition with a for-profit organization (IRC section 511 on unrelated business income). The overall structure is such that charitable organizations pay no taxes on their primary fundraising activities. Therefore, the government does not receive any form of direct taxes from charitable organizations. The government further compounds this loss of revenue by allowing individual taxpayers several advantageous tax deductions for making contributions to these charitable organizations. For example, IRC section 170 allows individuals to deduct most contributions to a qualified IRC section 501(c)3 organization. In addition to allowing this tax deduction for direct contributions, the government offers a further tax incentive if a donation of stock or tangible personal property (used by the charity for a two-year period) is made to a charitable organization. The taxpayer receives a fair market value deduction rather than the original tax cost to the donor. As a result of this, the

appreciation difference between the taxpayers basis and the fair market value also escapes taxation. This form of donation has resulted in substantial tax benefits for individuals like Ted Turner and Bill and Melinda Gates when they donated stocks in their respective organizations to charitable foundations. The government does not tax the revenue and also allows a deduction for the same funding, thereby surrendering revenue on both sides of the transaction. The desire to achieve certain social considerations offers the only logical reason, from the standpoint of taxation, to enact any of these provisions. Economic considerations. In the Economic Recovery Act of 1981, depreciation on all fixed assets was substantially modified by the adoption of the Accelerated Cost Recovery System (ACRS, the precursor of MACRS). This tax act changed depreciation from a useful life concept with a salvage life computation to a mid-year convention using a double-declining balance methodology. Perhaps reflecting the times, ACRS reduced the depreciation on real property from a normal useful life of 3545 years to a flat 15 years. The committee reports and the underlying congressional debates contained discussions indicating that the reason for the change was that existing depreciation methods were not able to provide the investment stimuli necessary for economic expansion (Economic Recovery Act of 1981, section 201). More recently, Congress adopted the Housing and Economic Recovery Act of 2008 (P.L. 110-289), which granted first-time homeowners a $7,500 interest-free loan that could be paid back over 15 years. In addition, this act relaxed rules for mortgage lenders and increased the insurance on Federal Housing Administration (FHA) loans. Less than seven months later, Congress adopted the American Recovery and Reinvestment Act of 2009 (Public Law 111-5; better known as the Stimulus Act). A portion of this act allowed first-time homeowners a nonrefundable $8,000 credit for the purchase of a new home. While there may have been some slight social considerations (because it was limited to firsttime home buyers, the bill encouraged taxpayers that had not made a home purchase to do so), the primary purposeas set out in the House and Senate comments on the bill was to stimulate the housing market; thus, a

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tax benefit was granted for the sole reason of spurring the economy. Once again, there was absolutely no pure tax logic to this transaction, and it resulted in diminished federal resources. Credits and deductions. There are various types of tax incentives, including tax credits and deductions. A tax credit represents a dollar-for-dollar reduction of the taxpayers income tax liability, with some limitations. A deduction is allowed as an offset against the taxpayers revenue before the calculation of taxes owed. As stated previously, most of these factors include both social and economic factors, so in discussing tax incentives, the distinction is not critical. Special tax incentives available for businesses include several specialized accounting benefits such as LIFO (last-in, first-out accounting) and its related cousins. Other business incentives include IRC section 179; the immediate deduction for research and development costs, specialized accounting in many industries, such as the oil and gas business; international tax benefits, including outsourcing and offshore planning; and others. For any kind of tax reform or tax simplification to be considered, every deduction for business would have to be reevaluated. Other examples of business tax incentives would include the following: Low-income housing creditsto encourage investment in low income housing Qualified school construction credits to help schools rebuild and repair by the granting of a credit in lieu of interest Work opportunity creditstax rebates for those who hire high-unemployment groups Renewable energy creditsto encourage investment in alternative energy sources. (Form 3800, General Business Credit, lists over 25 different business credits; even this list is not comprehensive.) This same logic also applies on the state and local tax levels, when a government agency agrees to forego taxation (usually on real estate) in exchange for a business or organization to locate in a particular site or jurisdiction. These abatements are justified as providing both an economic and social boost, but at the cost of tax revenue. There are numerous other tax incentives in the area of individual taxation, including the earned income credit, the American opportunity tax credit (as well as lifetime learning and hope credits),

the residential energy-efficient property credit, the alternative motor vehicle credit, the elderly and disabled credit, the retirement savings credit, the adoption expenses credit, the child tax credit, the dependent care expense credit, the first-time homebuyers credit, the charitable contribution deduction, the mortgage interest deduction, the student loan interest deduction, and individual retirement accounts (SEP, Simple, IRA, Roth IRA, 401[K]). Many of the tax credits available to both businesses and individuals not only result in a loss of revenue to the government, but can also represent a negative cash flow because the credits might be refundable. For example, the earned income credit not only generates no tax revenue, but also

If the objective of a tax system is to be fair and equal to all, then several factors suggest that this is not currently being achieved.

refunds money to taxpayers who did not originally pay these funds to the government. This is not a waiver of tax; rather, it represents a negative tax. Credits like this represent a form of social welfare because, while they reward work effort, they lack the controls of food stamps or other forms of direct welfare. Like this credit, several of the other credits and deductions have a Robin Hood impact, reallocating resources from high-income taxpayers to lowincome taxpayers. In these situations, the governments purpose in foregoing tax

revenues through these tax advantages is to further social and economic goals as a means of implementing public policy. Stealth taxes. These disincentives arise from any action that creates an additional tax burden without being included in an actual tax law or tax change that fails to note that it results in a tax increase for certain classes of taxpayers. The most obvious example under the current tax structure is the alternative minimum tax (AMT). Inflation has always resulted in a kind of stealth tax increase through bracket creep, as inflation eroded the amount of consumable funds, while static tax brackets and rates caused taxpayers to suffer an effective tax increase even though their real income remained the same. But as tax rates, deductions, and other items are now generally indexed to inflation, this form of stealth taxation has been minimized. (It has not been totally eliminated, as the factors used for inflation adjustment do not always adjust to the actual inflation impact.) The AMT, however, has not been indexed for inflation, and so many middle-income taxpayers are increasingly subject to the AMT for the first time, a stealth increase. Stealth taxes can also include the movement of particular fundssuch as gasoline taxes collected from a road and highway fundinto a general fund. Whereas a married couple with two qualifying children can receive a tax credit equal to $2,000, a married couple with no children can receive a tax bill with no credit that is $2,000 higher; this can also be considered a stealth tax. Stealth taxes are not just limited to the lower brackets. There are many situations where a taxable deduction is phased out based on income. Some of the phaseouts include the child tax credit, excess itemized deductions, personal exemptions, IRA deductions, and others that are phased out for high-income individuals. These adjustments are not recognized as a tax increase. Penalty taxes. Penalty taxes exist to elicit certain behaviors from businesses or individuals through tax incentives or disincentives. Sometimes these taxes are assessed to curb consumption (such as limiting harmful emissions) or, alternatively, to help pay a social penalty for the potential harm that results from certain types of behavior; examples would include taxes on alcohol, tobacco, gasoline, and luxury items. These taxes garner an additional assessment above a basic sales tax.
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Traditional thinking on penalty taxes holds that the tax will be progressive in nature; quite often, the actual application has a tendency to be regressive in nature. In addition, some of these taxes may miss their mark: if there is a luxury tax on a boat and a prospective buyer decides not to buy because of the additional tax, the wealthy individual electing not to make the purchase does not suffer, but the potential seller is the one suffering the lost sale. The government doesnt only collect the revenue of the penalty tax; economic activity is negatively impacted as well, because the sale does not occur.

Prospects for Reform

During this election year, all the presidential political candidates have called for tax reform of one type or another. The question is whether the current system should indeed be reformed and whether implementing significant tax reform is indeed feasible. As noted above, the U.S. Tax Code has evolved over time, as Congress has used it to encourage or discourage certain economic and social behavior by individuals or businesses. As to whether reform is desirable, there is no simple answer. If the objective of a tax system is to be fair and equal to all, then several factors suggest that this is not currently being achieved. The present system favors people or companies who can afford to hire professional advisors with the expertise to interpret a tax code that exceeds 72,000 pages in length (not including regulations and other interpretations). The system requires billions of hours in preparation time, which engenders billions of dollars of deadweight costs. People like Mitt Romney and Warren Buffett have lower effective tax rates than those who work for them. Under the current system, almost half of the individuals earning income pay no tax at all. While these factors seemingly point to a lack of parity, there are other considerations. The tax rates that favor the Romneys and Buffetts exist, in part, to encourage them to take the kinds of risks that generate the commensurate rewards. Although the tax code has reached a level of complexity that discourages the average person from attempting a return without professional help, it has also created a significant closet industry that supports many professionals. Identification of the inequities is the easy part. The desire to change them, however, is
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almost certainly going to be uneven. If prior history is to be believed, any serious attempt to remove favored deductions will result in all sorts of protests. Change that would be viewed as favoring certain groups would probably result in an expansion of the class warfare that the present system has already engendered. The concept of tax reform might be desirable, but the reality of accomplishing it less so. To achieve a logical format of taxation, Congress would need to vote to remove all the social and economic factors from the IRC. The list of provisions this entails is substantial. Even if Congress agreed that this is a desirable goaland agreement has not been the watchword of the political environment in Washington recentlyit would require that Congress identify alternatives for accomplishing the kinds of behavior that the present tax system engenders or acknowledge that such objectives are no longer desirable. The deduction for charitable contributions is a case in point. By promoting the creation and underwriting of the funding of charities, the need for the government to step in and do good things is reduced.

Even if the political environment in Washington were to change, such that one party had sufficient control to enact its platform or both parties became willing to enact a compromise agenda, the issues involved are so far-reaching that the authors do not believe that substantive tax reform is a possible outcome. For that matter, it is equally difficult to believe that the majority of the electorate would approve of such a drastic revision because practically every taxpayer would be faced with the loss of some favored tax treatment in some form or another. For these reasons, the authors conclude that significant tax reform has no real chance of being implementedno matter the results of the upcoming elections. As a concept, this is probably going to be relegated to campaign rhetoric that surfaces every four years, only to disap pear until the next election cycle. Michael E. Roach, JD, is an instructor, and William G. Jens, Jr., PhD, is an assistant professor, both at McNeese State University, Lake Charles, La.

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C C O U N T I N G

& A accounting

U D I T I N G

A New Reality Ahead for Pension Accounting?

The Recessions Aftermath and IAS 19R Prompt Changes in Accounting Practices
By James M. Fornaro
he accounting for defined benefit pension plans has been the subject of contentious debate for nearly three decades. Disparate stakeholdersregulators, academics, analysts, investors, preparers, and othershave criticized the complex assumptions, arcane rules, and techniques used to minimize the inherent volatility of pension assets and obligations. Many claim that these practices produce an opaque and misleading portrayal of a sponsors true

T
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obligations and negatively impact the quality of reported earnings. Many companies that sponsor defined benefit plans have long advocated for the delayed recognition techniques and other mechanisms to reduce earnings volatility. In Statement of Financial Accounting Standards (SFAS) 87, Employers Accounting for Pensions (par. 177178), FASB acknowledged that particular conclusions on these issues were pragmatic and without conceptual basis. Most
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now agree that an overhaul of existing accounting practice is long overdue, and FASB is proceeding with a phased approach, in tandem with the International Accounting Standards Board (IASB). During 2010 and 2011, several prominent U.S. companies (AT&T, Verizon Communications, UPS, and others) changed their longstanding accounting practices from the delayed recognition of pension costs to a fair-value approach that now provides immediate recognition of most changes in plan assets and liabilities. These changes appear to be motivated by two key factors. First, plan sponsors experienced a significant buildup of unrecognized losses during the depths of the recession, which had a devastating impact on the health of such plans (particularly in 2008). The accounting changes resulted in retrospective adjustments to prioryear financial statements for these unrecognized net losses and eliminated a drag on future earnings. Second, recent revisions to International Accounting Standard (IAS) 19, Employee Benefits, will dramatically change existing practices used by companies reporting under International Financial Reporting Standards (IFRS). Essentially, IAS 19R (effective in 2013) will eliminate all delayed recognition mechanisms and require a fair-value approach to the recognition of changes in plan assets and liabilities. The most far-reaching change is that actuarial gains and losses will be immediately reported in other comprehensive income (OCI) and will no longer be amortized to earnings. Several U.S. companies have pointed to the fair-value approach under IAS 19R as support for their accounting changes. The following is an examination of emerging issues in U.S. GAAP and IFRS, with respect to defined benefit pension plans. First, an overview of existing accounting practices under U.S. GAAP and IAS 19 is provided, with a particular focus on delayed recognition mechanisms present in both sets of standards. Particular provisions of IAS 19R are discussed and contrasted with existing standards, along with consequences for U.S. companies if convergence with IFRS is achieved. Recent accounting changes by certain U.S. companies are examined, including likely motivations and related financial impact. Finally, a snapshot of the health of U.S.
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defined benefit pension plans is provided, along with strategies that may warrant consideration. In the near term, more U.S. companies with accumulated unrecognized losses will likely contemplate a change to a fair-value approach for pension accounting. Given FASBs commitment to convergence with IFRS, and despite the lack of a formal decision by the SEC regarding the timing or method of incorporating IFRS into the U.S. financial reporting system, U.S. companies should consider the impact of IAS 19R on their financial condition and future earnings.

cepts are largely applicable to other postretirement plans (e.g., medical).

U.S. GAAP: Net Periodic Pension Cost and Delayed Recognition Mechanisms
Accounting Standards Codification (ASC) 715-30-35 identifies the components of the net periodic cost of defined benefit pension plans. Below is a brief description of each component followed by the relevant provisions, where applicable, that permit delayed recognition or smoothing of costs over future periods. Service cost. This cost component represents the actuarial present value of benefits computed using the plans benefit formula related to services rendered by employees during the period. Interest cost. This cost component represents the increase in the projected benefit obligation (i.e., the actuarial present value of accrued benefits at a point in time) during the period, due to the passage of time. It is computed using a discount rate multiplied by the balance of the pension benefit obligation at the beginning of the period. This discount rate should reflect current prices of annuity contracts or rates on high-quality, fixed-income investments at which the pension benefits could be effectively settled at the measurement date. Return on plan assets. For a funded plan, the actual return on plan assets represents the difference between the fair value of plan assets at the end of the period and the fair value at the beginning of the period, adjusted for employer contributions and benefit payments made during the period; however, ASC 715-30 permits companies to smooth period-to-period fluctuations in plan assets by using the expected return on plan assets in computing net periodic pension cost. The expected return is used by most companies and is computed using two components. One is the expected long-term rate of return on plan assets, which reflects expectations of the average rate of earnings on existing plan assets, as well as related reinvestment rates. The second is the market-related value of plan assets, in which companies can use the fair value of plan assets or, more commonly, a calculated value that recognizes changes in fair value in a systematic and rational manner over not more than five years (ASC 713-30-20). For example, it can represent a moving aver-

Overview: Expense Recognition for Defined Benefit Plans

One of the overriding objectives of accounting for defined benefit pension plans, under both U.S. GAAP and IFRS, is to recognize compensation cost in the periods in which the eligible employee renders services. Inherent in this process is a benefit formula that provides the basis for determining the amount of payment to which a participant may be entitled, and a number of actuarial and other underlying assumptions about future events, including mortality, employee turnover, retirement date, changes in future compensation, and other factors. The long-term nature of defined benefit plans, coupled with a multitude of assumptions that are often beyond a sponsors control, can produce volatility in the reported annual cost of such plans. Moreover, retroactive plan amendments, revisions to underlying assumptions, and differences between actual experience and expectations can complicate the predictability of annual costs. In reaction to constituents concerns about these uncertainties, FASB incorporated provisions for the deferral or delayed recognition of particular changes in plan assets and liabilities. SFAS 87 (par. 85) describes the delayed recognition feature as a concept where certain changes in the pension obligation (including those resulting from plan amendments) and changes in the value of assets set aside to meet those obligations are not recognized as they occur but are recognized systematically and gradually over subsequent periods. These mechanisms are discussed below. Though this discussion is particular to defined benefit pensions, the con-

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age of fair values for up to five years based on the composition of the portfolio of plan assets. The difference between the actual and expected return on plan assets is also recognized as a gain or loss in accumulated OCI, and it is included in the amortization of gains and losses discussed below. Amortization of prior service cost (or credit). Plan amendments (or the initiation of a plan) generally provide increased benefits that are associated with employee services rendered in prior periods. This results in an immediate increase in the pension benefit obligation and an offsetting debit to OCI. Plan amendments can also reduce benefits and have the opposite effect. ASC 715-30-35 stipulates that prior service cost should be amortized over the remaining service period of participants expected to receive benefits under the plan. Other amortization approaches are permitted, depending upon whether plan participants are active or inactive when an amendment is made. A company is also permitted to choose a less complex approach that amortizes the cost of retroactive amendments more rapidly, provided that the method is used consistently and is

properly disclosed. ASC 715-30-35-16 precludes a policy of immediate recognition. Gain or loss. These represent changes in the value of either the projected benefit obligation or plan assets resulting from 1) differences between actuarial assumptions and actual experience, or 2) a change in actuarial assumptions (e.g., retirement age, mortality, employee turnover, discount rate). The difference between the actual and expected return on plan assets (noted above) is also included. Gains and losses are initially recognized in OCI. The cumulative amount of these gains and losses impact future net pension cost through an amortization process. ASC 715-30-35-24 requires that the minimum annual amortization of the net gain or loss be computed using the corridor approach. Amortization under the corridor approach is required if, as of the beginning of the year, that net gain or loss exceeds 10 percent of the greater of the projected benefit obligation or the market-related value of plan assets. If such an excess exists, the minimum amortization shall be that excess divided by the average remaining service period of active employees expected to receive benefits under the plan.

The corridor approach is used by most entities, and it often results in amortization over periods of 10 to 15 years. (A calculation of the minimum amortization using the corridor method is illustrated in Exhibit 1.) Alternative approaches are permitted including immediate recognition of gains and losses in annual defined benefit cost, or another systematic approach that amortizes gains and losses more rapidly than under the corridor approach, provided that the alternative is consistently used and is applied similarly to both gains and losses (ASC 715-30-35-20 and 25).

IAS 19 and Differences from U.S. GAAP

Under IAS 19, the annual expense of defined benefit plans consists of five main components. Two elementscurrent service cost and interest costhave equivalent counterparts under U.S. GAAP. The other three elements, existing delayed recognition provisions, and pertinent differences from U.S. GAAP are discussed below. Expected return on plan assets. This value is computed using an expected longterm rate of return, multiplied by the fair value of the plan assets. Unlike U.S. GAAP, however, use of the market-related value of plan assets to smooth asset gains and losses is not permitted. The difference between the actual and expected return on plan assets is an actuarial gain or loss (see below). Past service cost. Changes in past service costs (prior service costs under U.S. GAAP) from the initiation of a plan or a plan amendment are expensed immediately for fully vested employees and amortized into income on a straight-line basis over the remaining period for employees who are not vested. U.S. GAAP provides delayed recognition of both vested and nonvested benefits. Actuarial gains and losses. Similar to gains and losses under U.S. GAAP, actuarial gains and losses under IAS 19 include differences between actuarial assumptions and actual experience, changes in actuarial assumptions, and differences between the actual and expected return on plan assets. Entities are permitted to choose among three alternatives to recognize actuarial gains and losses to profit or loss. First, the corridor approach to amortization (similar to U.S. GAAP) may be used to delay
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EXHIBIT 1 Amortization of Gains and Losses: The Corridor Approach

Nanco Inc. sponsors a defined benefit pension plan that covers substantially all full-time employees. In computing the amortization of gains and losses for 2013, the company uses the corridor approach. The following information is available as of January 1, 2013 (all figures in thousands of dollars): Market-related value of plan assets (MRVA) Projected benefit obligation (PBO) Unrecognized net (gain) or loss in other comprehensive income Average remaining service life of active employees Amortization of net loss for 2013 is computed as follows: Greater of the MRVA or the PBO Corridor (10% $ 3,200,000) Unrecognized net loss as of January 1, 2013 Less corridor Excess over corridor Average remaining service life of active employees Amortization for 2013 included in defined benefit cost $ 2,500,000 3,200,000 750,000 10 years

$ 3,200,000 $ 320,000 $ 750,000 320,000 430,000 10 $ 43,000

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recognition until future periods. Second, any systematic method that results in faster recognition than the corridor approach is acceptable, including immediate recognition. A third alternativenot permitted under U.S. GAAPis to recognize all actuarial gains and losses in OCI in the period they occur, without subsequent amortization to the income statement. This alternative serves to reduce the volatility of defined benefit costs in the income statement, as compared to U.S. GAAP. IAS 19 does not require that the components of pension cost be reported as a

single net amount, as is required under U.S. GAAP. Accordingly, entities reporting under IFRS often report interest cost and the expected return on plan assets as financing costs on the income statement.

IAS 19R: A New Direction?

FASB and the IASB have comprehensive projects on their respective agendas concerning particular aspects of postretirement benefits. Phase 1 of FASBs project was completed in 2006 with the issuance of SFAS 158, Employers Accounting for Defined Benefit Pension

and Other Postretirement PlansAn Amendment of FASB Statements No. 87, 88, 106, and 132(R), which requires that the funded status of postretirement plans be recognized on the balance sheet. Meanwhile, the IASB agreed to address recognition, presentation, and disclosure issues in phase 1 of its agenda. Phase 1 of the IASBs project was concluded in June 2011 with the issuance of IAS 19R, which is effective beginning January 1, 2013 (early application permitted). FASB has indicated that the conclusions reached by the IASB will provide a

EXHIBIT 2 Summary of Delayed Recognition Provisions: U.S. GAAP, IAS 19, and IAS 19R
Delayed Recognition Provision Prior (Past) Service Cost

U.S. GAAP Vested and unvested benefits are generally amortized over the remaining service period of participants expected to receive benefits under the plan. Used to compute the expected return on plan assets. Represents either the fair value of plan assets, or a calculated value that permits gains and losses on plan assets to be smoothed for up to five years. Calculated as the expected long-term rate of return on plan assets, multiplied by the market-related value of plan assets.

IAS 19 (Present) Expensed immediately for employees who are vested. For nonvested employees, amortized on a straight-line basis over the remaining vesting period. Use of a calculated marketrelated value of plan assets is not permitted. The fair value of plan assets is used.

IAS 19 (Revised) Delayed recognition attributable to unvested benefits is eliminated. All past service costs are expensed in the period the plan is amended or curtailed. Use of a calculated marketrelated value of plan assets is not permitted. The fair value of plan assets is used.

Market-Related Value of Plan Assets

Expected Return on Plan Assets

Calculated as the expected long-term rate of return, multiplied by the fair value of plan assets.

Expected return on plan assets and interest cost on the pension benefit obligation have been eliminated. Interest on the net defined benefit liability or asset (using the discount rate) is introduced. Single Approach All actuarial gains and losses (i.e., remeasurements) are recorded in OCI in the period they occur, without subsequent amortization to profit or loss.

Gains and Losses

Permitted Alternatives Recognized in defined benefit cost under alternative approaches: Corridor approach Immediate recognition of all gains and losses Any other systematic method that results in faster amortization than under the corridor approach.

Permitted Alternatives Recognized in profit or loss using the same alternative approaches permitted under U.S. GAAP or Recognized in OCI in the period they occur, without subsequent amortization to profit or loss.

OCTOBER 2012 / THE CPA JOURNAL

27

roadmap for future changes to U.S. GAAP. At its August 29, 2007 meeting, FASB decided to leverage the IASBs work, and it indicated that once the IASB completed phase 1 of its project, it will consider whether adopting similar measurement requirements would improve reporting in the United States. The final step is a joint project to comprehensively reconsider the current accounting model for pensions and other postretirement benefits. IAS 19R eliminates the delayed recognition mechanisms, reconfigures the compo-

nents of defined benefit cost, and enhances disclosures concerning the characteristics and risks associated with defined benefit plans. Selected changes included in IAS 19R are briefly discussed below. Exhibit 2 compares the delayed recognition provisions under U.S. GAAP and IAS 19 as well as the changes in these practices included in IAS 19R.

New Components of Pension Cost

Net interest on the defined benefit liability or asset. IAS 19R eliminates the interest cost component and the expected

return on plan assets and introduces a single net interest component. This is calculated as the discount rate times the net defined benefit liability (if underfunded) or plan asset (if overfunded). Accordingly, net interest expense is recognized if the plan is underfunded or net interest income is recognized if the plan is overfunded. The IASB views the net pension liability (or asset) as the equivalent of an amount payable to (or receivable from) the plan. The elimination of the expected return on plan assets will result in higher annual

EXHIBIT 3 Changes in Accounting Practices for Defined Benefit Plans During 2010 and 2011: After-Tax Impact on Net Income for Selected U.S. Companies
Below are 10 companies that changed their pension accounting practices during 2010 and 2011. A brief description of the accounting change(s) and the impact on after-tax net income for the year of the change and three prior years are provided. The highlighted areas reveal the impact of 2008, when many corporate plans experienced significant unrecognized losses during the depths of the recession. All figures are in millions of dollars. After-Tax Increase (Decrease) in Net Income * Year of Change Company Name AT&T Inc. Honeywell International Inc. Verizon Communications Inc. Fortune Brands Home & Security Inc. Kaman Corporation PerkinElmer Inc. PolyOne Corporation Reynolds American Inc. United Parcel Service Inc. Windstream Corporation Year of Type of Change Change 2010 2010 2010 2011 2011 2011 2011 2011 2011 2011 1, 2 1, 3 1, 2 1, 3 1 1, 2 2 1, 3 1, 3 2 $ $ ($1,644) 57 $ 531 $ 2.4 ($ 39.3) ($ 45.3) $ 20 ($ 409) ($ 77.6) % Prior year $ % Two Years Prior Three Years Prior $ % (71%) 7% (23%) (4%) 116% (1%) (9%) 19% $ $5,081 $ 150 $1,691 ($ 57.8) $ 2.8 ($156.8) ($ 894) ($2,348) % 43% 6% 31% (9%) 8% (60%) (67%) (78%)

(8%) ($ 397) 26%

(3%) ($15,492) (120%) ($ 8,621) (134%) $ ($ ($ $ 2.9 7.6) 3.5) 7) 64

3% ($ 605) (28%) ($ 1,986) $1,243 34% 12% 2% 0% 1% 1%

($ 41.6) (693%) $ 6.6 5% ($ 2.7) (84%) $ 7.1 (21%) $ 1% $ 0 8

(7%) ($

($ 57.1) (45%)

$ 57.2

(10%) ($ 150) (31%) $ 1.9

(4%) ($ 184)

($241.1) (58%)

Notes: * After-tax amounts were determined from 10-K reports for each company. Impact for year of the change was determined from fourth-quarter earnings releases or other company sources. Percentage change is calculated as: change in net income net income as originally reported before the accounting change. The accounting changes fall into three main categories: 1. Changed from the use of a calculated market-related value of plan assets to fair value in the computation of the expected return on plan assets 2. Discontinued the use of the corridor approach (10% or other percentage) and immediately recognized all gains and losses 3. Continued the use of the corridor approach, but immediately recognized gains and losses in excess of the corridor

28

OCTOBER 2012 / THE CPA JOURNAL

expenses compared to U.S. GAAP and existing IAS 19 because the expected longterm rate of return on plan assets will be replaced with the lower discount rate. Past service cost. IAS 19R eliminates the delayed recognition for the unvested portion of past service costs and requires that all past service costs be recognized when a plan is amended or curtailed. Compared to U.S. GAAP and existing IAS 19, this change will increase the volatility of profit or loss for those companies with significant plan amendments. Actuarial gains and losses. As mentioned above, IAS 19R eliminates the corridor approach and other amortization alternatives. All actuarial gains and losses are immediately recognized in OCI and not amortized or recycled into income in subsequent periods. Accordingly, IAS 19R will result in greater volatility of OCI but will reduce volatility of profit or loss compared to U.S. companies and those companies that presently recognize profits or losses under IAS 19.

Presentation of Defined Benefit Cost

IAS 19R introduces changes in terminology and definitions that impact financial statement presentation; however, it does not require that net pension cost be reported as a single component on the income statement, but suggests that presentation be consistent with prior practice (par. BC201). Defined benefit cost will consist of three components: Service cost. This component consists of current-period service cost, past service costs, and certain gains and losses on nonroutine plan curtailments. It is reported in profit or loss. Net interest on the net defined benefit liability (asset). The component (discussed above) is also reported in profit or loss. Remeasurements of the net defined benefit liability (asset). This component primarily includes 1) actuarial gains and losses on the defined benefit obligation, and 2) the difference between the actual return on plan assets and the interest income included in the net interest component. It is reported in OCI.

Changes by U.S. Companies: Motivations and Financial Impact

Under U.S. GAAP, companies may elect to change certain existing practices
OCTOBER 2012 / THE CPA JOURNAL

related to the delayed recognition provisions of defined benefit costs. One option is to change the method used to determine the market-related value of plan assets by smoothing asset gains and losses over a period shorter than five years, or by changing from a calculated value to the fair value of plan assets. Entities may also elect to change from the corridor approach to a policy that accelerates the amortization of gains and losses. Examples include changing the size of the corridor (e.g., from 10% to 5%), recognizing all gains and losses in excess of the corridor, or eliminating the corridor completely and immediately recognizing all gains and losses in the year they occur. Each represents a change in accounting principle under ASC Topic 250, Accounting Changes and Error Corrections, and requires retrospective application of the new method to all prior years. A preferability letter from the external auditors is also required. During 2010 and 2011, certain U.S. companies changed their longstanding accounting policies related to the recognition of defined benefit costs. Each company had employed some variant of the delayed recognition provisions related to gains and losses. One key factor prompting these changes appears to have been the desire to eliminate the precarious accumulation of unrecognized losses experienced in 2008 during the depths of the recession and to avoid the related drag on future earnings. For example, AT&T Inc. implemented the following two accounting changes at the end of 2010: it discontinued use of the corridor method and the use of a calculated market-related fair value in order to smooth asset gains and losses and to compute the expected return on plan assets. The company adopted a fair value approach to immediately recognize all gains and losses in the income statement. The after-tax impact of the changes amounted to a $1.64 billion (8%) reduction in net income for the year ended December 31, 2010. In accordance with ASC 250, prior-year financial statements were also retrospectively adjusted to reflect the impact of the change. The previously reported net income for 2008 was reduced by $15.5 billion (120%). Verizon Communications Inc. reported accounting changes in 2010 similar to those adopted by AT&T; however, the after-tax amount of the change for the year ending

December 31, 2010, amounted to a $531 million (26%) increase in net income, compared to previous accounting practices. Prior-year financial statements were retrospectively adjusted, with a reduction in previously reported net income for 2008 of $8.6 billion (134%). Honeywell Inc.s management noted that its accounting practices were more conservative than its peers. Previously, Honeywell had smoothed asset gains and losses over three years (compared to five years for most companies) using a calculated market-related fair value of plan assets. Gains and losses in excess of the corridor were previously amortized over a shorter period of six years. Though Honeywell discontinued the smoothing of asset gains and losses using a marketrelated fair value of plan assets, the company elected to retain the 10% corridor but immediately recognize gains and losses in excess of the corridor each year. On a retrospective basis, the reduction in after-tax net income totaled $605 million (28%) for 2009 and approximately $2 billion (71%) for

29

2008. Other companies that also changed their pension accounting practices during 2011 included Reynolds American Inc. and United Parcel Service Inc. Exhibit 3 includes a sample list of companies, the changes made, and the impact to previously reported net income. In corporate announcements, press releases, and investor presentations, the management of such companies explained the nature of the accounting changes and the impact on financial results. The following were common themes in their rationales: Existing accounting practices are simplified. Accounting is now better aligned with preferable fair value concepts. Gains and losses due to market fluctuations are recognized in the period they arise. Expense recognition is better aligned with current market returns, interest rates, and actuarial assumptions. There is consistency with new international accounting standards. Current period results have improved transparency. There is no impact to cash flows, plan funding, employee benefits, or dividend policy. There is minimal impact to the balance sheet. The change is reflected as a reduction in retained earnings and an increase to accumulated OCI. Some corporate announcements referred to the fair value approach in IAS 19R in their explanations. In its press release announcing the change, Honeywell noted that independent auditors have agreed as to the preferability of this change, and importantly International Financial Reporting Standards (IFRS) utilize a MTM [mark-to-market] methodology for pension accounting (November 16, 2010). Similarly, in an analyst call to explain the accounting change, Verizon CFO Francis J. Shammo indicated: This is actually a preferable accounting method and one that aligns with the fair value accounting concepts and current IFRS proposals (January 21, 2011). The benefits of these changes, however, must be weighed against concomitant risks. The predictability of annual defined benefit cost from existing smoothing techniques will be replaced with increased volatility in earnings and added difficulty in accurately forecasting future results. In

fact, during several investor conference calls held by companies to explain their recent pension accounting changes, analysts appeared to be more interested in the impact on forecast accuracy and the risk of surprises, since the fair value adjustments for gains and losses will be reported only in the fourth quarter of the year.

calculated market-related value of plan assets and the corridor method will have a negative impact on earnings for years to come.

Whats Ahead?
The recent accounting changes and revisions to IAS 19 have provided U.S. companies with a preview of the challenges ahead. Some may view this as an opportunity to eliminate the overhang of unrecognized losses and the drag on future earnings. But the risks of increased volatility in earnings and forecasting difficulties should not be dismissed. Now is the time to examine long-term strategies. Although the SEC final staff report (Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers, issued July 13, 2012) does not clarify the timing or method of incorporating IFRS into U.S. GAAP, U.S. companies should consider the impact of IAS 19R on their financial condition and future earnings. IAS 19R will likely reduce volatility in earnings, but increase volatility in OCI. Moreover, the elimination of the expected return on plan assets will likely increase defined benefit costs, because returns in excess of the discount rate will be reported in OCInot earnings. Current investment strategies to support a higher long-term rate of return could warrant a shift away from equities and riskier assets to a portfolio better matched to the plans liabilities. Finally, companies anticipating future plan amendments should also consider the immediate recognition of vested and unvested benefits, as provided in IAS 19R. Overall, the movement toward a fair value model and away from delayed recognition represents a major step toward improving accounting practices that have lingered for the past 25 years. But it does not settle the broader issue concerning the measurement of defined benefit costs, which represents the next step for FASB and the IASB in their long-term effort to overhaul pension accounting practices. James M. Fornaro, DPS, CPA, CMA, CFE, is an associate professor in the department of accounting, taxation, and business law at SUNY at Old Westbury, Old Westbury, N.Y.
OCTOBER 2012 / THE CPA JOURNAL

The Economic Crisis and its Aftermath

Standard & Poors (S&P) reported that defined benefit pension plans for companies in the S&P 500 were overfunded by $63.4 billion at the end of 2007that is, before the global economic crisis hit (S&P 500 2011: Pension and Other PostEmployment Benefits, July 2012). Since then, the recession and other factors have had a devastating impact on the health of corporate pension plans. The S&P 500 index had a negative total return of 37% in 2008, and the pension plans of S&P 500 companies experienced (on average) a 43% gap between expected and actual returns. Total plan assets declined by 26.9%, or approximately $400 billion, contributing to a record underfunding of $308.4 billion at the end of 2008. The S&P 500 index rebounded with total returns of 26.5% in 2009 and 15.1% in 2010, but these gains were on a significantly lower asset base. Further complicating this situation is that the historically low interest rate environment has resulted in a drop in the average discount rates used to measure pension liabilities, from 6.3% in 2008, to 5.8% in 2009, and 5.3% in 2010. Unfortunately, lower discount rates serve to increase the present value of existing pension liabilities, generate additional unrealized losses, and exacerbate the funded status of plans. At the end of 2010, the pension plans of S&P 500 companies had an aggregate underfunding of $245 billion. During 2011, a further decline in the average discount rate to 4.7%, coupled with a meager total return of 2.1% for the S&P 500 index, helped increase aggregate pension underfunding to a record $354.7 billion. Accordingly, higher future pension contributions will be necessary, either from existing resources or additional borrowing. These economic results present a unique situation for companies with defined benefit pension plans. Moreover, given the significant overhang of unrecognized losses from prior years, the continued use of the

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C C O U N T I N G

& A auditing

U D I T I N G

Audit Fee Patterns of Big Four and NonBig Four Firms

A Study of the Potential Effects of Auditing Standard 5
By H. Leon Chan, David G. DeBoskey, and Kevin Hee Overview
This empirical examination focused on the following two questions: What has been the overall impact of AS 5 on the audit fee behavior of nonBig Four and Big Four audit firms? In their November 2009 article, Aloke Ghosh and Robert Pawlewicz documented that the Big Four increased audit fees by 42% more than nonBig Four firms (The Impact of Regulation on Auditor Fees: Evidence from the Sarbanes-Oxley Act [SOX], Auditing: A Journal of Practice & Theory, vol. 28, no. 2, pp. 171197). The authors suggested that during the post-SOX era (the AS 2 period) the Big Four were subjected to a disproportionately greater exposure to litigation risk. They also found that only the nonBig Four firms continued to discount fees on initial engagements in order to attract new clients in the post-SOX years. In addition, Ghosh and Pawlewicz suggested that their findings were consistent with arguments that competition for new clients among the Big Four is low and that client turnover for the Big Four is relatively low. To date, however, it is unclear how this pattern of audit fees could have changed following the passage of AS 5. The following is a detailed analysis of audit and nonaudit fee data since 2003 for Big Four and nonBig Four audit firms. Moreover, the sections below address why the cost-savings trends anticipated by AS 5 might have a different trajectory for Big Four and nonBig Four audit firms. The analysis reveals at least three practical implications for policy makers, clients of audit firms, and the audit firms themselves.

he PCAOBs replacement in November 2007 of Auditing Standard (AS) 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction with an Audit of Financial Statements, with AS 5, An Audit of Internal Control Over Financial Reporting That Is Integrated with an Audit of Financial Statements, created an interesting opportunity to explore the longerterm impact of AS 5 on the characteristics of Big Four and nonBig Four audit fees. Has AS 5 had the same impact on the audit fees charged by both types of audit firms? How can the differences in the fee trends be interpreted by policy makers, clients, and firm management? In recent years, BDO Seidman, Grant Thornton, and other nonBig Four firms have gained market share in the auditing services market for small and medium-sized public companies. Thus, there is a greater need for information concerning relative auditor quality among the nonBig Four. In particular, there has been little focus on the audit fee trends of nonBig Four firms, which provides additional motivation for examining the impact of AS 5 on the behavior of nonBig Four firms, as well as the Big Four, with respect to audit fees. The following is a comparison of the audit fee trends of both Big Four and nonBig Four audit firms, and it reveals similarities and differences in the audit fee behavior of these firms. Policy makers should be interested in the data showing the long-term effects of auditing standards. In addition, the discussion below contains information that is relevant to management at both small and large companies who might find the results useful in negotiating audit fees in the future.

Does the resultant change in audit fees apply equally to Big Four and nonBig Four auditors? These questions have been left largely unanswered in practitioner-focused publications. Although recent studies have pointed to a reduction in audit fees following the implementation of AS 5, the longerterm impact on audit fees has remained mostly undocumented. In their April 2009 article, Wei Jiang and Jia Wu demonstrated only a small increase in audit fees in the postAS 5 era (The Impact of PCAOB Auditing Standard 5 on Audit Fees, The CPA Journal, pp. 3438). The authors indicated that this finding was significant because audit fees tended to rise at a relatively steady pace. This implies that AS 5 had an impact on reducing actual audit costs in the first year of its adoption. A review of the most recent data indicates that the favorable trend in audit fees has continued in earnest through 2011.

Data Sources and Variable Measures

The sample below was drawn from the Audit Analytics database (www.audit
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32

analytics.com) and included all firms with information on audit and nonaudit fee data from 2002 to 2011 (although 2011 only includes partial-year observations). The audit fee variable captures both audit fees and other fees related to an audit. (For further clarification on the distinction and definitions of the various types of audit fees, see Jiang and Wu 2009.) For the purposes of this analysis, audit fees are categorized as follows: Audit fees Audit-related fees Other fees (i.e., nonaudit services other than tax) Tax fees. Annual audit fees are calculated as the average audit fees for each year in the sample. The total fees represent the mean of total audit fees (including audit and nonaudit) over all firms in each year included in the sample. Finally, abnormal audit fees are calculated as the mean of the difference between average annual audit fees each year and a three-year moving average (where available) of annual audit fees for each firm in the sample.

Nonaudit Fee Data Analysis

Ever since regulators expressed concern over the possibility that auditors independence is impaired when they also provide nonaudit services to clients (see The Numbers Game, by Arthur Levitt,

The CPA Journal, December 1998), the effect of nonaudit fees on audit quality has been examined closely. Although prior research findings have been mixed, many believe that audit quality will always be somewhat suspect if other services are provided (Jere R. Francis, What Do We Know About Audit Quality? The British Accounting Review, vol. 36, no. 4, pp. 345368). Thus, it is not surprising to find that auditors have scaled back the scope of nonaudit services in the post-SOX period. As Exhibit 1 demonstrates, the overall trend in the ratio of nonaudit fees to total fees has significantly decreased, from 46.4% in 2002 to 18.4% in 2011. The authors attribute this decline to SOX and subsequent SEC regulations that greatly restricted the provision of nonaudit services by a firms auditor. While the overall trend in the ratio of nonaudit fees to total fees has decreased for both Big Four firms and nonBig Four firms, average annual nonaudit fees have increased 7.49% for nonBig Four firms and have decreased 14.92% for Big Four firms. The authors suggest the following two plausible explanations for this phenomenon: Big Four auditors are more likely than nonBig Four auditors to be concerned about a loss of reputation and litigation exposure; therefore, the Big Four are more willing to reduce economic bonding with

their clients through the provision of nonaudit services. This argument is consistent with the findings of Chee-Yeow Lim and Hun-Tong Tan (Non-Audit Service Fees and Audit Quality: The Impact of Auditor Specialization, Journal of Accounting Research, vol. 46, 2008, pp. 199246) that the effect of nonaudit services on audit quality depends upon auditor industry specialization. NonBig Four firms are more likely than Big Four firms to be asked by their small to medium-sized clients to provide nonaudit services in order to meet the SOX requirements because nonBig Four auditors have superior knowledge of local markets and better relation with their clients (Louis Henock, Acquirers Abnormal Returns and the NonBig Four Auditor Clientele Effect, Journal of Accounting and Economics, vol. 40, no. 3, pp. 7599).

Audit Fee Data Analysis:

Big Four versus nonBig Four firms. Exhibit 2, Exhibit 3, and Exhibit 4 depict the trends in fees charged by audit firms during the sample period. The exhibits clearly illustrate that average annual total fees (audit and nonaudit) and average audit fees have declined from 2007 (well documented in prior studies) through 2011 (new information not previously documented). The decline in audit fees between 2007 and 2011 is most likely due to the implemen-

EXHIBIT 1 Nonaudit Fees as a Percentage of Total Fees

90.0% 80.0% 70.0%

59.0%

71.6%

77.6%

79.5%

78.4%

79.6%

80.2%

79.0%

81.6%

60.0% 50.0% 40.0% 30.0%

46.4% 53.6% 41.0% 28.1%

20.0% 10.0% 00.0% 2002 2003 2004

22.4%

20.5%

21.6%

20.4%

19.8%

21.0%

18.4%

2005

2006

2007

2008

2009

2010

2011

Ratio of nonaudit fees to total fees

Average annual non-audit fees

OCTOBER 2012 / THE CPA JOURNAL

33

tation of AS 5. The reduction of average audit fees by the Big Four during the AS 5 period has actually brought the average back to the pre-SOX (2002) level. This decline in fees from 2007 to 2011, however, appears to take on a different meaning for nonBig Four firms. This is important because prior research (Jiang and Wu) implied that these audit fee decrements would most likely continue as auditors became more comfortable with the risk-based, top-down approach. The authors updated data set indicates that these declines in audit fees have continued

through 2011; however, the change in average annual audit fees seems to have slowed dramatically for nonBig Four firms since 2009. AS 5s impact on audit fees found in academic research appears to be driven by Big Four clients (Exhibit 3), as opposed to nonBig Four clients (Exhibit 4). Exhibit 3 clearly shows a decreasing trend in audit fees paid by Big Four clients, compared to the relatively flat trend in fees paid by nonBig Four audit clients. Given the relative size of the Big Four firms, it is expected that

they will drive the overall audit fee trend; thus, this analysis also includes the percentage change in audit fees over the sample period to allow for a more informative comparison. Exhibit 5 provides a comparison of the year-to-year percentage change in audit fees for Big Four firms and nonBig Four audit firms. Specifically, Big Four firms started to reduce their audit fees in 2007 by 3.76%, and the passage of AS 5 helped to further reduce their fees in 2008 and 2009 by 4.27% and 13.54%, respectively. In addition, nonaudit fees, as a percent-

EXHIBIT 2 Total Average Annual Fee Trends (Big Four and NonBig Four)
$2,500 $2,000 $1,500 $1,000 $500 $0 $(500) 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Audit Fees ($000s)

Abnormal Audit Fees ($000s)

Nonaudit Fees ($000s)

Total Fees ($000s)

EXHIBIT 3 Total Average (Big Four) Annual Audit Fee Trends

$2,500 $2,000 $1,500 $1,000 $500 $0 2002 $(500)
Audit Fees ($000s) Nonaudit Fees ($000s) Abnormal Audit Fees ($000s) Total Fees ($000s)

2003

2004

2005

2006

2007

2008

2009

2010

2011

34

OCTOBER 2012 / THE CPA JOURNAL

age of total fees, have been relatively flat since 2004. From 2002 to 2008, audit firms charged higher-than-expected (i.e., abnormal) audit fees (based on a three-year moving average). In 2009, however, abnormal audit fees decreased below zero; this implied that, compared to prior years, audit firms were charging less than expected. Furthermore, the ratio of audit fees to clients sales revenuea measure of audit efficiencyincreased by 13% for Big Four firms and 8.85% for nonBig Four firms from 2007 to 2010. This indicates that both Big Four and nonBig Four firms were able to perform audits more efficiently in the AS 5 era. Lee Duran, a managing partner at BDOs San Diego office, has proffered that potential pricing pressure, leading to both Big Four and nonBig Four firms charging lower overall audit fees to gain client share, is the main driver behind this trend (November 2011). NonBig Four firms. As previously noted, although the audit fee trend for the overall sample is driven by the Big Four mostly due to the differences in scalethe impact of AS 5 on nonBig Four firms is still extremely important, given their smaller size and the importance for these firms to control audit costs. In addition, in a nontabulated analysis, the authors calculated that the percentage of all audited companies in the sample with nonBig Four auditors increased from 13.7% in 2003 to 39.5% in 2011, while the percentage with Big Four auditors correspondingly declined from 86.3% to 60.5%. Based on these

numbers, one could argue that any changes in audit standards is of increasing importance for these smaller audit firms that are gaining more clients. Exhibit 4 shows the significant increases in audit fees from 2003 to 2006 (post-SOX, preAS 5 era); this trend continued into the beginning of the AS 5 era. Exhibit 5 provides the quantitative support for the graphical trends portrayed in Exhibits 24. Specifically, the nonBig Four firms increased their audit fees in 2007 and 2008 by 21.03% and 15.15%, respectively, and only started to reduce their fees in 2009 by 1.10%. (The average client size, proxied by total assets and market capitalization, of the nonBig Four firms increased by 1.3% in 2008 and decreased by 13.2% in 2009; the decrease in average audit fees in 2009 might have been affected by economic factors and the size of clients.) This could lend itself to an interpretation that AS 5 has had less of an impact on nonBig Four audit fees than Big Four audit fees. The authors speculate that the nonBig Four firms might follow a more prescriptive approach than the Big Four, leading to fewer opportunities to benefit from economies of scale. Until 2007, the growth in annual audit fees paid by nonBig Four clients had been stronger; from 2007 to 2009, nonBig Four audit fees have declined at a slower pace. Finally, both Big Four and nonBig Four firms have been charging lower audit fees than expected since 2009. Although the

exact causes of this trend cannot be certain, the authors speculate that downward pricing pressures for both large and small audit firms is a major contributing factor. Moreover, 2008 marked the beginning of the financial crisis; it is possible that pricing power was limited during these tight economic times.

Implications
SOX and the resulting AS 2 standard have been controversial ever since their initial implementation. Much of that controversy has focused on the increased financial burden felt by the companies that had to deal with the new financial reporting requirements that accompanied the legislation. In response, the PCAOB implemented AS 5, with a focus on a more customized audit that could potentially ease the burden on smaller companies that did not require many of the audit processes called for under AS 2. While existing research on AS 5 has found that audit fees, decreased in the first several years of implementation, there has been little to no research on the current effects of AS 5 on audit fees, now that companies have had enough time to get comfortable with its requirements (i.e., five fiscal years have passed since 2007). Undoubtedly, the use of nonBig Four auditors is pervasive, and many private and smaller public companies employ the auditing expertise of these firms; thus, the impact of AS 5 on the audit fees for nonBig Four auditors can shed light on

EXHIBIT 4 Total Average (NonBig Four) Annual Audit Fee Trends

$70 $60 $50 $40 $30 $20 $10 $0 $(10)

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Audit Fees ($000s) Nonaudit Fees ($000s)

Abnormal Audit Fees ($000s) Total Fees ($000s)

OCTOBER 2012 / THE CPA JOURNAL

35

the differential impact AS 5 has had on larger versus smaller audit firms. This is particularly important because AS 5 was created in direct response to the complaints by smaller companies that the costs of SOX and AS 2 were too high; most smaller companies employ a nonBig Four auditor to attest their financial statements and internal controls. The findings show that there has certainly been a change in the trend in audit fees charged by both Big Four firms and nonBig Four firms during the switch from the AS 2 era to the AS 5 era. Most notably, nonBig Four audit fees have remained mostly flat over the last three years, after steadily increasing since 2002; audit fees for the Big Four, on the other hand, have steadily decreased since 2007. One plausible explanation for these trends is that AS 5 emphasized the need to customize audits and make audits less prescriptive in order to better fit the specific characteristics of the company being audited. Given the economies of scale and resources available to the Big Four, these auditors might have been able to adjust their

audits more quickly and decrease fees when compared to the nonBig Four audit firms. But this potential explanation requires additional research, because one could also argue that the trends should be attributed to the systematic differences between clients. Although prior research suggests that the competition for new clients and client turnover among Big Four firms is relatively low, the results of this analysis suggest that AS 5 and the economic environment might change the Big Fours pricing behavior. It seems that, from 2008 to 2011, the Big Four reduced average audit fees by 12.43% annually. While these findings provide preliminary evidence of some type of pricing pressure, it should be noted that the decrease in audit fees for Big Four firms during the sample period could have resulted from factors beyond pricing pressure from nonBig Four firms (e.g., macroeconomic factors, less negotiating leverage, stronger internal controls across the board, more efficient audits). In any event, it appears that nonBig Four audit fees have stabilized, and management should

take these market-wide audit fee trends into consideration during audit price negotiations with their auditors. For now, AS 5 appears to have curtailed the unbridled audit fee increases during the post-SOX and postAS 2 eras. The implications of the data extend to all companies in the midst of their audit fee negotiations and should provide a platform from which to understand the latest audit fee trends. In addition, policy makers should bear in mind that audit standards and regulations have a different impact on Big Four firms and nonBig Four firms; therefore, they should adopt a balanced approach when setting such standards. H. Leon Chan, PhD, is an assistant professor; David G. DeBoskey, PhD, CPA (N.J. inactive), is an assistant professor and KPMG Faculty Fellow; and Kevin Hee, PhD, CPA, is an assistant professor, all in the Charles W. Lamden School of Accountancy, San Diego State University, San Diego, Calif.

EXHIBIT 5 Annual Percentage Changes in Fees

Comparison of year-to-year change in total fees (includes audit and nonaudit fees): 2003 2004 2005 2006 2007 2008 Overall -- 13.11% 26.78% -- 0.49% 2.21% -- 1.68% -- 5.19% Big Four -- 13.26% 26.46% -- 1.10% 1.68% -- 2.17% -- 5.79% NonBig Four 4.83% 57.69% 47.09% 2.21% 18.20% -- 5.19% Comparison of year-to-year change in audit fees: 2003 2004 2005 Overall 10.49% 54.68% 7.33% Big Four 10.44% 54.52% 6.69% NonBig Four 14.78% 68.05% 54.19% Comparison of year-to-year change in nonaudit fees: 2003 2004 2005 Overall -- 33.51% -- 13.32% -- 20.57% Big Four -- 33.62% -- 13.62% -- 21.03% NonBig Four -- 14.51% 30.65% 23.26%

2009 -- 13.66% -- 0.92% -- 13.66%

2010 -- 2.59% -- 2.76% -- 2.59%

2011 -- 28.82% -- 30.01% -- 1.31%

2006 4.77% 4.14% 36.42%

2007 -- 3.13% -- 3.76% 21.03%

2008 -- 3.65% -- 4.27% 15.15%

2009 -- 13.07% -- 13.54% -- 1.10%

2010 -- 4.03% -- 4.22% 0.32%

2011 -- 26.47% -- 27.68% -- 0.96%

2006 -- 6.66% -- 6.82% 3.34%

2007 3.96% 3.99% 2.53%

2008 -- 10.78% -- 11.26% 15.84%

2009 -- 15.99% -- 16.37% 0.20%

2010 3.24% 3.07% 9.47%

2011 -- 37.64% -- 38.66% -- 3.39%

Audit fees scaled by millions of dollars in client revenue, year-to-year: 2003 2004 2005 2006 Overall 353 480 496 504 Big Four 355 481 500 514 NonBig Four 1,308 1,690 1,696 1,751

2007 461 472 1,764

2008 457 465 1,535

2009 483 480 1,873

2010 415 411 1,608

2011 237 199 1,084

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OCTOBER 2012 / THE CPA JOURNAL

C C O U N T I N G

& A U D financial reporting

I T I N G

Disclosures on Derivatives and Hedging Transactions

A Review of Best Practices
By Ira G. Kawaller
ASBs disclosure requirements provide a fair amount of detail about derivatives and hedging transactions; yet, despite efforts by auditors to comply with them, readers of financial statements often find that these disclosures are not entirely satisfying. Some of the required information might be presented in a manner that is misleading or confusing. Perhaps more importantly, the discussion might fail to appropriately or adequately describe the nature or scale of the activities under consideration. The best practices described below can make disclosures on derivatives and hedging transactions more helpful to financial statement users. related hedged items reported in the income statement or balance sheet Identification of effective versus ineffective outcomes, as well as components of results that had been excluded from consideration of hedge effectiveness The net gain or loss recognized in earnings when a firm commitment no longer qualifies as a hedged item in a fair value hedge For cash flow hedges, a description of the conditions that will result in the reclassification of accumulated other comprehensive income (AOCI) into earnings and a schedule of the estimated reclassification expected in the next 12 months For cash flow hedges, except hedges of variable interest rate exposures, the maximum length of time that hedging is anticipated The amount reclassified into earnings as a result of discontinued cash flow hedges because associated forecasted transactions are no longer probable. Not all of this list is straightforward and unambiguous. Two of the preceding points are particularly prone to misinterpretationthe requirements relating to the disclosures of ineffective earnings and prospective reclassifications. One of the critical preconditions for hedge accounting to be applied is that hedges have to be shown to be highly effective in offsetting the effects of the risks being hedged. If these offsets dont occur with sufficient closeness, hedge accounting is simply disallowed. Presumably, if the high-effectiveness hurdle has been satisfied, these impacts on ineffective earnings would be of a relatively minor magnitude. The amount of ineffective earnings is a specific disclosure requirement; however, the value of this disclosure is questionable. How should readers of the financial statements interpret this disclosure? One of the two following assumptions could be made: Ineffective earnings could simply reflect a transitory hiccup in a reasonably robust hedge relationship, in which case the ineffectiveness recorded in the current period would likely be reversed in subsequent periods. Ineffective earnings could be an indicator of things to come. Without added discussion by preparers, readers might not know which interpretation is correct. Unfortunately, even the hedging entity might not have a clue as to whether the ineffectiveness is temporary or permanent. Given this inherent uncertainty and the fact that the magnitude of the ineffectiveness is necessarily constrained, why bother with this disclosure, aside from the obvious fact that its mandated? The prospect of the disclosure providing any information of value is limited, while simultaneously opening the door for mis-

Disclosure Pitfalls
U.S. GAAP requires a host of disclosures related to derivatives, irrespective of 1) the type of derivative, 2) whether it is used for hedging or speculative purposes, and 3) the type of accounting treatment appliedfor example, nonhedge accounting, cash flow hedge accounting, fair value hedging, or hedges of net investments of foreign investments. The following nonexhaustive list highlights the disclosures required in all of the aforementioned circumstances: The context needed to understand intended hedge objectives (i.e., how the derivatives affect the entitys financial position, financial performance, and cash flows) The accounting treatment applied in connection with derivative transactions, for both the hedged item and the hedging derivative when hedge accounting is applied The location of the fair value of the amounts of derivatives reported on a gross basis, presented as assets or liabilities, and segregated by market segment (e.g., interest rate, foreign exchange, commodity, or other) The location and amount of the gains and losses on any hedging derivative and

The check the box approach that satisfies FASBs disclosure requirements for derivatives serves readers of financial statements poorly.
interpretation. And if this is the case, perhaps the reporting entity should caution users about making an inappropriate judgment. To FASBs credit, these kinds of qualitative disclosures are encouraged. The second disclosure pitfall relates to the requirement to disclose the amount that is expected to be reclassified out of AOCI into earnings in the upcoming 12 months. Consider two companies, identical in every way except for this disclosure value. The first reports an expected gain of $X in the upcoming 12 months from this reclassification process, while the second projects a loss of
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38

$Y. (While hypothetical, this situation could arise if the two entities entered into their respective hedges at different times and different pricesfor example, if one entity entered into the hedge when prices were high, and the other entered into the hedge when prices were low and then quarter-end prices moved to a midrange value.) Most readers of the two respective disclosures would likely judge the first company (i.e., the one reporting deferred gains) to be in the more favorable circumstance. Unfortunately, just the opposite is likely to be the case. At first blush, financial statement users need to be reminded that this reclassification relates to an effective hedge, such that the earnings or losses associated with the derivative should be expected to be equal to and opposite of the earnings impact relating to the risk being hedged. That consideration might make it seem as if neither the magnitude nor the direction of the disclosed, projected reclassification amount would be relevant. That conclusion would only hold, however, if the entirety of the exposure were being hedged, which is rarely the case. Typically, companies hedge only a portion of their exposures, rather than the whole; in those cases, the preferred outcome would be one where the company could claim a huge loss due to reclassification as good news, because it could expect an even larger positive earnings effect coming from its overall (hedged plus unhedged) exposure.

A Better Disclosure?
The consideration above highlights what might be the most critical omission of the disclosure requirements: the rules fail to require a transparent presentation of the scope of the hedging activitythat is, the portion of the companys exposure that is being hedged. Ideally, this information should be presented according to market and type of derivative. It would certainly be relevant to discussions about hedging activity (the first point in the list provided above), but it is not explicitly required; as a consequence, it is often difficult to discern. At present, reporting entities must disclose the fair values, earnings, OCI allocations, and reclassifications for their derivative positions. This content is required to be broken down by the associated market segment (e.g., interest rate, foreign exchange, commodity contracts) and whether the positions are designated
OCTOBER 2012 / THE CPA JOURNAL

as hedging instruments. The way this information is presented generally follows examples offered in the Accounting Standards Codification (ASC), particularly ASC 815-10-55-182; however, these displays fail to show the portion of exposures covered by hedging contracts. This information is critical to understanding the companys risk orientation and, thus, its prospects for future performance. In order to provide the proposed information, reporting entities would have to offer a more detailed breakdown of the various instruments in use, reflecting the exposures for which hedging is intended. The following are the predominant interest rate risk exposures for interest rates, foreign currencies, and commodity price risk: Uncertain interest rate payments on existing or planned assets and liabilities Price risk associated with recognized fixed-rate assets and liabilities Foreign currency risks Anticipated transactions with foreign counterparties Existing assets or liabilities denominated in foreign currencies Net investments in foreign operations Commodity price risk Uncertain payments for commodity purchases or sales Inventory price risk. In a limited number of cases, derivatives may be acting as hedges without hedge accounting being applied, either because the prerequisite qualifying conditions were not satisfied or because the entity simply elected not to seek hedge accounting. Nonetheless, readers of financial statements should be informed about the hedging objectives associated with any contracts that are designed as an economic hedge. For each of the categories mentioned above, it would seem reasonable and appropriate to disclose information about the associated hedging relationships. For those exposures relating to uncertain future prices (most likely, but not necessarily, cash flow hedges), an improved disclosure would segment exposures into appropriate risk horizons and detail the portion of risks being hedged by existing derivative positions. For example, a company that manages prospective foreign currency purchases or sales may hedge (and disclose that it is hedging) approximately 35% to 50% of purchases anticipated in the most

immediate six-month horizon, and 20% to 30% of such exposures for the subsequent 18-month period. Some lack of precision in these proportions should be expected, however, because the volume of forecasted business activity will generally not be known with certainty. As a consequence, a given hedge could end up hedging a higher or lower portion of prospective transactions, depending upon whether the volume of those transactions rises or falls from some initial estimate. An analogous volumetric uncertainty does not arise for hedges of existing price risk (normally fair value hedges, but not necessarily). In these cases, the risk is associated with recognized assets or liabilities, or with firm commitments. The portion of these risks being hedged should be more readily and more precisely discernible. For such hedges, disclosures would be improved by detailing the portion of any balance sheet price risk that is currently hedged with derivatives.

Best Practices
Besides disclosing the percentage of hedge coverage in identified exposure areas, reporting entities should also offer greater detail about the types of derivatives they usethose with symmetric payoff functions (e.g., futures, forwards, swaps), where gains or losses accrue in magnitudes consistent with price changes in either direction, or those with asymmetric payoffs (e.g., options, caps, floors, combinations of each), where payoffs are constrained in some fashion. A company that enters into an interest rate swap has a much different character from one that enters into an interest rate cap. Depending on the extent of the hedging activities, these distinctions could have material effects that would be relevant to discerning analysts. The check the box approach that satisfies FASBs disclosure requirements for derivatives serves readers of financial statements poorly, especially in light of current disclosure rules that require virtually no directives relating to the portion of exposures being hedged. Businesses couldand shoulddo better. Ira G. Kawaller is the founder of Kawaller & Co., a consulting company based in Brooklyn, N.Y., that assists companies in using derivative instruments.

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T A X A T I O N compliance & enforcement

The Economic Substance Doctrine

Understanding the IRSs Guidance on its Proper Application
By Karyn Bybee Friske, Karen M. Cooley, and Darlene Pulliam

ven though the concept of economic substance has been codified, concern about the proper application of this doctrine still exists. Thus, the IRS has released administrative guidance clarifying when the application of this doctrine is appropriate. Rigorous conditions must be met before a transaction can be treated as lacking economic substance, thereby subjecting it to the penalties for the underpayment of taxes that stem from such a transaction.

Background
In its war on tax shelters, the Treasury Department has aggressively pursued taxpayers in the courts. One of the most common ways to attack these transactions has been the economic substance doctrine. The Tax Court in ACM Partnership v. Commr described the economic substance doctrine as follows: The tax law, however, requires that the intended transactions have economic substance separate and distinct from economic benefit achieved solely by tax reduction. The doctrine of economic substance becomes applicable, and a judicial remedy is warranted, where a taxpayer seeks to claim benefits, unintended by Congress, by means of transactions that serve no economic purpose other than tax savings. (T.C. Memo 1997-115) But the courts have, over time, used various and often inconsistent interpretations of the doctrine. (For a comprehensive discussion of this legal history, see Karyn A. Friske, Karen M. Cooley, and Darlene A. Pulliam, Economic Substance Codification: Clarification or Convolution, Practical Tax Strategies, December 2010.)

The Health Care and Education Reconciliation Act of 2010 codified the economic substance doctrine in Internal Revenue Code (IRC) section 7701(o), which specifies a conjunctive two-prong test for determining whether a transaction is treated as having economic substance. First, under IRC section 7701(o)(1)(A), the

transaction must change the taxpayers economic position in a meaningful way (apart from the federal income tax effect). Second, under IRC section 7701(o)(1)(B), the taxpayer must have a substantial purpose for entering into the transaction (apart from the federal income tax effect). IRC section 7701(o) resolved existing
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conflicts among the various courts about how to apply the doctrine. According to Congresss Joint Committee on Taxation, the codification was not intended to change present law standards, except to clarify that the test is conjunctive (Technical Explanation of the Revenue Provisions of the Reconciliation Act of 2010, as Amended, in Combination with the Patient Protection and Affordable Care Act, JCX-18-10, March 21, 2010). The Health Care and Education Reconciliation Act also introduced IRC section 6662(b)(6), which imposes a penalty of 20% if an underpayment is attributable to the application of the economic substance doctrine. (This penalty increases to 40% if the transaction is not adequately disclosed.) The filing of an amended return is not taken into account if it is filed after the taxpayer has been contacted. IRC section 6664 was amended to disallow the reasonable cause exception for transactions disallowed under IRC section 7701(o); consequently, the penalty is a strict liability, or no-fault, penalty. IRC section 6676 was also amended to include a penalty for erroneous refund claims attributable to a transactions lack of economic substance. Both IRC section 7701(o) and the penalties described above apply to transactions entered into after March 30, 2010.

62.pdf). According to this notice, the IRS will continue to rely on relevant case law under the common-law economic substance

doctrine in applying the two-prong conjunctive test. Although it will continue to analyze when the economic substance doc-

EXHIBIT 1 When the Economic Substance Doctrine Is Likely Not Appropriate

IRS Guidance
Although IRC section 7701(o) is titled Clarification of Economic Substance Doctrine, it leaves many questions unanswered. According to IRC section 7701(o)(5)(C), the determination of whether the doctrine is relevant to a transaction should be made in the same manner as before the section was enacted. The law is clear, however, about the need to apply the conjunctive test to determine the economic substance and any onerous penalty provisions that may be imposed. Notice 2010-62. The IRS issued Notice 2010-62 in September 2010 to provide interim guidance on the codification of the economic substance doctrine and the related amendments to the penalties (Interim Guidance under the Codification of the Economic Substance Doctrine and Related Provisions in the Health Care and Education Reconciliation Act of 2010, IRB 411, http://www.irs.gov/pub/irs-drop/n-10OCTOBER 2012 / THE CPA JOURNAL

Transaction is not promoted/developed/administered by tax department or outside advisors Transaction is not highly structured Transaction contains no unnecessary steps Transaction that generates targeted tax incentives is, in form and substance, consistent with Congressional intent in providing the incentives Transaction is at arms length with unrelated third parties Transaction creates a meaningful economic change on a present value basis (pre-tax) Taxpayers potential for gain or loss is not artificially limited Transaction does not accelerate a loss or duplicate a deduction Transaction does not generate a deduction that is not matched by an equivalent economic loss or expense (including artificial creation or increase in basis of an asset) Taxpayer does not hold offsetting positions that largely reduce or eliminate the economic risk of the transaction Transaction does not involve a tax-indifferent counterparty that recognizes substantial income Transaction does not result in the separation of income recognition from a related deduction either between different taxpayers or between the same taxpayer in different tax years Transaction has credible business purpose apart from federal tax benefits Transaction has meaningful potential for profit apart from tax benefits Transaction has significant risk of loss Tax benefit is not artificially generated by the transaction Transaction is not pre-packaged Transaction is not outside the taxpayers ordinary business operations. In addition, it is likely not appropriate to raise the economic substance doctrine if the transaction being considered is related to the following circumstances. The choice between capitalizing a business enterprise with debt or equity A U.S. persons choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment The choice to enter into a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C The choice to utilize a related-party entity in a transaction, provided that the arm's length standard of [Internal Revenue Code] section 482 and other applicable concepts are satisfied. Source: Step 1: Doctrine Likely Not Appropriate, Guidance for Examiners and Managers on the Codified Economic Substance Doctrine and Related Penalties, LB&I-4-0711-015, July 15, 2011, http://www.irs.gov/Businesses/Guidance-forExaminers-and-Managers-on-the-Codified-Economic-Substance-Doctrine-andRelated-Penalties

41

trine is relevant in the same manner as before the enactment of IRC section 7701(o), the IRS expects that the case law regarding the circumstances in which the doctrine is relevant will continue to evolve. The Treasury Department and the IRS do not intend to issue general administrative guidance on the types of transactions that will be subject to the application of the economic substance doctrine. Furthermore, the IRS will not issue private letter rulings or determination letters on whether the economic substance doctrine applies or whether a transaction complies with the requirements of IRC section 7701(o). Notice 2010-62 provides some clarification on the disclosure requirements, which will be satisfied by transactions that

are not reportable transactions if the disclosure is adequate under IRC section 6662(d)(2)(B), regarding substantial authority and reasonable basis, and is filed on Form 8275, Form 8275-R, or as otherwise prescribed. For reportable transactions, disclosure is adequate if it meets the above requirements, as well as those of IRC section 6011. Notice 2010-62 also indicates that there will not be safe harbors. The first directive. Also in September 2010, the commissioner of the IRSs Large and Mid-Size Business Divisionnow the Large Business and International Division (LB&I)issued a directive to ensure consistent administration of the penalties related to application of the economic substance doctrine (Codification of the

EXHIBIT 2 When the Economic Substance Doctrine Might Be Appropriate

Transaction is promoted/developed/administered by tax department or outside advisors Transaction is highly structured Transaction includes unnecessary steps Transaction is not at arms length with unrelated third parties Transaction creates no meaningful economic change on a present value basis (pre-tax) Taxpayers potential for gain or loss is artificially limited Transaction accelerates a loss or duplicates a deduction Transaction generates a deduction that is not matched by an equivalent economic loss or expense (including artificial creation or increase in basis of an asset) Taxpayer holds offsetting positions that largely reduce or eliminate the economic risk of the transaction Transaction involves a tax-indifferent counterparty that recognizes substantial income Transaction results in separation of income recognition from a related deduction either between different taxpayers or between the same taxpayer in different tax years Transaction has no credible business purpose apart from federal tax benefits Transaction has no meaningful potential for profit apart from tax benefits Transaction has no significant risk of loss Tax benefit is artificially generated by the transaction Transaction is pre-packaged Transaction is outside the taxpayers ordinary business operations. Source: Step 2: Doctrine May Be Appropriate, Guidance for Examiners and Managers on the Codified Economic Substance Doctrine and Related Penalties, LB&I-4-0711-015, July 15, 2011, http://www.irs.gov/Businesses/Guidance-forExaminers-and-Managers-on-the-Codified-Economic-Substance-Doctrine-andRelated-Penalties

Economic Substance Doctrine and Related Penalties, LMSB-20-0910-024, http:// www.irs.gov/Businesses/Codification-ofEconomic-Substance-Doctrine-andRelated-Penalties). The primary purpose of the directive was to notify examiners that any proposal to impose a penalty under the new law required prior approval by the appropriate director of field operations (DFO)that is, an LB&I executive who supervises territory managers within a certain area of responsibility (Exhibit 4.46.1-1, Glossary of LB&I Terms, Internal Revenue Manual, http://www. irs.gov/irm/part4/irm_04-046-001. html#d0e127). DFOs report directly to the deputy commissioner of operations and hold high positions of responsibility within the IRS (http://www.irs.gov/pub/irs-utl/ lbiorgchart.pdf). The second directive. The second directive, Guidance for Examiners and Managers on the Codified Economic Substance Doctrine and Related Penalties,

The IRS will not issue private letter rulings or determination letters on whether the economic substance doctrine applies.

was issued on July 15, 2011 (LB&I-40711-015). It aimed to instruct examiners and their managers on how to determine when it is appropriate to seek the approval of the DFO in order to raise the economic substance doctrine. This directive was intended to ensure consistency in application of the doctrine and to prevent its asserOCTOBER 2012 / THE CPA JOURNAL

42

tion in inappropriate situations. It contains a series of questions for an examiner to develop and analyze after an initial determination that the doctrine should be raised. In addition, the directive requires that the penalties under IRC sections 6662(b)(6) and (i) and IRC section 6676 may be imposed only upon the application of the economic substance doctrine. These penalties cannot be imposed based upon the application of another similar rule of law or judicial doctrine until further guidance is issued. This precludes penalties for issues involving the step transaction doctrine, substance over form, or a sham transaction, according to the directive. Furthermore, this second directive includes a four-step process for determining whether the economic substance doctrine should be applied. Before beginning the analysis described below, the examiner should notify the taxpayer that the application of the economic substance doctrine to a specific transaction is under consideration. The four steps are as follows: Step 1. The examiner should evaluate whether the circumstances in the case are those where application of the economic substance doctrine to the transaction is likely not appropriate (Exhibit 1). If some of these factors cause the examiner to believe that the doctrine should be applied, the examiner should continue to analyze the situation using Steps 24. At this point, taxpayers should try to show that the economic substance doctrine is not applicable; if a taxpayer can demonstrate that none of the factors in this step are satisfied, the examiner cannot consider the economic substance doctrine, and the remaining steps cannot be completed. Step 2. An examiner should evaluate whether the circumstances in the case are those where application of the economic substance doctrine to the transaction may be appropriate (Exhibit 2). Step 3. If an examiner determines that the application of the doctrine is appropriate, the guidance provides a series of inquiries that the examiner must make before seeking approval to apply the doctrine (Exhibit 3). Step 4. If an examiner, along with a manager and territory manager, determines that application of the economic substance is merited, the directive provides guidance on how to request approval
OCTOBER 2012 / THE CPA JOURNAL

from the DFO. An examiner, in consultation with a manager or territory manager, must describe in writing the process completed in order to determine that the doctrine should be applied. The DFO should review the material and consult with legal counsel before making a decision. If the DFO believes that the issue should be pursued, the taxpayer should be given the opportunity to explain his position, either

in writing or in person. The DFOs final decision must be communicated to the examiner in writing.

Coordination with Other Judicial Doctrines

The interaction between the application of the economic substance doctrine (and related penalties) and the application of other judicial doctrines, such as substance

43

over form or step transaction, should be considered before seeking a DFOs approval. An examiner should use the strongest argument available to challenge the transaction. Generally, the provisions of the economic substance doctrine will not be applied when another judicial doctrine is more appropriate. The most important

direction contained in the guidance is that the penalties discussed above only apply to underpayments or refund claims when the economic substance doctrine is raised. The 20% and 40% penalties discussed above will not apply if the deficiencies are the result of another judicial doctrine or similar rule of law.

Chief Counsel Notice

In April 2012, the IRS Office of Chief Counsel (OCC) issued Notice 2012-008, providing coordination procedures to ensure that the economic substance doctrine and related penalties are only raised in appropriate cases (Coordination Procedures for the Economic Substance Doctrine and Related Penalties, CC-2012008, April 3, 2012, http://www.irs.gov/ pub/irs-ccdm/cc-2012-008.pdf). The notice incorporates the two previously issued IRS directives on this matter and details the procedures as follows: Examination. The OCC should provide timely assistance regarding common law or the codified economic substance doc-

EXHIBIT 3 Inquiries to Develop a Case for Approval by the Director of Field Operations

Is the transaction a statutory or regulatory election? If so, then the application of the doctrine should not be pursued without specific approval of the examiners manager in consultation with local counsel. Is the transaction subject to a detailed statutory or regulatory scheme? If so, and the transaction complies with this scheme, then the application of the doctrine should not be pursued without specific approval of the examiners manager in consultation with local counsel. Does precedent exist (judicial or administrative) that either rejects the application of the economic substance doctrine to the type of transaction or a substantially similar transaction or upholds the transaction and makes no reference to the doctrine when considering the transaction? If so, then the application of the doctrine should not be pursued without specific approval of the examiners manager in consultation with local counsel. Does the transaction involve tax credits (e.g., low income housing credit, alternative energy credits) that are designed by Congress to encourage certain transactions that would not be undertaken but for the credits? If so, then the application of the doctrine should not be pursued without specific approval of the examiners manager in consultation with local counsel. Does another judicial doctrine (e.g., substance over form or step transaction) more appropriately address the noncompliance that is being examined? If so, those doctrines should be applied and not the economic substance doctrine. To determine whether another judicial doctrine is more appropriate to challenge a transaction, an examiner should seek the advice of the examiners manager in consultation with local counsel. Does recharacterizing a transaction (e.g., recharacterizing debt as equity, recharacterizing someone as an agent of another, recharacterizing a partnership interest as another kind of interest, or recharacterizing a collection of financial products as another kind of interest) more appropriately address the noncompliance that is being examined? If so, recharacterization should be applied and not the economic substance doctrine. To determine whether recharacterization is more appropriate to challenge a transaction, an examiner should seek the advice of the examiners manager in consultation with local counsel. In considering all the arguments available to challenge a claimed tax result, is the application of the doctrine among the strongest arguments available? If not, then the application of the doctrine should not be pursued without specific approval of the examiners manager in consultation with local counsel. Source: Step 3: Development of Case for Approval, Guidance for Examiners and Managers on the Codified Economic Substance Doctrine and Related Penalties, LB&I-4-0711-015, July 15, 2011, http://www.irs.gov/Businesses/Guidance-forExaminers-and-Managers-on-the-Codified-Economic-Substance-Doctrine-andRelated-Penalties

It appears that the IRS intends to proceed carefully and ensure that a determination of lack of economic substance will hold up in court.
trine and related penalties, as requested during an examination. It should consider the factors outlined in previous directives as well as relevant case law. If a taxpayer has previously received a favorable private letter ruling or determination letter with respect to the transaction, the OCC should request the Associate Chief Counsel to reviewand, if appropriate, revokethe ruling or letter. This procedure is required even if the ruling or letter did not address the economic substance doctrine. This revocation must occur before the IRS proposes an adjustment asserting the economic substance doctrine. Statutory notices of deficiency and notices of final partnership administrative adjustment. If a proposed statutory notice or notice of final partnership administrative adjustment concludes that a transaction lacks economic substance, the OCC will coordinate with Division Counsel headquarters and the Office of the Associate Chief Counsel (Procedure and Administration), which will then coordiOCTOBER 2012 / THE CPA JOURNAL

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nate the National Office review with all of the Associate Chief Counsel offices that have jurisdiction over the relevant issues. Litigation. Before raising the economic substance doctrine as a new issue in a Tax Court case or in a defense or suit letter to the Department of Justice, the OCC will coordinate with Division Counsel headquarters and the Office of the Associate Chief Counsel (Procedure and Administration), which will then coordinate the National Office review with all Associate Chief Counsel offices that have jurisdiction over the relevant issues. The same procedures as those required in the examination stage regarding revocation of favorable rulings or letters also apply. Administrative pronouncements. Any division or associate offices that have jurisdiction over administrative pronouncements will, in coordination with the Associate Chief Counsel (Administration and Procedure), make sure that any discussion of economic substance in these pro-

nouncements is consistent with statute, LB&I directives, relevant case law, and Notice 2012-008.

Implications
Chief Counsel Notice 2012-008 adds new layers to the process of asserting the economic substance doctrine. In addition, it strengthens the importance of the guidance provided in the directives. The second directive provides very specific guidance for examiners to follow before they may assert the economic substance doctrine. It appears that the IRS intends to proceed carefully and ensure that a determination of lack of economic substanceand the associated penaltieswill hold up in court. Although the IRS has clearly stated that these directives are not official pronouncements of law and cannot be used, cited, or relied upon as such, they do seem to clarify the IRSs approach and might limit the application of the doctrine. The added transparency of the IRS process pro-

vided by the second directive should help inform taxpayers and their advisors. The discussion of the revocation of favorable rulings or letters in Notice 2012-008 suggests new opportunities for asserting the economic substance doctrine. It might be some time before the ultimate effects of the codified economic substance doctrine are thoroughly fleshed out. For now, taxpayers and their advisors should consider the guidance and include protective disclosures in tax returns in order to preempt the oner ous penalty provisions. Karyn Bybee Friske, PhD, CPA, is the Schaeffer Professor of Business Ethics and a professor of accounting; Karen M. Cooley, CPA, is an instructor of accounting; and Darlene Pulliam, PhD, CPA, is a Regents Professor and the McCray Professor of Business, all in the department of accounting, economics, and finance at West Texas A&M University, Canyon, Tex.

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T A X A T I O N state & local taxation

Marriage Equality in New York and Beyond

To Love, Cherish, and Tax
By David Spaulding and Jay Freeberg
sex marriages, civil unions, and domestic partnerships.) To highlight some of the hazards, one should examine the Northeast Corridor (i.e., the stretch of the East Coast from Washington D.C. to Maine). It begins on an island of marriage equality in the nations capital, the only jurisdiction below the Mason-Dixon Line that allows same-sex couples to marry. It is surrounded by alternative positions. Virginia has an opposing on U.S. citizens upon marriage, encompassing health insurance, veterans and Social Security benefits, estate taxes, retirement savings, and immigration. Continuing up the coast, Pennsylvanias statutes define marriage as a union between one man and one woman. New Jersey grants most, but not fully equal, rights under its Civil Union Act of 2006. New York does not recognize civil unions under MEA, but it will recognize same-sex marriages from neighboring Connecticut, Massachusetts, New Hampshire, and Vermont. Rhode Island recently added a civil union statute to its books. Finally, Maine serves as a reminder that state law prevails; it has a statute that defines marriage in a similar fashion as Pennsylvania, while granting some state-level spousal rights to domestic partners. Of the 13 jurisdictions along a nearly 12-hour train trip through the Northeast Corridor, one passes through six jurisdictions that allow gender-neutral marriage (with varying rights), three states that recognize civil unions, and four others that wont recognize any rights beyond those defined in DOMA. Looking west, Iowa is the only state to offer and recognize same-sex marriage. In 2008, a majority of California voters approved Proposition 8, which repealed that right and adopted language from DOMA into the state constitution. The remaining West Coast statesWashington, Oregon, and Nevadaoffer domestic partnerships that grant nearly all state-level spousal rights. Hawaii similarly grants some (though reduced) state-level spousal rights under its domestic partnership law.

he New York State Marriage Equality Act (MEA) of 2011 has little more than the word marriage in common with the Defense of Marriage Act (DOMA) of 1996. And even this term takes on two different meanings in each act: New Yorks law was specifically written in gender-neutral language, whereas the federal statute defines marriage as a union between a man and a woman. In fact, DOMA goes so far as saying that, under the law, no U.S. state or political subdivision is required to recognize a samesex marriage treated as a marriage in another state. Advisors of same-sex couples should become familiar with the tax, gift, and estate planning issues raised by the enactment of MEA, key equality issues in other states, and the differences that exist between various local statutes and DOMA. The discussion below will address these topics, as well as two serious court challenges to the constitutionality of DOMA.

A Survey of the States

Several currents drive the legal differences that exist from state to state. A total of 37 states ban same-sex marriage or refuse to recognize it, either by constitution or statute. (While there are currently six states that allow same-sex marriage, two other states Maryland and Washingtonhave approved legislation allowing it. Those laws are not yet in effect, however, and might be subject to voter referendum.) In the six states (and the District of Columbia) that presently issue and recognize same-sex marriages, some clergy do not feel bound to sanctify or recognize it. These jurisdictional differences make it more difficult to advise domestic partners on legal, tax, and legacy issues than traditionally married couples. (See the sidebar, Legal Definitions of Same-Sex Relationships, for distinctions between same-

Advisors of same-sex couples should become familiar with the tax, gift, and estate planning issues raised by the enactment of MEA, key equality issues in other states, and the differences that exist between various local statutes and DOMA.
definition of marriage in its constitution, while Maryland only recognizes same-sex marriages from other states. In Delaware, civil unions are the law. (Farther south, North Carolina joined the ranks of states with a constitutional ban on same-sex marriage in May 2012.) Each of these states provides differing spousal rights to unmarried couples or domestic partners. Furthermore, these rights are less than the fully equal rights granted by either Washington D.C.s marriage and domestic partnership laws or New Yorks MEA. The General Accounting Office (GAO) has determined that there are more than 1,100 rights and protections conferred

Parsing the Differences

What do all of these different laws and rights mean? Tax professionals advising unmarried life-partners or united couples living under a domestic partnership, civil union, or gender-neutral marriage have a
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tremendous responsibility to keep up with these laws and the spousal rights granted under each, as well as to understand the related tax codes. An advisors knowledge of these jurisdictional issues must then be reconciled with DOMA, at the national level, for each couple because there is ultimately no recognition of any rights or substantial benefits to these unions by the federal government. (Portions of DOMA have been deemed unconstitutional by two recent federal district court decisions that will be discussed later.) Some relevant issues for tax professionals to follow include income taxes, gift and estate taxes, dependent relations, community property, immigration, healthcare benefits, the Employee Retirement Income Security Act (ERISA) of 1974 and pension benefits, Social Security benefits, adoption credits, and domicile and residency questions. Legal, financial, and risk mitigation issues that require the services of other professional counsel, such as attorneys, financial advisors, or insurance specialists, are beyond the scope of this article. Tax counsel must take a multidisciplinary approach in order to suitably carry out their professional responsibility.

Case Study
Specific issues can be demonstrated through a case study concerning a hypothetical couple. Mike and Adam are both in their mid-forties and tied the knot in Central Park last September. They reside

in New York, where they jointly own a condominium. They have a school-age child, Sophia; Mike is her biological parent. Because both are executives in the financial sector, they have substantial income and a combined net worth in excess of $6 million. Adam owns a beach house in Asbury Park, New Jersey, and, via family bequest, Mike owns a beach house in North Carolinas Outer Banks. Their advisor should examine the following key tax issues in order to provide guidance for the family and its individual members: The advisor needs to confirm that they are, in fact, domiciled in New York in order to know which state law and tax code to follow for income tax reporting. The advisor needs to determine whether Sophia was adopted by Adam, which is both a legal concern and a tax question because it can impact how one of the partners reports the dependent on the federal Form 1040. (The advisor might also want to ask how much time the couple spends in each of the other states where they hold property, in order to explore their potential exposure with respect to parental healthcare issues in case something should happen to the child while outside New York State.) For federal purposes, it might be advantageous to have Sophia listed as a dependent on one or the others parental Form 1040, depending upon the effective household benefit.

The legal recommendation might be to have Adam (the nonbiological parent) adopt Sophia in order to secure parental rights in both New Jersey and North Carolina (as well as other states) because such rights cannot be assumed in other jurisdictions. Under MEA, this couple must file a New York tax return as either married filing joint (MFJ) or married filing separately (MFS). The resulting New York returns must be prepared as if the same status were applied at the federal levelin spite of DOMAbut separate individual federal tax returns must be filed for each partner either as single or head of household, depending upon dependency. Tax planning for New York couples like Mike and Adam requires professionals to prepare multiple versions of a return in order to get to the required filings for each federal and state jurisdiction. Work travel. If Adam has to travel to Hoboken, New Jersey, on a regular basis in order to work in his employers back office, he might have to file an additional state tax return in New Jersey, which would likely match the status filed in New York because New Jerseys civil union law recognizes the New York marriage for tax-filing purposes. This might require Adam to report Mikes nonresident income on the New Jersey return. Homeowner expenses. For a joint tax return, homeowner expenses are ordi-

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narily itemized deductions on the federal Schedule A; however, for domestic partners, tax advisors must look more closely at how to allocate those deductions on both the joint state and separate federal returns in order to ensure the maximum family tax benefit. Healthcare. Healthcare expenses and domestic partner health insurance coverage are additional areas that tax professionals must examine. In this case study, Adams employer has the better plan and offers family coverage for domestic partners. The additional income that Adam receives from this benefit is not taxable at the state level in New York, but it is fully taxable at the federal level and must be added to his wages on Form 1040. In addition, Mikes constructive receipt of the value of those benefits could be a reportable gift to Mike, thus requiring Adam to file a gift tax return. In addition to Mike and Adams key income tax considerations and compliance issues, they would also have financial planning concerns (and opportunities). Gift tax. Under MEA, Mike and Adam have unlimited spousal gifting in parity

with traditionally married couples at the state level; however, there is no such right at the federal level, where gifts in excess of $13,000 in any calendar year must be reported to the IRS. As one might imagine, this requires the taxpayers to track two sets of basis for such gifts, with implications later on for each of their respective estates. Estate tax. Under MEA, Mike and Adam have all the same spousal estate rights as traditionally married couples, but the death of one spouse is treated very differently for federal purposes. If Mike predeceases Adam, Mikes estate is immediately subject to estate tax at the federal level; conversely, Mikes New York estate can flow directly to Adam, and the state would have to wait until Adam passes away before any tax is due on the (total) estate. Other concerns. Additional planning concerns must take into account who Sophias legal parents are. Mike is biologically related to Sophia; therefore, he is a legal parent. But if Adam did not codify his parenthood by legal adoption,

LEGAL DEFINITIONS OF SAME-SEX RELATIONSHIPS

hile New Yorks Marriage Equality Act (MEA) will recognize and bestow all of the rights of marriage in New York to a same-sex couple that was legally married by any foreign or state government where such marriages are performed, civil unions and domestic partnerships are not covered under the law. The following are the legal definitions of these relationships: Same-sex marriageA legal marriage between people of the same sex (i.e. female-female, male-male). Most of the jurisdictions that have legalized marriage in this manner use the term same-sex marriage, but New York has removed gender from the term entirely. Civil unionA specific class of law that was created to extend certain rights to same-sex couples. These rights are recognized only in the state where the couple resides and the extent of those rights, though they may closely approximate those bestowed upon legally married couples in that state, differ substantially between these states. Domestic partnershipA category of law that has been around for the longest amount of timeSan Francisco and New York City formally recognized such relationships for benefits purposes as far back as 1982 and 1997, respectively. Domestic partnerships can be determined at either the local or state level and can apply to either same-sex couples or opposite-sex couples that choose not to get married. This category of law is the most varied in the benefits extended to such couples ranging from access to healthcare coverage by a partners employer to nearly full marital rights and responsibilities under Californias Domestic Partnership Rights and Responsibilities Act of 2005.

upon Mikes death Sophia may not be considered his daughter for any purpose. Even if it is so stated in Mikes will, Adam might not be appointed her guardian by the court. Advisors who represent couples across the country must consider several other tax and estate issues. The IRS has recently issued new guidance for domestic partners and same-sex spouses in community property states, such as in California, Nevada, Washington, and Wisconsin (Chief Counsel Advice 201021050, September 22, 2011). For tax years beginning after December 31, 2005, in states that have extended full community property treatment to registered domestic partners (civil unions and marriages assumed), federal tax treatment of community property should apply. This means that domestic partners living in these states must recognize the principle of community income, salaries and services by either or both spouses, where such income and expense (including community business property) are reported on their respective federal tax returns (IRS Revised Publication 555, Community Property; Chief Counsel Advice 201021050). Advisors must also consider the income tax ramifications related to a states recognition, or nonrecognition, of a gender-neutral marriage from another country. Canada and the federal district of Mexico City both issue gender-neutral marriages. Likewise, several European Union countries, as well as South Africa, Iceland, and Argentina, issue and recognize same-sex marriage. (Israel does not perform genderneutral marriage but does recognize such unions.) Some states will recognize marriages performed in these countries, necessitating the filing of a joint tax return at the state level. This could then impact the taxability of foreign income at the state level.

Relevant Case Law

A May 30, 2012, decision by the U.S. Court of Appeals for the First Circuit in Boston ruled that DOMA discriminates against gay couples (Commonwealth of Massachusetts v. U.S. Dept of Health and Human Services [No. 10-2204]). (The appeals case was, in part, related to a suit brought by the Boston-based legal group Gay and Lesbian Advocates and Defenders.) Agreeing with the lower court judge, the appeals court upheld a
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2010 ruling claiming that DOMA interferes with the right of a state to define marriage; it denies married gay couples federal benefits given to traditionally married couples, including the ability to file joint tax returns. The First Circuit followed closely on the heels of four other federal courts that had similarly stated that DOMA was indefensible; however, the court went on to say that its ruling would not be enforced until the U.S. Supreme Court decides the case. More importantly, the June 6, 2012, the U.S. Court of Appeals for the Second Circuitin Windsor v. United States (833 F. Supp. 2d 394), which followed similar arguments on Fifth Amendment and Fourteenth Amendment (equal protection) grounds as Pedersen v. Office of Personnel Management (10 CV 1750, July 31, 2012)ruled that section 3 of DOMA is unconstitutional because it disallows the surviving same-sex spouse a marital deduction that would be allowable if the union was a heterosexual marriage.

As a direct result of these recent rulings, advisors in the field are now recommending that, in addition to filing the required federal income or estate tax returns under current law, adversely affected same-sex couples or surviving spouses should file protective refund claims with the IRS. The IRS will hold the protective claims in abeyance until the Supreme Court makes a final decision on the matter. (In amending any tax return, the statute of limitations to make a claim for refund is generally three years from the due date of the original return.)

An Evolving Landscape
Tax professionals who counsel in this area have an enormous responsibility to know the myriad and conflicting tax codes, as well as their consequences on domestic partners. This advisory role is further complicated by the dynamic political, religious, and social pressure on lawmakers as the movement for same-sex marriage continues to evolve from state to state. Nothing illustrates the shifting

sands more than California voters controversial adoption of DOMAs core language into their constitution, overturning the states short-lived marriage equality law. In New York, an organization called New Yorkers for Constitutional Freedoms is similarly pursuing a lawsuit to overturn New Yorks MEA. The key to planning for domestic partners is to ensure a current and complete understanding of each state jurisdiction that the couple lives, owns property, and works in. Although death and taxes are sure things, DOMA ensures great uncertainty for same sex spouses in domestic partnerships. David Spaulding, EA, CRPC, is a principal and Jay Freeberg, CPA, CFP, is a partner at Janover LLC, New York, N.Y. They are both members of the Domestic Partners Network, a multidisciplinary network of professionals founded by David Spaulding in 2009.

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F I N A N C E personal financial planning

Transfers for Valuable Consideration

Tax Issues when Transferring a Life Insurance Policy
By Andrew I. Shapiro

any people believe that life insurance proceeds are received by a beneficiary free from income tax (Internal Revenue Code [IRC] section 101[a][1]), regardless of whether the underlying policy is an individual policy, a group policy, a cash value policy, or a term policy. Although individuals rarely look to see if there are exceptions to this rule, they do occurmost frequently through violations of the transfer-for-value rule. Recently, this author has seen an increase in inquires concerning the transfer of ownership of a life insurance policy, thereby increasing the possibility of subjecting the death benefit to income taxation. Some of these inquiries concern individuals exploring the option of transferring ownership of a policy because of the impending reduction in the estate tax exemption; some involve transferring policies owned by a business or used to fund a buy-sell agreement; and others are just runof-the-mill policy transfers that wouldnt otherwise merit a second glance. Many individuals concerned with the change in the estate tax exemption are considering a sale of the policy, rather than a gift, in order to avoid the three-year rule (IRC section 2035). This rule brings certain giftsspecifically, life insurance on the life of the party making the transfer back into the taxable estate for a period of three years from the date of the transfer. Regardless of the reason, violating this transfer-for-value rule subjects a portion of the death proceeds to income taxation, which can easily result in individuals failing to achieve their financial objectives and can possibly subject both insurance and tax professionals to litigation.

The Transfer-for-Value Rule

Transfer for valuable consideration often referred to as the transfer-for-value

rulestates that if the policy, or any interest in the policy, is transferred for valuable consideration, then the proceeds received by the beneficiary shall only be exempt from income tax to the extent of the beneficiarys cost basis (IRC section 101[a][2]). But this rule can potentially come back to haunt an individual any time the owner transfers ownership of a life insurance policy, or designates or changes a beneficiary, in exchange for anything that has value. While a sale for cash is an obvious example, there are many others, discussed below. This issue is even more complicated because IRC sections 101(a)(2)(A) and (B) provide exceptions to the transfer-for-value rule itself, such as transfer to the insured; transfer to a partner of the insured (i.e., a legal business partner, not personal partner); transfer to a partnership in which the insured is a partner;

transfer to a corporation in which the insured is a shareholder or officer; and perhaps the most confusing, a transfer where the basis of the policy in the hands of the transferee (the party receiving the benefit) is determined in whole or in part by reference to its basis in the hands of the transferor (the party releasing the benefit). The sidebar, Scenarios Where Transfer for Value Could Apply, provides examples of situations that might be subject to the transferfor-value rule.

Transfers of Personally Owned Policies

The situation seen most often with respect to transfers of personally owned policies is a transfer between spouses. If the transfer is an outright gift or is made for valuable consideration, it does not violate the transfer-for-value rule. In such a situation, the basis carryover exception applies. There is no gain or loss recognized on transfers between spouses, and the basis
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of the transferee remains that of the transferor (IRC section 1041[a] and [b]). This exception will not apply if the transferee is a nonresident alien (IRC section 1041[d]). Currently, transfers for valuable consideration between same-sex married partners are not treated as transfers between spouses for federal tax purposes and are subject to the rules for transfers between nonspouses, according to the 1996 Defense of Marriage Act. Another question arises, however: what if the transfer is the result of a divorce and the individuals are no longer married on the date of transfer? If the transfer is incident to a legally recognized separation agreement or divorce decree, then there is no transfer-for-value violation and there is a carryover basis (IRC section 1041). Even if the transfer is not directed by a court, the transfer will be treated as incident to the divorce and not subject to transfer for value, as long as it takes place within one year of the termination of the marriage

(Treasury Regulations section 1.1041-1T, A-1, A-6). Transfers to other family members typically occur when the original owner of a life insurance policy gifts or sells it in order to remove it from the taxable estate. Other than spouses, family members have no exempt status under the transfer-forvalue exceptions, and thus such transactions are fraught with possibilities to trigger taxation. If the transaction qualifies as an outright gift, the transferor needs to be concerned about the three-year rule under IRC section 2035. If the transfer does not qualify as a gift and is, in fact, a bona fide sale for an adequate and full consideration in money or moneys worth (IRC section 2035[d]), then it will be subject to the transfer-for-value rule (IRC section 101[a][2]). But what if it is a part-gift, partsale transaction? Related parties transferring an asset for something less than full consideration will find themselves having made a gift, possibly subjecting the trans-

action to gift tax and the three-year rule, and having made a sale. Because the cost basis of this transaction is partially determined by the transferors basis, however, the transaction is not subject to the transfer-for-value tax (IRC section 2512[b]).

Transfers of Business-Owned Policies

One common transaction is the distribution of business-owned policies to individual owners in order to fund a cross-purchase buy-sell agreement. This can arise due to a switch from an entity purchase to a cross-purchase, or simply from a decision to repurpose existing businessowned coverage for the cross-purchase agreement. The proper structuring of a cross-purchase involves each owner owning a policy on each other owners life, as shown in Exhibit 1. This transaction requires the business to distribute a life insurance contract on the life of Owner A to Owner B, and on the life of Owner B to Owner A. Each

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owner is the beneficiary of the policy he owns on the life of the other owner. Whether the policies are characterized as a distribution or purchased by the owners of the business does not change the fact that there is a transfer for value. If the policy transfer was through a cash sale, then the trigger is the sale and no exception applies. If the transfer was characterized as a distribution, then the trigger is that the transfer was done in exchange for relieving the company from the obligation to continue the contract and the promise contained in the buy-sell agreement to use the death benefit to complete the agreement.

These promises constitute valuable consideration. There is one exception: if the owners are partners, the transaction falls under the partners exception to the transfer-forvalue rule. Identical issues exist if the owners attempt to repurpose individually owned policies to fund the cross-purchase by exchanging, purchasing, or otherwise transferring ownership of the policies to each other. Another scenario that occurs when attempting to avoid a transfer for value in a buy-sell agreement is to have each owner purchase a policy on her own life. They

are the owner and the insured, but they have named the other business owner as beneficiary. Typically, this is presented as a way to avoid a policy exchange at a later date, when the owner no longer believes she will need the buy-sell agreement, and when each owner would like to start accessing the cash value in her own policy to supplement retirement income on a tax-preferred basis (IRC section 72[e]). At this point in time, they would simply change the beneficiary designation back to their family, trust, or other party. The problem here is, once again, an exchange of valuable consideration for the naming of

SCENARIOS WHERE TRANSFER FOR VALUE COULD APPLY

Example 1 Mother (M) owns a life insurance policy with a current death benefit of $1 million. M sells the policy to her son (S) for its fair market value of $200,000. S continues to pay the premiums on the policy until the death of M, an additional $50,000. Transfer for value applies in this situation. S purchased a life insurance contract and does not fit into any of the exceptions of Internal Revenue Code (IRC) section 101(a)(2)(A) or (B). At Ms death, S will receive $1 million. S has a total cost basis of $250,000 (the original purchase price of $200,000 plus the additional $50,000 in premiums); $750,000 (death benefit minus cost basis) will be subject to ordinary income tax under the transfer-for-value rule. Example 2 This example follows the same fact pattern as Example 1, but with one twistM and S are partners in a business at the time of the transfer. In this case, transfer for value does not apply because the transfer was to a partner of the insured. Example 3 M owns a life insurance policy with a current death benefit of $1 million. It has a cost basis of $50,000 and has an outstanding loan of $100,000. M gifts the policy to. S continues to pay the premiums on the policy until the death of M, an additional $50,000. Transfer for value applies in this example. M actually received something of value when she otherwise gifted the policy to Sshe was relieved from the loan obligation, which was greater than her cost basisand none of the exceptions apply. S accepted the obligation to repay the loan and this, in and of itself, is valuable consideration. S will receive $900,000 upon Ms death (the $1 million death benefit minus the loan amount, assuming it has not been repaid prior to death). S has a total cost basis of $150,000; $750,000 will be subject to ordinary income tax under the transfer-for-value rule. Example 4 This example has the same fact pattern of Example 3, but with one twistthe outstanding loan is $40,000. Transfer for value does not apply in this situation. Because S received the policy with a cost basis greater than the value of the loan, this transfer would fall under the basis transfer exception because it would be deemed a part-gift, part-sale transaction. Example 5 A and B, two equal shareholders of a corporation (C), valued at $2 million, enter into a cross-purchase buy-sell agreement. A is no longer insurable due to medical reasons. C currently owns a life insurance policy on each owner for $1 million. Those policies had been viewed as key person policies, but A and B decide to repurpose them for the benefit of the buy-sell agreement. Knowing that the proper structure of the cross-purchase buy-sell agreement requires A to own the policy on B and vice versa, they distribute the policies correctly and recognize the proper income taxation on the distribution. The taxable value of each policy on the date of distribution is $200,000, and each pays an additional $50,000 in premiums before A dies. Transfer for value applies in this situation for two reasons. First, the transfer, which could not be described as a gift, is to a person other than the insured. Second, the transfer occurred for the purpose of securing the buy-sell agreement, which has value in and of itself. B would receive the $1 million death benefit with a cost basis of $250,000 (the taxable value at transfer of $200,000, plus the additional premium of $50,000); $750,000 (the $1 million death benefit received minus the cost basis of $250,000) would be subject to taxation.

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the owner/insureds cobusiness owner as the beneficiary. And yet again, the partners exception or the transfer to the insured exception might be available. What would otherwise appear as a properly designed life insurance funding arrangement can still go wrong if there are three or more owners and each owns a policy on the others. Upon the first death, the buy-sell agreement is triggered. The policies owned by the survivors on the life of the decedent pay to the survivors. The death benefit is used to purchase the decedents share of ownership. One problem that might arise concerns the policies owned by the decedent on the lives of the survivors; for example, A, B, and C each own equal parts of a $3 million business and have a cross-purchase buy-sell agreement funded with life insurance. Policies owned by A insure B and C for $500,000 each; B owns identical policies insuring A and C, and C owns identical policies insuring A and B.

Assuming that A dies first, the policies on As lifeowned by B and Cpay out, and the proceeds are used to purchase As ownership interest. What happens to the contracts on the lives of B and C that were owned by A? If the policies are transferred to the insured, they are no longer useful for the buy-sell agreement because they will be owned by the insured. While this is an exception to the transfer-for-value rule under the transfer to the insured exception, it renders the remaining portion of the buy-sell agreement underfunded. If the policies are transferred in a manner that continues the proper funding of the cross-purchase agreement (B obtains ownership of the policy on C; C obtains ownership of the policy on B), then the transfer-for-value rule is once again violated, because the policies were obtained for the purpose of utilizing the death benefit to complete the buy-sell agreement. This situation demonstrates two potential exceptions to the transfer-for-

value rule: the first would be the previously discussed partners exception, and the second would be to transfer the policies owned by A on the lives of B and C to the corporation previously owned by A, B, and Cnow owned only by B and Cand create a combination crosspurchase/stock redemption buysell agreement. B and C would still use the life insurance contracts they own to fund a portion of the buy-sell agreement, and the corporation would use the policies it owns to fund the remaining portion of the agreement. This structure falls under the transfer to a corporation in which the insured is a shareholder exception to transfer for value. Once again, the partners exception could apply ifand only ifthere is an existing partnership that included A, B, and C at the time of As death. It is important to remember that the partnership does not have to be the business concern that is involved in the current buysell agreement.

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Businesses with multiple owners often look to a trusteed cross-purchase buy-sell agreement (sometimes described as an escrowed buy-sell agreement). While there are several advantages to the basic cross-purchase structure, ease of administration is not one of them if there are more than two owners. The number of policies needed is N(N1), where N is equal to the number of owners; for example, a business with five owners would require 20 policies to fund the agreement. In an attempt to mitigate the administrative issues associated with a large number of policies, businesses have a trustee own one policy on each owner and authorize the trustee to administer the cross-purchase buy-sell agreement. This significantly eases administrative issues. On the other hand, this strategy does nothing for the transfer-for-value issue that exists when existing policies are transferred to facilitate a cross-purchase agreement. In the previous examplewhere A, B, and C each own an equal interest in a business worth $3 millionthe appointed trustee would receive the funds from A, B, and C required to purchase one $1 million policy on each owner. Assuming the death of A, the trustee receives the proceeds of the life insurance policy on A and uses those proceeds to purchase As ownership interest from As estate. The trustee then evenly distributes the ownership to B and C, thus keeping their ownership interests

equal. From a transfer-for-value perspective, the problem occurs because the beneficial interest in the remaining policies is now modified. B and C each now have a greater interest in each policy for the sole purpose of using the proceeds to complete the remaining portion of the buy-sell agreement; again, the one clear exception is if there was an existing partnership among A, B, and C. Because the partners exception continues to pop up in each example, one must ask: is there a way to integrate a partnership into the buy-sell agreement itself? The IRS has issued private letter rulings (PLR) that have concluded that a partnership may be created for the sole purpose of completing the buy-sell agreement (PLR 9042023, PLR 9309021). If there is a concern that state law might not recognize a partnership designed solely to complete a buy-sell agreement, then another recognized business activity could be housed in the partnership, such as owning or managing real estate or leasing office equipment to the primary business.

Split-Dollar Agreements
Split-dollar agreements can be another source of frustration in the transfer-forvalue arena. One component of many splitdollar agreements is either transfer of ownership or the naming of a beneficiary in exchange for something of value. As dis-

EXHIBIT 1 Cross-Purchase Buy-Sell Agreement Funded with Life Insurance

Business Cross-Purchase Buy-Sell Agreement

Owner A

Owner B

Owner A owns the life insurance policy. Owner B is the insured. Owner A is the beneficiary.

Owner B owns the life insurance policy. Owner A is the insured. Owner B is the beneficiary.

cussed above, such events can have negative results under the transfer-for-value rule. Although a discussion of the tax issues specific to split-dollar plans is beyond the scope of this article, many articles have appeared in The CPA Journal specifically addressing the subject. The most common structure of split-dollar agreements today is the economic benefit endorsement split-dollar agreement. In this structure, the life insurance policy is owned by the business, and the employee or owner is given the right to designate a beneficiary for some or all of the death proceeds. The typical agreement gives the company the right to receive an amount of the death proceeds equal to the greater of premiums paid or cash value; however, other variations exist. The most common alternative is to give the owner or employee the right to name the beneficiary for the nonbusiness portion of the death proceeds. This would not result in a transfer for value under the transfer to the insured exception. But sometimes the right to name the nonbusiness portion of the death benefit is given to a different party. This party could be a trust, drafted with the desire to prevent an incident of ownership in an attempt to keep the death proceeds out of the individuals taxable estate under IRC section 2035. But unless that third-party owner is a partner of the insured or can be treated as the insured, such as a grantor trust (IRC sections 671677), the proceeds will be subject to the transfer-for-value tax. A newer type of split-dollar agreement created under the final regulations, known as a loan regime split-dollar agreement, provides for a policy owned by an employee or owner to have some or all of the premium paid by the company as a loan, with the policy itself being transferred under a collateral assignment in order to secure the loan (Treasury Regulations sections 1.6122, 1.83-3[e], 1.83-6[a][5], 1.301-1[q], 1.7872-15; Technical Decision [TD] 9092, Internal Revenue Bulletin [IRB] 2003-46). This transaction avoids the transfer-forvalue tax issue for any death benefit received by the company, because a collateral assignment is not deemed a transfer for value (Treasury Regulations section 1.101-1[b][4]). This extends to old grandfathered economic benefit collateral assignment split-dollar plans as well.
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In an attempt to avoid split-dollar issues, the parties will sometimes enter into a shared or split ownership agreement. In this form, the companys premium payments are secured through an absolute assignment in the policy. Because this type of assignment is not protected under Treasury Regulations section 1.101-1(b)(4), there is no exemption from transfer for value, and it will exist from the inception of the plan. The only remaining possible exceptions to the transfer-for-value rule would be if the insured is a shareholder or officer of the company, ormuch less likelyif the employer is a partner of the insured. It is important to keep in mind that the party being subjected to the transferfor-value tax here is the employer: it is the party who is exchanging something of value for the right to receive death benefit. This is one of those issues where the resulting tax is usually minimal and, therefore, acceptable to the parties involved. The reason for this is that the transfer-for-value

tax is applicable only to the benefit received in excess of the partys cost basis. Because most shared ownership agreements stipulate that the employer will receive the greater of the premium paid or the cash value, there is rarely significant tax exposure.

Other Considerations
Regardless of how many transfers a policy goes through or how many times it is exposed to the transfer-for-value tax, it is the last transfer before death that ultimately determines whether the proceeds will be subjected to the tax. If a policy is currently positioned in such a way that the tax would be triggered, it should be reviewed in light of the proscribed exceptions to the rule. While the focus of this article is transfer for value, it is also important to remember that whenever a life insurance policy is being transferred, either through a gift or sale, the proper valuation is the fair mar-

ket value. In conjunction with the transferfor-value discussion, a common question is whether the cash value is an appropriate value for the policy. The IRS has made it abundantly clear that it is not (Revenue Procedure 2005-25). It is also important to remember that other IRC sections might inadvertently trigger taxation of the death benefit, such as IRC section 101(j), which addresses the treatment of certain employer-owned life insurance contracts. Furthermore, the sale or purchase of life insurance by a grantor trust, from the grantor on the life of the grantor, will be treated as a sale to the grantor, thus circumventing both the threeyear rule and the transfer-for-value prob lem (Revenue Ruling 2007-13). Andrew I. Shapiro, MSM, CLU, ChFC, holds the title of directoradvanced consulting group, Nationwide Financial, Columbus, Ohio.

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M A N A G E M E N T corporate management

A Potential Resurgence of Outsourcing

Essential Questions Answered
By Charles E. Davis and Elizabeth Davis
or some, the word outsourcing conjures thoughts of domestic jobs transferred overseas. For others, it calls to mind images of potential bottom-line improvement. And for at least one companyRenesas Electronics Corp., which produces 40% of the microprocessors used by automakers around the worldit is a way to hedge against supply-chain interruptions; the company recently reported plans to outsource 25% of its production by 2013 (up from 8% currently) in response to the earthquake and tsunami that hit Japan in March 2011 (Chester Dawson, Even Japan Inc. Looks Offshore, Wall Street

F
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Journal, April 11, 2011). Regardless of ones personal view on outsourcing, it is a business practice that is here to stayand it is likely to increase in the future. Businesses and their advisors should keep the following considerations in mind when looking to outsource operations.

Overview of Outsourcing
Although outsourcing started in earnest in the late 1970s as a business strategy that allowed companies to focus on their core competencies while moving noncore competencies to providers
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with relevant expertise, businesses relied on outsourcing much earlier than that. ADP, for example, began offering payroll services to companies in the 1950s; today, the company is among the worlds largest providers of outsourced business processes. In its most basic method of implementation, outsourcing is the use of an external service provider to perform functions that a company prefers not to perform internally. For example, a company located in Waco, Texas, might choose to contract with a company in Seattle, Washington, for Internet sales, fulfillment, and shipment services; a call center in Toronto, Canada, for telephone customer support; and a computer services company in Bangalore, India, for application development and programming services. As shown in Exhibit 1, each of these three arrangements illustrates a different, specific category of outsourcing, based on the geographical distance between the service buyer and the service provider. In an onshoring arrangement, a company outsources work to a service provider in its home country, as illustrated by the Waco companys use of a service provider in Seattle. Offshoring, on the other hand, is the general term used for outsourcing across national borders. These types of arrangements are often referred to differently, depending upon the distance between the domestic service buyer and the international service provider. For example, if the international service provider is geographically

close to the service provider, the arrangement is referred to as nearshoring; when the international service provider is geographically distant from the service buyer, the arrangement is referred to as farshoring. There is no single outsourcing solution that is ideal for all companies; rather, each company must consider which combination of onshoring, nearshoring, and

farshoring will allow it to best accomplish the strategic and operational goals set by managementa practice that is sometimes called rightshoring. This article, however, will use the generic termoutsourcingrather than distinguish between the various specific methods. While not technically outsourcing arrangements, shared service centers and

EXHIBIT 1 Three Categories of Outsourcing Arrangements

Seattle Toronto Waco Bangalore

OFFSHORING

WACO TO SEATTLE: ONSHORING Using a service provider in ones home country

WACO TO TORONTO: NEARSHORING Using a service provider in an adjacent or relatively close foreign country

WACO TO BANGALORE: FARSHORING Using a service provider in a distant foreign country

EXHIBIT 2 Areas of Information Technology (IT) Outsourcing

Website/e-commerce systems Software as a service Network operations IT security Help desk Disaster recovery services Desktop support Database administration Data center operations Application maintenance Application development 0% 10% 20% 28% 24% 21% 31% 22% 21% 28% 38%

43% 58%

51% 30% 40% 50% 60% 70%

Percentage of surveyed organizations outsourcing IT functions Source: Computer Economics, IT Outsourcing Statistics, 2010/2011

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captive centers represent alternatives that companies might consider. A shared service center is an internal business unit that provides services across a company, such as information technology (IT) support or procurement services; this allows the company to reduce redundancies by consolidating functions into a single location. Bain & Companys Management Tools & Trends 2011 survey found that

the use of shared service centers is declining, and some early adopters of this business model have turned to outsourcing. A captive center is basically a shared service center that is located in a foreign country, often one with lower wages, in order to realize cost savings without having to deal with a middleman outsourcing provider. First seen in the 1980s, the use of captive centers has grown more than

300% since 2003 (Jan Erik Aase, Four New Offshore Captive Center Models, July 27, 2011, http://www.cio.com/article/ 686791/4_New_Offshore_Captive_Center_ Models). But some companies have begun to sell off these centers to reduce fixed costs and free up invested capital, as Citibank did when it sold captive centers to Tata Consultancy Services and Wipro in 2008 and 2009, respectively.

EXHIBIT 3 Globally Outsourced Finance and Accounting Functions

Who Is Outsourcing?
There are two sides to an outsourcing partnershipthe service buyer and the service provider. A company of any size can act as an outsourced service buyer, and companies in any industry can outsource their operations. As an example of the variety of industries that participate in outsourcing arrangements, Verizon, Procter & Gamble, Catholic Health Partners, Barclays, and Thames Water have all signed new outsourcing agreements in the past several months. There are myriad outsource service providers, and the International Association of Outsourcing Professionals (IAOP) compiles an annual list of the best outsource service providersThe Global Outsourcing 100. The IAOPs 2012 full list can be found online (http://www.iaop.org/content/ 19/165/3437).

100% Percentage of Organizations Outsourcing 80% 60% 40% 20% 0% Procure to Pay Order to Cash Record to Report

85%

69%

69%

Source: EquaTerra, Global Finance & Accounting Outsourcing Service Provider Performance and Satisfaction (SPPS) Survey: 2010

EXHIBIT 4 Top 10 Global Outsourcing Locations by Attribute

Financial Attractiveness Vietnam Indonesia Senegal Pakistan Ghana Sri Lanka Philippines India Egypt Tunisia People Skills and Availability United States* India China United Kingdom* Germany* Canada France* Brazil Spain Australia Business Environment Singapore Germany* Canada Estonia United Kingdom* Australia France* Ireland United Arab Emirates Czech Republic

Why Are Companies Outsourcing?

The main reason that companies turn to outsourcing is to reduce operating costs. In a survey by AMR Research, 78% of middle-market companies and 79% of enterprise companies stated that this was the primary reason for outsourcing (Josh Hyatt, The New Calculus of Offshoring, CFO.com, October 1, 2009). Secondary drivers for outsourcing differ, however, depending upon the size of a company. Enterprise companies are more likely to use outsourcing in order to make global operations more effective and to transform or reengineer existing processes. Middlemarket companies, on the other hand, are more likely to see outsourcing as an opportunity to gain access to new skill sets or technology that the company doesnt have in house. When it comes to outsourcing finance and accounting operations, cost savings were the primary driver of future finance and accounting outsourcing deals for 92%
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Rank 1 2 3 4 5 6 7 8 9 10

* Second-tier locations in the country Source: A. T. Kearney Global Services Location Index, 2011

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of companies that took part in a recent survey, Global Finance and Accounting Outsourcing Service Provider Performance and Satisfaction Survey 2010, conducted by outsource advisor EquaTerra (which was acquired by KPMG in February 2011). The next three most important drivers were quality improvement (49%), financial flexibility (24%), and access to skills (19%), according to the survey.

What Are Companies Outsourcing?

The answer to this question might be What are companies not outsourcing? All functional areas are candidates for outsourcing, as long as the decision to outsource makes strategic and operational sense. The most commonly outsourced functions are IT, human resources, finance and accounting, procurement, and facilities management, according to an EquaTerra report, 4Q10 Advisor and Service Provider Pulse Survey Results. One major area that is frequently outsourced is IT. A company might choose to outsource all of its IT operations or it might choose to outsource one or more discrete areas. These outsourcing arrangements can be large, as evidenced by the recent five-year, $200 million contract for ACS to provide managed IT services for MGM Resorts Intl. Exhibit 2 gives a snapshot of the extent and forms of IT outsourcing, as recently reported by a Computer Economics survey of 210 IT organizations in the United States and Canada. Software as a service (SaaS), a relatively recent phenomenon, has been embraced by 58% of the surveyed organizations. As the use of cloud computing increases, it is likely that even more companies will utilize this type of outsourcing. The Computer Economics survey also found that outsourcing differs between smaller and larger organizations. For instance, 66% of large companies (as measured by IT budgets) reported outsourcing application development functions, compared to only 45% of small and mid-sized firms. While the survey examined the extent of outsourcing a number of individual IT functions, the discussion below focuses solely on application development in order to illustrate the extent of the differences that exist between companies of various sizes. Furthermore, the future of outsourcing application development functions differs
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according to organization size, with 43% of large firms expecting to increase the level of outsourcing, compared to only 19% of small and mid-sized firms. A small percentage of these entities expects outsourcing of application development to decrease in the future (12% for small to mid-sized firms; 5% for large firms). This expectation for decreased outsourcing likely resulted from dissatisfaction with the quality of current outsourcing arrangements and the realization that, in some cases, outsourcing functions is more costly than providing the service internally. Finance and accounting functions are ripe for outsourcing. EquaTerra followed the development of finance and accounting outsourcing (often referred to as FAO) and examined 110 FAO contracts, with a total value of over $1 billion, in its survey, Global Finance & Accounting Outsourcing Service Provider Performance and Satisfaction (SPPS): 2010. The survey found a high degree of consensus on the finance and accounting functions that organizations are outsourcing. As Exhibit 3 shows, the procure to pay cycle is the most frequently outsourced finance and accounting function. Doing so allows organizations to not only reduce their operat-

ing costs, but also realize cost savings from the reduced purchase prices that result from the volume discounts that the outsource provider is able to negotiate.

Where Are Companies Outsourcing To?

The entire world is available to a business looking for a location to outsource its operations. Since 2003, A. T. Kearney has conducted an annual study of the most attractive outsourcing destinations and has ranked the top 50 of these using a weighted score that includes financial attractiveness (40%), people skills and availability (30%), and business environment (30%). The top three most attractive locations for outsourcingIndia, China, and Malaysiahave not changed since 2007. Rounding out the rest of the 2011 top ten are Egypt, Indonesia, Mexico, Thailand, Vietnam, the Philippines, and Chile (http://www.atkearney.com/index. php/Publications/offshoring-opportunitiesamid-economic-turbulence-the-atkearney-global-services-location-indexgsli-2011.html). While there appears to be relative consistency in the top 10 locations overall, this is not the case when examining the three individual components of the overall ranking. As Exhibit 4 shows, several countries

EXHIBIT 5 Top 10 Global Outsourcing Locations by Outsourced Process Type

Business Process Outsourcing Voice Operations IT Outsourcing

Country India China Malaysia Egypt Indonesia Mexico Thailand Vietnam Philippines Chile

High industry activity

Low industry activity

Source: A. T. Kearney Global Services Location Index, 2011

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that are not in the top 10 overall global outsourcing locations still fare well when looking at individual characteristics. For example, Singapore has the best business environment for outsourcing and the United States (in second-tier mid-sized cities such as Madison, Wisconsin; Raleigh/Durham, North Carolina; and New Orleans, Louisiana) has the greatest advantage for people skills and availability, but neither country places in the top 10 overall ranking. These differences mean that decision makers will likely need to make some trade-offs when selecting an outsourcing location. Not all countries are created equal when looking at the type of activity that is best

outsourced there, as shown in Exhibit 5. For example, the 2011 Kearney report found that India has a high level of outsourced activity in business process outsourcing, voice operations, and IT outsourcing. China, on the other hand, has very low levels of outsourced voice operations. And while Thailand is viewed as the seventh most attractive location for outsourcing, it has actually seen little outsourcing activity to date. When considering FAO, India is a clear choice, followed by Central and Eastern Europe, as shown in Exhibit 6. These differences illustrate that outsourcers must consider the type of processes being outsourced, and the ability of a particular location to

handle those processes at an acceptable level of service, when choosing an outsource location. Just as different industries outsource different business processes, they also choose to outsource those processes to different locations. Based on results reported in BDO 2011 Technology Outlook: Executive Summary, it appears that this choice of location changes over time. Exhibit 7 shows the preferred outsourcing locations from 2008 to 2011 for technology companies. The percentage of technology companies surveyed that outsource operations in India has steadily declined during this period, while those using Western Europe has increased.

EXHIBIT 6 Global Financial and Accounting Outsource Locations

90% 80%

Looking to the Future

Predicting the future is always a tricky business, and outsourcing is no different. In a 2004 study of offshoring, Forrester Research predicted that 3.4 million service jobs in the United States would be offshored by 2015up from 315,000 in 2003 (John C. McCarthy, Near-Term Growth of Offshoring Accelerating, May 14, 2004). Other studies have conjectured that as much as 25% of jobs in the United States are potential candidates for offshoring (Linda Levine, Offshoring (or Offshore Outsourcing) and Job Loss Among U.S. Workers, Congressional Research Service, January 21, 2011). But outsourcing advisors and service providers appear to disagree on where outsourcing is heading, as reported in EquaTerras 4Q10 Advisor and Service Provider Pulse Survey Results. Exhibit 8 shows that providers and advisors differ most on the future of social media and social networks used for business purposes, as well as on the poor economic conditions driving companies to look for additional outsourcing opportunities. As companies look to establish new outsourcing contracts or renegotiate existing ones, the contract details will likely look different from those of the past. Companies are realizing that outsourcing is more than just securing initial operating cost savings. The unexpected costs that arise during a long-term contract can negate those initial cost savings. Unstable political environments in some countries that are home to outsourced operations increase the potential for a deal to go bad. New contracts will
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Percentage of Organizations

70% 60% 50% 40% 30% 20% 10% 0% 43% 19% 18% 14% 8% 78%

India

Central and Central America Eastern Europe

Caribbean

Philippines and China

South America

Source: EquaTerra, Global FAO Service Provider Performance and Satisfaction Survey, 2010

EXHIBIT 7 Geographical Concentration of Technology Company Outsourcing

70% 60% 50% 40% 30% 20% 10% 0% 2008 2009 2010 2011

Canada

China

Eastern Europe

India

Latin Southeast America Asia

United States

Western Europe

Source: BDO 2011 Technology Outlook: Executive Summary, 2011

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be shorter and will include the ability to renegotiate the contract as circumstances change during the life of the contract. These contracts will also focus more on pay-for-performance metrics to ensure that promised efficiencies and cost savings are actually realized (Josh Hyatt, The New Calculus of Offshoring, CFO.com, October 1, 2009). If past events are any indication, outsourcing might be headed for a resurgence. The recessions of both the early 1980s and 2001 saw companies turning to outsourcing as a means of reducing operating costs and focusing on core business competencies. The latter recession saw more companies outsourcing white-collar jobs, as the supply of highly educated, low-cost professional workers grew in low-wage countries like India. With the recent economic woes around the world, increased levels of outsourcing may be on the horizon. Because unemployment has risen in the United States during the recent economic crisis, some believe that companies are now bringing previously offshored jobs back

to the domestic front. As second- and thirdtier cities in the United States become more attractive locations for outsourcing, previ-

With the recent economic woes around the world, increased levels of outsourcing may be on the horizon.

But even though this movement might be occurring to some extent for manufacturing jobs, businesses are still interested in the use of nearshore and farshore outsourcing, as well as captive service centers, for business services, such as IT, finance and accounting, and human resources, according to a KPMG report, Sourcing Advisory 4Q11 Global Pulse Survey. Over 50% of outsourcing providers and advisors surveyed believed that there would be either some or a significant increase in the demand for nearshore and farshore outsourcing in the future. While specific predictions about the future of outsourcing are impossible to make with exact accuracy, one thing seems certainoutsourcing is here to stay. Charles E. Davis, PhD, CPA, is the Walter Plumhoff Professor of Accounting in the Hankamer School of Business at Baylor University, Waco, Tex. Elizabeth Davis, PhD, CPA, is an executive vice president and provost, also at Baylor University.

ously offshored work might return to the United States. For example, Starbucks recently announced plans to move some manufacturing of coffee mugs from China back to a dormant plant in Ohio.

EXHIBIT 8 Future Outsourcing Trends

Cloud computing overall Global sourcing/globalization Cloud computing in lieu of outsourcing Poor economic conditions, debt crisis, etc., driving more outsourcing Remote infrastructure management Shared service centers Social media or social networks used for business purposes Poor economic conditions, debt crisis, etc., driving less outsourcing Protectionism/less outsourcing Offshore captives 1.0 2.0 3.0 4.0 5.0
Advisors Service Providers

1.0 = Cold (little market impact); 5.0 = Hot (major market impact) Source: EquaTerra, 4Q10 Advisor and Service Provider Pulse Survey Results

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E S P O N S I B I L I T I E S

& education

E A D E R S H I P

Multiple Financial Accounting Standards Intensify the Dilemma of What to Teach

Stalled Convergence Presents Challenges for Educators
By Heather M. Lively and Nicholas J. Mastracchio, Jr.
ith the prospect of a completely converged set of accounting standards seemingly no longer imminent, public accounting firms must face complying with different standards for different clients. Moreover, financial accounting instructors face the challenge of teaching multiple accounting standards in one course and fitting this additional subject matter into their curriculum. The discussion below considers the current state of convergence, how it affects the teaching of accounting standards, and what can be done to address this issue. The added costs from having to use this complex hodgepodge (different country reporting standards) of financial information can run in the tens of millions of dollars annually. In the international arena, they can act as a barrier to ( Defining Issues , no. 7-34, p. 1, November 2007) And a presidential white paper on regulatory reform stated: Accounting standard-setters (the IASB [International Accounting Standards

A Single Set of Standards

Currently, the sets of accounting standards that might be taught in college courses are U.S. GAAP and International Financial Reporting Standards (IFRS). In 2010, the SEC stated that it has long promoted the development of a single set of high-quality, globally accepted accounting standards, and, in February of that year, the SEC directed its staff to develop and execute a work plan detailing the incorporation of IFRS into the U.S. financial reporting system (http://www.sec.gov/ spotlight/globalaccountingstandards.shtml). Although the SEC was expected to decide the fate of IFRS in the United States in 2011, it postponed the release of the final staff report until July 2012 (http://www.sec. gov/spotlight/globalaccountingstandards/ifrs -work-plan-final-report.pdf), and its release does not include a firm recommendation. The idea that IFRS should become the single set of global financial standards had been promoted for some time before the SEC developed its work plan. In May 2005, former FASB Chair Robert Herz stated:

forming and allocating capital efficiently. Thus, there are growing demands for the development of a single set of high quality international accounting standards. (In Search of a New Financial World Order, May 2005) Diverse institutions supported this sentiment. For example, KPMG stated: The current and growing breadth of IFRS adoption across the world suggests that IFRS has become the most practical approach to achieving the objective of having a single set of high-quality, globally-accepted standards for financial reporting. Those who share this belief are influenced by the fact that the IASBs structure and due-process procedures are open, accessible, responsive, and marked by extensive consultation.

Board] and FASB) need to continue to make substantial progress toward adoption of a single set of high quality standards. Improving and eliminating international differences in fair value accounting are key ingredients of regulatory reform of financial markets. (Financial Regulatory Reform, White House White Paper, June 2009).

Moving Away From Convergence

Recently, the prospect of a single set of accounting standards has dimmed. In December 2011, former SEC Chief Accountant James Kroeker commented on the progress of FASB and the IASBs convergence efforts: Based on the deliberations and tentative conclusions reached thus far, it is
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unclear whether the Boards will be able to reach convergence on key aspects of all projects. Further, the Boards reprioritization of certain Joint Projects makes it unclear whether these projects would be completed in the foreseeable future and, if so, whether substantial progress towards convergence would be made before any Commission consideration of whether to incorporate IFRS into the financial reporting system for U.S. issuers (A Comparison of U.S. GAAP and IFRS , SEC staff paper, November 16, 2011). Contrary to Herzs statement in 2005, the current members of FASB have abandoned the idea of a single set of standards. In October 2011, FASB Chair Leslie F. Seidman said that convergence was no longer the boards goal, but that a condorsement approachthat is, a practical approach allowing the standards to continue to be labeled as U.S. GAAPwould be more appropriate. This would entail adopting some IFRS standards but not other, while remaining independent and maintaining U.S. GAAP. In a December 2011 speech at the AICPA National Conference on Current SEC and PCAOB [Public Company Accounting Oversight Board] Developments, Seidman stated that the original objective was overly ambitious in scope (http://www.fasb.org/ cs/ContentServer?site=FASB&c=Document_ C&pagename=FASB%2FDocument_C%2F DocumentPage&cid=1176159498181). The head of the IASB agreed with her conclusion (FASB, IASB Chiefs Agree New Convergence Model Is Needed, Journal of Accountancy, December 2011). In an interview with CPA Journal Editor-in-Chief Mary-Jo Kranacher, Seidman was asked whether she agreed with the statement that permitting different U.S. standards on some issues (i.e., carve-outs) doesnt really provide a truly global set of standards. She responded that she was not sure that carve-outs were necessarily bad. This answer further demonstrates the boards reluctance to embrace one single set of standards. In a September 2011 survey, the AICPA found that approximately 54% of respondents approved of optional adoption of IFRS. But without a clear regulatory timetable, there will continue to be a delay in preparing for global standards. On February 9, 2012, the AICPA reported that
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the monitoring board and the trustees of the IFRS Foundationthe parent of the IASBissued recommendations for improving the governance of the foundation and setting its strategy (Oversight Groups Report on Steps to Enhance IASB Governance, Financing, by Ken Tysiac). The AICPA stated that this effort puts additional pressure on the United States to incorporate IFRS, used by public companies in more than 100 nations. With the SEC and FASB emphasizing the concept of condorsement, however, it seems likely that both IFRS and U.S. GAAP are here to stay. Based upon its survey with practicing CPAs, the AICPA has decided that entrylevel CPAs should be familiar with IFRS; thus, questions relating to IFRS have been incorporated into the CPA exam. In April 2011, the New York State Board of Accountancy voted 123 that the inclusion of IFRS on the CPA exam was premature. The Colorado State Board has expressed a similar opinion. But despite some objections, the CPA exam now features questions addressing IFRS.

panies should not be leading the charge, en masse, to an IFRS-based set of standards before the SEC makes a decision on U.S. public companies (Report to the Board of Trustees of the Financial Accounting Foundation, January 2011). The FAF formed a trustee working group to address the blue ribbon panels report and, in October 2011, it proposed instead to create a Private Company Standards Improvement Council (PCSIC) that ultimately would be subject to FASB ratification over the standards-setting process. Immediately following the announce-

In addition to the continued presence of U.S. GAAP and IFRS, it appears that, in some cases, separate rules will exist for large and small companies.
ment of the FAFs proposal to create the PCSIC, AICPA President and CEO Barry Melancon and AICPA Chair Paul Stahlin showed their disappointment with the FAFs proposal through their press release, Addressing FAFs Failure to Create an Independent Standard Setting Board for Private Company Financial Reporting. NASBA, however, endorsed this approach. The PCSIC would have replaced the current Private Company Financial Reporting Committee (PCFRC), which was created in 2006 to advise FASB on accounting standards for private companies; however, it has been criticized for not being independent and for having its proposals rejected by FASB. Even the FAF acknowledged that the PCFRC has not been wholly successful in achieving its mission, in part because in its early years, the FASB did not participate fully in its processes or pay sufficient attention to its recommendations (Plan to Establish the Private Company Standards

Private Company Standards

In addition to the continued presence of U.S. GAAP and IFRS, it appears that, in some cases, separate rules will exist for large and small companies. A Blue Ribbon Panel on Private Company Financial Reporting was formed in 2009 by the AICPA, the Financial Accounting Foundation (FAF), and the National Association of State Boards of Accountancy (NASBA). The members of the panel represented a cross-section of financial reporting constituencies, including lenders, investors, and owners, as well as preparers, auditors, and regulators. In January 2011, the panel recommended that a separate board be established under the FAF, which also oversees FASB. International standards already have provisions for small companies. In 2009, the IASB developed and published separate guidance intended to apply to the generalpurpose financial statements of small and medium-sized entitiesIFRS for SMEs. IFRS for SMEs is organized by topic, with each topic presented in a separate numbered section. Although the blue ribbon panel considered IFRS for SMEs, it rejected this model because U.S. private com-

63

Improvement Council, FAF Board of Trustees, October 2011). In May 2012, the FAF announced the establishment of a Private Company Council (PCC), replacing the earlier PCSIC proposal. The PCCs decisions will be subject to endorsement by FASB, rather than ratification, and other provisions have been made to ensure that the PCC can exercise sufficient independence from FASB (see Nicholas C. Lynch, The Controversy over Private Company Reporting Standards, The CPA Journal, July 2012). The final implementation differs from the blue ribbon panels initial recommendation, but the PCC ultimately won the support of the AICPA (Why the AICPA Supports FAFs Creation of Private Company Council, by Barry Melancon, http://blog.aicpa.org/ 2012/06/why-the-aicpa-supports-fafs-creation-of-private-company-council.html).

knowledge of IFRS (Robert P. Derstine and Wayne G. Bremser, The Journey Toward IFRS in the United States, The CPA Journal, July 2010). PricewaterhouseCoopers is providing material for faculty to use in their classes, with the hope that these resources will be useful to faculty who wish to introduce IFRS into the classroom. The PricewaterhouseCoopers Charitable Foundation awarded grants to 30 schools to develop IFRS in

Part of the reason for the lack of coverage of IFRS in the curriculum could be that faculty members have been waiting for complete convergence.
the curriculum. Even with material like this, however, the teaching of IFRS has been slow to catch on. Of the 30 schools to receive grants, 17 do not list any separate courses in international accounting or IFRS in their online course descriptions. The University of Wisconsin has also developed a program structured around integrating IFRS into the curriculum. The school received a grant from the PricewaterhouseCoopers Charitable Foundation, under which the faculty of the department of accounting and information systems developed an integrated set of IFRS instructional activities in 12 courses, with participation by 14 faculty members. The activities were designed so that the materials could be used in multiple courses or with students at different stages in the program sequence. The material includes syllabi for the courses, and both the courses and the syllabi are on the schools website. The University of Delaware states that its goal is to develop a graduate course in IFRS. The University of Dayton has an arrangement where students in an interna-

Teaching Financial Accounting Standards

As recent developments indicate, there is substantial disagreement as to how different standards would be overseen but no fundamental objection to the idea of separate standards for small companies. There will be different standards for small companies that will have to be taught and applied in practice. Thus, there exists a dilemma about what academia should do with respect to teaching these standards, given the restraints of university resources. Some schools have taken steps to introduce multiple standards into accounting courses: In 2008, Virginia Polytechnic Institute published an 87-page guide on introducing IFRS into intermediate accounting courses. It referenced three intermediate accounting texts: Kieso, Weygandt, and Warfield (Wiley); Spiceland, Sepe, and Tomassini (McGraw-Hill/Irwin); and Stice, Stice, and Skousen (South-Western). It also suggested discussions and questions covered in the texts various topical units. In the summer of 2009, KPMG collaborated with the American Accounting Association (AAA) on a survey of educators that focused on the current status of IFRS education in universities. The AAA survey reported the widespread view (39% of professors surveyed) that the class of 2014/2015 will be the first graduating class of accounting students with a substantial

tional accounting course spend 10 days in England and receive a certificate in IFRS from the Institute of Chartered Accountants in England and Wales (ICAEW). In addition to the international accounting courses, the ICAEW also offers a separate IFRS certificate class. But these efforts seem to be the exception to the rule. This articles authors conducted a survey of 160 colleges and universities that offer degrees in accounting or related subjects. In a search of catalogs, course descriptions, and websites, 77% do not mention international requirements or IFRS. Twenty-nine percent had a course listed as international accounting; however, one-third of those did not indicate that it covered IFRS, but that it covered such things as foreign currency exchange, foreign corrupt practices, and other international topics. Over one-quarter of the schools listing an international accounting course did not offer the course within the last year. It is possible that some schools might be covering IFRS and not reporting it in their course descriptions. Recent editions of textssuch as Intermediate Accounting by Kieso, Weygandt, and Warfieldinclude brief discussions of the differences between U.S. GAAP and IFRS at the end of each chapter. These authors also have an IFRS edition, which is used primarily outside the United States; only 30 schools in the United States use the international edition, according to the texts publisher. These courses are usually IFRS-specific courses outside of the traditional intermediate financial accounting sequence. Part of the reason for the lack of coverage of IFRS in the curriculum could be that faculty members have been waiting for complete convergence, after which they could use texts that focus solely on IFRS. Another reason could be that instructors are reluctant to add subject matter that they are not familiar with to their courses. An additional reason is that brief comments on the differences between the two systems do not capture the fact that IFRS is principles-based and U.S. GAAP is rulesbased; U.S. GAAP has 17,500 pages, compared to the 2,500 pages of IFRS.

What Must Be Done?

Regardless of the reason, the two sets of standards are here now and there are no
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indications that this status quo will change soon. It might seem hard to believe that most of the economic world can adopt IFRS while the United States does not, but this would not be a first for the country; the Metric Conversion Act of 1975 designated the metric system as the preferred system of weights and measures for U.S. trade and commerce, and directed federal agencies to convert to the metric system to the extent that it was feasibleincluding the use of metric in construction of federal facilities. It also created the United States Metric Board to assist in the conversion. This board no longer exists. Most observers would probably agree that the conversion to the metric system has failed in the United States. To serve the students and the firms that will employ their graduates, schools need to adopt a curriculum that incorporates both IFRS and U.S. GAAP. The use of end-ofchapter acknowledgment of the difference between U.S. GAAP and IFRS on the

topic discussed in the chapter would be a simple way to accomplish some coverage. For example, the University of Detroit Mercy indicates in its description of intermediate accounting that international differences in a few accounting areas are briefly discussed. The school uses the intermediate book by Kieso, Weygandt, and Warfield that has endof-chapter discussions of IFRS and the course description discusses these end-ofchapter presentations. With respect to the issue of Big GAAP, Little GAAP, the authors are hopeful that the differences implemented for small companies will be minimal. If so, it will also be possible to teach this topic through end-ofchapter material in intermediate financial accounting texts. No doubt it will also appear in future CPA exams. Logically, there should not be a need for multiple sets of standards for financial reporting, such as IFRS, IFRS for SMEs, U.S. GAAP, and private company U.S. GAAP; however, the situation does exist,

and academia must recognize that fact and adjust curricula accordingly. Of course, the dilemma exists not just in academia; public accounting firms must also comply with the different standards for different clients. Because todays students will make up tomorrows workforce, it is important for firms to remain aware of these education al developments. Heather M. Lively, MAcc, CPA, is an instructor at the University of South Florida, Sarasota-Manatee, Fla. Nicholas J. Mastracchio, Jr., PhD, CPA, is an assistant professor, also at the University of South Florida. He was formerly the Arthur Andersen Alumni Professor of accounting at the University at Albany, where he holds emeritus status; was a chair of the New York State Board of Accountancy; and spent three years on the AICPA Board of Examiners that oversees the CPA exam.

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E S P O N S I B I L I T I E S

& education

E A D E R S H I P

Multiple Auditing Standards Intensify the Dilemma of What to Teach

Diverging Guidance Presents Challenges for Educators
By Nicholas J. Mastracchio, Jr., and Heather M. Lively
In October 2011, after an extensive fouryear project, the ASB issued new standards in a format that essentially converged with ISAs. For example, the new SAS 122, Statements on Auditing Standards: Clarification and Recodification, is an 805page pronouncement that supersedes AU section 110, Responsibilities and Functions of the Independent Auditor; AU section 120, Defining Professional Requirements in Statements on Auditing Standards; AU section 150, Generally Accepted Auditing Standards; AU section 201, Nature of the General Standards; AU section 210, Training and Proficiency of the Independent Auditor; AU section 220, Independence; and AU section 230, Due Professional Care in the Performance of Work. On September 1, 2011, the AICPA issued a report, Substantive Differences Between the International Standards on Auditing and Generally Accepted Auditing Standards [GAAS], that analyzed the differences, labeled as Requirements in the ISAs not in GAAS. It concluded that almost all of the differences are due to laws and regulations or accounting frameworks that are not applicable in the United States. Only two exceptions were cited: ISA 600, The Work of Related Auditors and Other Auditors in the Audit of Group Financial Statements, does not allow the audit report on group financial statements to make reference to a component auditor unless required by law; GAAS does. ISA 810, Engagements to Report on Summary Financial Statements, allows two different phrases in opining on summary financial statements; GAAS only uses one. The new pronouncements are effective for audits of financial statements for periods ending on or after December 15, 2012. Although the CPA Exam Content Specification Outline lists international auditing standards, the questions on the exam will include the new GAAS standards and will probably eliminate the international standards because they have almost all converged into GAAS.

hile the gap between standards issued by the International Auditing and Assurance Standards Board (IAASB)the auditing standards-setting committee of the International Federation of Accountants (IFAC)and those issued by the Auditing Standards Board (ASB) has been minimized, auditing standards within the United States for audits of publicly traded companies and private companies have grown even further apartand indications are that they will continue to do so. At present, there seems to be little hope for the convergence of the ASBs auditing standards and those of the Public Company Accounting Oversight Board (PCAOB), which regulates the activities of auditors of public companies in the United States. Thus, educators who teach courses on auditing are faced with the dilemma of how to present multiple standards, as well as explain the differences that exist between codified ethical standards in the United States and international standards.

Two Sets of U.S. Auditing Standards

In April 2003, the PCAOB adopted certain preexisting standards as its interim standards, including GAAS, as described in 43 sections of the ASBs SASs. Essentially, because the PCAOB did not adopt the revisions to GAAS, its standards are based on the superseded SASs and are no longer identical to the ASBs standardsthat is, many of the 49 AU sections still used by the PCAOB have been superseded by the ASB, the original author. In the meantime, the PCAOB has issued 14 outstanding standards; thus, two sets of substantially different auditing standards now exist in the United Statesthe ASBs standards and the PCAOBs standards, which consist of the ASBs superseded standards and some of its own. Unfortunately, unlike the ASBs efforts to converge with international standards, the PCAOB has expressed no interest in converging with the ASBs standards. At the annual NASBA meeting in October 2011, PCAOB Chair James Doty was asked whether there was any effort to converge the PCAOBs and ASBs standards. He said that the PCAOB talks to the ASB but has not established any task force nor made any formal effort to converge with ASB standards. Craig Mills, AICPA vice president of examinations, was asked at this same meeting which set of standards would be covered on the CPA exam. He replied that both would be covereda logical conclusion, because entry-level CPAs should be expected to know both.

Convergence with International Standards

In 2007, the ASB initiated the Clarity Project to address the clarity, length, and complexity of its auditing standards. It decided to redraft the standards and converge the Statements on Auditing Standards (SAS) with International Standards on Auditing (ISA) issued by the IAASB. The ASB established a Clarity Task Force to clarify and converge the SASs and the ISAs. The clarified standards were restructured, and objectives were established for each clarified SAS, including a definition section and a separation of requirements from application material.

Teaching Auditing Standards

Many colleges do not have the resources for two auditing courses, and they face a
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choice about what to cover in the course that they do have. Thus, auditing instructors are confronted with two sets of standards and the dilemma of deciding what to incorporate into an auditing course. The authors review of university course descriptions for auditing courses gave little hint as to the extent to which each set of standards was taught. There were a few exceptions, however, such as California State University, Long Beach, which claimed to cover current pronouncements of the PCAOB. The textbooks used in these courses can be a better indicator of what is being taught in auditing courses. Of course, that does not mean the text is not supplemented with additional material. A study of six leading auditing texts shows a bias between the two sets of standards. One text sets the tone in its introduction to the ASB: The AICPA continues as the standard setter for audits of nonpublic clients. The AICPA has gained back a good portion of the creditability it lost during the late 1990s (Larry E. Rittenberg, Karla Johnstone, and Audrey Gramling, Auditing: A Business Risk Approach, 7th ed., Cengage, p. 51). It then proceeds to start most chapters with discussions of the PCAOB and the integrated audit approach. Another text states: This text initiates its presentation with an integrated audit of financial statements and internal control over financial reporting (ICFR). It uses a public company integrated audit as its primary teaching platform (Karen L. Hooks, Auditing and Assurance Services: Understanding the Integrated Audit, Wiley, p. xxvi). A third text, although not as obviously as the other two, discusses topicssuch as the 10 general auditing standardswithout any indication that these were eliminated from GAAS over a year ago (the copyright is 2012), and it leads off with the PCAOB standards for reports (Alvin A. Arens, Randal J. Elder, and Mark S. Beasley, Auditing and Assurance Services: An Integrated Approach, 14th ed., Prentice Hall, p. 34). Another text introduces the pronouncements of both the ASB and the PCAOB, listing the relevant sections at the beginning of each chapter (Iris C. Stuart, Auditing and Assurance Services: An Applied Approach, McGraw-Hill/Irwin). The two final texts take the approach of using ASB standards, with commentary regarding PCAOB standards where necesOCTOBER 2012 / THE CPA JOURNAL

sary. One of these texts states, In the majority of this textbook we will focus on generally accepted auditing standards established by the AICPA. In areas in which there are differences, we will discuss them in addition (Ray Whittington and Kurt Pany, Principles of Auditing and Other Assurance Services, 18th ed., McGraw-Hill/Irwin, p. 33). The other states, In this book we use the U.S. ASB standards as a foundation and build in requirements from PCAOB standards that are more stringent than ASB requirements (William F. Messier, Steven M. Glover, and Douglas F. Prawitt, Auditing and Assurance Services: A Systematic Approach, 8th ed., McGraw-Hill/Irwin, p. 53). This text also lists ASB and PCAOB sections at the beginning of each chapter. All of these approaches will be more difficult now that there are fewer identical standards between the ASB and PCAOB. Auditing instructors must find a way to incorporate the two sets of standards into their auditing courses. The selection of a text that takes this approach would greatly assist in the process. The new ASB standards will make the teaching of both sets of standards more difficult, and the differences will likely increase over time. That said, there might have to be a reduction in subject matter if the curriculum includes only one three-credit course in auditing.

cations are structured differently, and both are included on the CPA exam. The IESBA standards consist of the following three parts: Part A establishes the fundamental principles and framework, and includes sections on threats and safeguards. Part B applies to accountants in public practice. Part C applies to accountants in industry. The AICPAs code of ethics is broken down into four parts: principles of professional conduct, rules of conduct, interpretations of the rules, and rulings by the professional ethics executive committee.

What Must Be Done?

As with accounting standards, there should not be a need for two sets of auditing standardsone set created by the PCAOB, the other by the ASB. Many educational institutions only offer one auditing course to students, and only a limited amount of time is available. The divergence of auditing standards is not likely to go away, however, and it must be dealt with by academia. Some schools are choosing their approach based on where their graduates are typically employed. Smaller schools might lean toward teaching the ASB standards. But the issue is not exclusively a problem for academia; public accounting firms must also comply with different standards, depending upon whether there will be an SEC filing. Lastly, although there are similarities between the two applicable codes of ethics, accounting instructors still face the dilemma of how to allocate class time to these topics and whether to teach both the AICPA code and the IESBA code. Nicholas J. Mastracchio, Jr., PhD, CPA, is an assistant professor at the University of South Florida, Sarasota-Manatee, Fla. He was formerly the Arthur Andersen Alumni Professor of accounting at the University at Albany, where he holds emeritus status; was a chair of the New York State Board of Accountancy; spent three years on the AICPA Board of Examiners that oversees the CPA exam; recently completed three years on the ASB; and served on the Clarity Task Force. Heather M. Lively, MAcc, CPA, is also an instructor at the University of South Florida.

Teaching Ethics
The teaching of ethics should be universal, regardless of the codification of ethical rules. The sources of ethical standards go back at least as far as Aristotle. The utilitarian approach suggests that ethical action is the one that provides the most good or does the least harm. The rights approach maintains that ethical action is the one that best protects and respects the moral rights of those affected. The fairness approach suggests that all equals should be treated equally. The common-good approach maintains that ethical actions should contribute to the life of the community. The virtue approach suggests that ethical actions ought to be consistent with certain virtues. But auditors do more than just follow these moral approaches; they must comply with rules of ethics that are codified either by the AICPA or IFACs International Ethics Standards Board for Accountants (IESBA). These two codifi-

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E C H N O L O G Y

it management

10 Questions Audit Committees Should Ask

Managing Information Technology Risks
By Jeff Krull and Kevin Rich

recent survey of corporate board members by Oliver Wymans Global Risk Center and the National Association of Corporate Directors (NACD) found that nearly half of respondents (47%) were dissatisfied with their boards of directors ability to provide information technology (IT) risk oversight, even though virtually all respondents believed that IT would impact their organization within the next five years (Jonathan Cohn and Mark Robson, Taming Information Technology Risk: A New Framework for Boards of Directors, Oliver Wyman and the NACD, 2011). This disconnect can have significant implications for an organizations audit committee, which is typically responsible for oversight of the effectiveness of internal controls that address risk. For example, a majority of audit committee members (58%) surveyed by KPMG and the NACD stated that they would like to devote more attention to IT risk and emerging technologies (2011 Public Company Audit Committee Member SurveyHighlights, KPMG and the NACD 2011). There are various IT-related questions that diligent audit committee members should pose to the management of their organizations. They should also pay attention to certain red flag responses that might arise and should consider avenues for further inquiry, as well as potential strategies for working with management to improve the state of IT controls.

Overseeing IT Risk
One important trait of a good audit committee member is the ability to ask probing questions of management; however, this can be hard to do in an environment that requires a significant amount of technical knowledge, such as IT,

because individuals might hesitate to ask questions on a topic that lies outside their expertise. Only 16% of Oliver Wyman/NACD survey respondents reported that they have been a chief information officer (CIO) or senior IT executive during their career; this lack of experience might limit the ability of audit committees to rigorously monitor the state of IT risk in their organizations. Effective IT risk oversight also requires strong communication between an audit committee and a companys IT leadership. Despite the importance of IT in the achievement of an organizations objectives, results from the KPMG/NACD survey suggest that audit committee members often feel that they have insufficient contact time with their organizations CIO. Therefore, it is critical that audit committees get the most out of the time that they do spend with IT leadership.

Audit committee members should consider the following questions as they assess their organizations IT risks and initiate a dialogue with IT leadership. Although asking a set of rigorous initial questions of IT leadership is critical, effective monitoring also requires a detailed critique of managements responses. The sections below provide examples of red flag responses, as well as potential follow-up questions and activities.

1. How Many Times Has the Company Been Hacked This Year?
A recent survey of 583 U.S companies suggested that over 90% of U.S. companies suffered at least one intrusion into their computer network in 2011 (Perceptions About Network Security: Survey of IT and IT Security Practitioners in the U.S., Ponemon Institute, 2011). Foreign and domestic hackers are attacking U.S. busiOCTOBER 2012 / THE CPA JOURNAL

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nesses using increasingly complex tools, some of which are able to infect machines, collect sensitive information, and send the information back to a host computer. Such network intrusions are rarely disclosed to the public, but when they are, they can generate a significant amount of negative press about an organization. Red flag response. A typical red flag response in this situation is We havent been hacked. Given the prevalence of attacks, a response of no intrusions might indicate that either 1) the organization has not done enough to determine whether its system has been hacked or 2) the person who knows the answer is not at the meeting. Next steps. The audit committee should inquire about the methods that IT leadership uses to identify hacker activity and should assess how much confidence management has in the metrics. Furthermore, committee members should determine whether a robust incident-response plan exists to mitigate any damage from attacks and notify the appropriate levels of management.

systems controls took place and whether it extended beyond financial controls.

3. What Is the Definition of a Successful IT Project?

Stakeholders often fail to appropriately define the criteria for a successful project upfront; even when they do, they allow it to change when problems arise. Setting goals and evaluating progress against them can be especially important, given that implementation consultants usually get paid more when there are

of hardware leads to a security breach that is followed by litigation. Red flag response. One potential red flag response in this case is, It costs too much. Although it may not be easy to concretely quantify the cost of data breaches, it is possible to estimate how much it would cost to encrypt all of an organizations laptops. Next steps. The audit committee should ask the IT organization to compile an estimated cost of encrypting all portable devices that contain sensitive information so that committee members can make an

Committee members should determine whether a robust incident-response plan exists to mitigate any damage from attacks and notify the appropriate levels of management.
issues than when everything proceeds according to plan. Red flag response. A vague response, such as a system that does what it is supposed to do, should be a red flag for audit committee members. Audit committee members should ask: Is it within budget? Was the system completed on time? Does the system contain all necessary features? When defining success, the audit committee should communicate, to those accountable for the project, what committee members find important and how it will deal with issues if they arise. Next steps. The audit committee should work with IT leadership to define concrete goals for IT projects over a specified dollar amount and periodically review performance against these goals. educated decision from a cost-benefit perspective. Moreover, the cost of encrypting devices continues to decrease, making it an increasingly viable option for organizations of all sizes.

2. How Many People Can Access Sensitive Data?

Many organizations lack a cohesive method of answering this question, especially with respect to confidentiality and privacy. It is important to remember that there are varying levels of access, ranging from the ability to change and manipulate data to being able to view sensitive information about customers, vendors, and employees stored in files on a computer network. Red flag response. One red flag might be if management answers, We have controls complying with the Sarbanes-Oxley Act of 2002 [SOX]. Such IT controls focus exclusively on internal controls over financial reporting; although these controls can play a role in providing that financial transactions are not manipulated, they do little to ensure that sensitive data are kept private and confidential. SOX controls generally only focus on the core financial systems and do not extend to other systems that might be operationally critical. Next steps. Audit committee members should determine which measures their organization takes in accordance with the Trust Services Framework, which is focused on confidentiality, privacy, processing integrity, availability, and security. It might also be useful to identify when the last review of
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5. Are Strong Password Policies Enforced?

Passwords, which play an integral role in providing a secure computing environment, serve as one of the last lines of defense against attempted intrusions. Hackers often have very sophisticated tools at their disposal for reverse-engineering passwords, and their task is made much easier when an organization fails to require strong passwords. Red flag response. One red flag response might be, Our users will just write them down on a post-it note. If this is the case, then it could indicate a lack of security awareness training or poor IT governance. The organization must reinforce the importance of strong passwords in keeping data secure, and it must remind employees to defend them with the same rigor that they would apply to their own Social Security numbers. Next steps. Audit committee members should work with management to devel-

4. Are Laptops and Other Portable Devices Encrypted?

At some point, every organization with data on portable devices will likely have to deal with a lost or stolen machine. Encrypting laptops helps show adequate controls, which can reassure stakeholders in the event of a lost machine. In addition, it can help avoid liability if the loss

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op a formal policy related to password security (including defined consequences for violations) and determine whether additional employee training sessions are warranted.

6. Has a Disaster Recovery Plan Been Tested Recently?

Testing is an integral part of ensuring that disaster recovery plans will work when they are needed. IT environments change frequently, and it is easy to overlook the latest changes made to a plan. As such, dis-

aster recovery plans should be completely tested on a regular basis. Furthermore, disaster recovery plans often encounter problems during the test run, at which point it is often much easier to rectify issues than when facing an actual crisis. Red flag responses. If management responds, We havent tested it, or It costs too much to test, the audit committee should be wary. Asking when the plan will be tested or how much it costs can help set the tone at the top for the organizations governance structure.

Next step. Similar to encryption, it is important to ascertain whether cost concerns for conducting a test of the disaster recovery plan are based upon fact or conjecture.

7. Are Service Providers Keeping Data Safe?

Many organizations outsource large pieces of their operations, ranging from data center maintenance to payroll processing. In addition, organizations increasingly utilize consultants to analyze historical transaction data in order to make recommendations on

EXHIBIT 1 Summary of Key Questions, Red Flag Responses, and Next Steps
Question 1. How many times has the company been successfully hacked this year? 2. How many people can access customers or employees sensitive data? Red Flag Responses We havent been hacked. We have SOX controls. Next Steps Inquire about the methods used to evaluate hacker activity.
Determine what the organization does that is related to the Trust Services Framework. Identify timing of last full IT controls review.

3. What is the definition of a successful IT project? 4. Are laptops and other portable devices encrypted? 5. Are strong password policies enforced? 6. Has a disaster recovery plan been fully and completely tested recently? 7. Are service providers keeping data safe? 8. Does the organization have any IT assets that are not controlled or administered by the IT department? 9. Has the organization performed and documented a formal IT risk assessment? 10. Is there adequate IT coverage from an internal audit perspective?

A system that does what it is supposed to do. It costs too much.

Work with management to develop concrete IT project goals and periodically assess performance against these goals. Ask for cost estimates to encrypt portable devices to facilitate a cost-benefit analysis. Work with management to develop a formal policy on passwords and determine if additional training is necessary. Require that IT leadership quantify the cost cost of testing the disaster recovery plan. Decide whether to pursue Service Organization Controls (SOC) 2 or SOC 3 reports from outside service providers. Evaluate whether a policy for the use of personal devices is appropriate. Work with IT leadership to develop a framework for periodic IT risk assessment procedures. Benchmark the IT internal audit function against peer organizations or industry best practices.

Our users will just write them down.

We havent tested it. It costs too much. We get a Statement on Auditing Standards (SAS) 70 report. Its in our contract. We dont know. Yes. We havent.

We havent evaluated it.

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improving profitability. These relationships create opportunities for sensitive data to exit the organization and are difficult for top management to track because of the ease of transmitting data. Red flag responses. The following are two potential red flags: Management might say, We get a Statement on Auditing Standard [SAS] 70, Service Organizations, report. Service Organization Controls (SOC) 1 reports based on Statement on Standards for Attestation Engagements (SSAE) 16, Reporting on Controls at a Service Organization, and the successor to SAS 70 reportsonly cover internal controls over financial reporting in a users financial statement audit. They have, by definition, a very limited scope and do very little to ensure and maintain data privacy. Management might claim, Its in our contract. This may be true, but contractual confidentiality guarantees will likely provide little protection in the event of a significant data breach, especially if the third-party provider is a much smaller organization. Next steps. The AICPA has set criteria for SOC 2 and SOC 3 reports that service providers can follow to assure clients about their IT control environment, including adherence to the Trust Services principles. It might also be beneficial for an audit committee to press IT leadership to enquire whether engaged third-party vendors have faced these kinds of examinations, the findings of which are often only released upon request.

mation, but lack the security features that assets under the control of the IT department possess. Red flag responses. Some red flag responses might be We dont know, or even, Yes. As smartphones and tablet devices continue to increase in popularity, this issue will likely only increase in importance. Next steps. The audit committee should encourage management to decide whether a policy is needed to authorize the use of personal devices for company purposes, which can include a review by the IT department for minimum security features.

Red flag response. One answer that should raise a red flag is, We havent evaluated it. Organizations devoting fewer resources to the IT internal audit function might have less robust IT risk management practices than otherwise comparable organizations. Next steps. The audit committee should suggest that management evaluate how the amount of IT internal audit coverage compares to peer organizations or industry best practices.

Successful Audit Committee Oversight

These 10 questions represent a starting point for audit committee members seeking to learn more about the state of IT risk at their organization. Because all organizations differ, additional questions designed to understand the specifics of how IT impacts operational activities might also be required. (See the sidebar, For More Information, for useful links.) In addition, audit committee members might need to consider whether a combination of minor problems can lead to major issues when critiquing responses from IT leadership. Audit committees can only provide effective oversight of IT risk when they have adequate access to an organizations key IT personnel. The authors recommend that audit committees periodically invite IT leadership and IT auditors to both executive sessions and audit committee meetings in order to gain a better understanding of how they are responding to the IT risks facing an organization. This can serve to elevate the position of IT-related issues with top management and ensure periodic outside monitoring. Jeff Krull, CPA, CISA, is a partner at ParenteBeard LLC, Philadelphia, Pa. Kevin Rich, PhD, CPA, CFE, is an assistant professor of accounting at Marquette University, Milwaukee, Wis.

9. Has the Organization Performed and Documented an IT Risk Assessment?

Risk assessment procedures are an excellent time to take an inventory of IT assets and evaluate how they impact an organizations operations. Furthermore, recurring IT risk assessment procedures require IT personnel to stay current with the latest outside threats. Red flag response. If management responds, We havent, then an audit committee should be wary of a potential red flag. Organizations rarely have unlimited resources to devote to IT security, and risk assessment procedures can help ensure that control procedures are placed where they yield the largest benefit. Next steps. Audit committee members should work with IT leadership to develop a formal framework for IT risk assessment procedures, paying particular attention to details such as scope and frequency. Once implemented, the committee should require that IT leadership report the results to them on a periodic basis.

8. Does the Organization Have Any Assets Not Controlled by the IT Department?
Any device that connects to an organizations network can expose it to a security breach, including those that are owned by individual departments or employees. These devices often contain sensitive infor-

10. Is there Adequate IT Coverage from an Internal Audit Perspective?

IT is often underrepresented in an organizations internal audit plan, for reasons ranging from cost to technical expertise.

FOR MORE INFORMATION

Trust Services Framework Service Organization Controls (SOC) 2 and SOC 3 Reports ISACA Risk IT Framework www.aicpa.org/interestareas/informationtechnology/resources/trustservices/pages/default.aspx http://www.aicpa.org/interestareas/frc/assuranceadvisoryservices/pages/aicpasoc2report.aspx http://www.isaca.org/Knowledge-Center/Risk-IT-IT-Risk-Management/Pages/Risk-IT1.aspx

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

Website of the Month: Tax Foundation

By Susan B. Anders

he Tax Foundation is a nonpartisan tax research and education group that provides information related to tax policy and government finance on its website, http://taxfoundation.org. Although this site was previously reviewed in The CPA Journal in December 2008, the upcoming national election, as well as major changes to the site, presents a good opportunity to revisit its resources. The Tax Foundation offers a vast selection of unique materialssuch as tax policy calculators and tax mapsthat can aid tax professionals in understanding current debates on tax policy, as well as in tax planning activities. The publications provided on the website are easy to read, and they contain useful tables, charts, and graphs. In addition, many data files are available as free downloads. The website is organized by topical area and type of resource. The topical coverage spans federal, state, and international tax issues, with information housed under the categories of tax basics, tax topics, federal tax policy, state tax policy, and legal tax reform, as well as other smaller topical pages. Users can access resources in a variety of formats, including publications, data and charts, videos, blog posts, maps, podcasts, and press releases; links to specific resources can be found in the upper righthand corner of the homepage. The sites press room section includes contact information for Tax Foundation staff, press releases, and media coverage. The center of the homepage highlights four featured articles in continuous rotation. At the time of this review, they included a comparison of the Obama and Romney tax plans; an interactive tax calculator with tax policy customization options; an article promoting an end to the estate tax; and a short video interview with Tax Foundation

President Scott A. Hodge, discussing the need for corporate tax reform. The remainder of the homepage highlights selected tax basics, key tax issues, a tax-by-state interactive feature, and the most recent posts from the Tax Policy blog.

The tax reform report includes a table that compares Obamas and Romneys plans to the Simpson-Bowles proposal. Selected issues include top marginal tax rates on personal income, corporate income, long-term capital gains, and divi-

Presidential Candidate Tax Proposals

An informative, prenational election feature is Romney, Obama, and SimpsonBowles: How Do the Tax Reform Plans Stack Up? by William McBride, which compares the two candidates tax plans with the proposal from the cochairs of the National Commission on Fiscal Responsibility and Reform (i.e., the Simpson-Bowles plan, November 2010). A link to the Tax Foundation report is available on the homepage; it can also be downloaded as a PDF. Both versions include footnoted links to informative underlying documents, such as a draft presentation on the Simpson-Bowles proposal.

dends. Tax expenditures and alternative minimum tax reforms, payroll tax rates, and the estate tax are also covered. One article found in the websites federal tax policy section, The Estate Tax: Even Worse than Republicans Say by David Block and Scott Drenkard, takes advantage of a Joint Economic Committee report (issued by the committees Republican staff) to reemphasize the Tax Foundations position on the estate tax and briefly summarize recent changes, current conditions, and current administration proposals. The remainder of the article focuses on the perceived failure of the estate tax to meet expectations, as
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well as potential damaging effects on the economy. Another example of how the Tax Foundation leverages its tax policy research in order to participate in the public debate is an article featured on the websites homepage at the time of this review, The Fiscal Costs of Nonpayers by Will Freeland, William McBride, and Ed Gerrish, released after remarks by presidential candidate Mitt Romney directed press attention to taxpayers who file but do not have any tax liability.

Publications
The Tax Foundation issues a variety of free publicationsincluding Tax Watch, a quarterly policy newsletter, and Tax Features, a bimonthly policy review found in the sites publications section. It also features studies, special reports, and booklets; longer books are available at relatively low prices. One example of a featured article is Taxing the Uninsured: The Latest Estimates by William McBride, which explores the Supreme Court ruling that the Patient Protection and Affordable Care Act falls under Congresss power to tax. It summarizes the tax effects for the uninsured and provides a table based on family size. Another article, State Tax Changes During 2011 by Joseph Henchman, reports on state tax collections, individual and corporate income tax rate changes, and adjustments to sales and excise taxes. A copy of a testimony given by Hodge to the U.S. Senate Committee on Finance, Are Tax Credits the Proper Tool for Making Higher Education Affordable? details the Tax Foundations view of some unintended consequences of introducing credits and deductions into the tax code, including price inflation and high fraud rates. The Tax Foundations convenient 50page booklet, Facts & Figures Handbook: How Does Your State Compare? by Scott Drenkard, can be downloaded for free, or a hard copy can be purchased for $10. The booklet includes individual and corporate income tax rates, as well as rates for other taxes, such as sales, excise, property, and excise and inheritance. A variety of other data is also covered, such as lottery revenue, state debt, and income and tax burdens per capita. The studies and special reports section address a wide selection of topics, rangOCTOBER 2012 / THE CPA JOURNAL

ing from state to international tax issues and from individuals, estates, and corporations to industry-specific taxation. Most of the reports average 10 pages in length and include tables, charts, and graphical summaries. Generally, only the reports introduction is available on the web; the rest must be downloaded in PDF format. A 28-page special report, A Global Perspective on Territorial Taxation by Philip Dittmer (August 10, 2012), provides background information on the debate over worldwide versus territorial taxation of corporation income. It also presents summary tables that reflect the move by many developed nations to the territorial approach and easy-to-read comparisons of aggregate data for outbound foreign direct investment, unemployment, and tax revenue. Surveys of five developed nations that have switched from worldwide to territorial taxation are also discussed.

Calculators and Data Tools

Useful calculators and interactive tools can be found in the tax basics section of the website (http://interactive.tax foundation.org/About/). For example, the tax burden calculator estimates an individuals tax liability under three basic scenarios: full expiration of all the Bushera tax cuts, the Republican plan to extend the Bush-era tax cuts, and the current administrations proposals. Users can change the tax policy options in any of the basic scenarios or create custom scenarios. In addition to the tax burden calculator, the website also offers a healthcare tax calculator, a marginal tax rates calculator and graph, and a value-added tax (VAT) calculator. The healthcare tax calculator estimates the tax effect of various provisions of the Patient Protection and Affordable Care Act, such as the excise tax on high-cost health insurance plans and the increase in the itemized deduction threshold for medical expenses. Users can drill down to brief descriptions and effective dates of the provisions. The marginal tax rates calculator includes two example scenarios with graphs and explanations, as well as video instructions for additional help. This calculator shows the marginal tax effects of changes to income and deductions. Users can also enter ranges, as opposed to specific amounts, and create tax rate graphs.

Another calculator allows users to estimate a potential U.S. VAT; they can also specify various policy parameters and taxation categories. The data tools resource, found on the same webpages as the calculators discussed above, includes information on property tax, migration, and state spending limits. Property tax data by county include national and state median property taxes paid, taxes as a percentage of median home value, and taxes as a percentage of median income. State-to-state migration data show the number of people moving into and out of a state and their net adjusted gross income. The state spending limit feature allows users to set an imaginary spending cap for a state and compare actual state expenditures to that limit. Selected federal tax rates for 2012, found in the federal tax policy section, include individual and corporate income tax, Social Security and Medicare, and several federal excise taxes. Historical federal individual income tax rates, in nominal and inflation-adjusted dollars, are available for every year from 1913 through 2011. U.S. corporate income tax rates are available from 1909 through 2012, along with comparisons to Organization for Economic Cooperation and Development data. State individual income tax rates, accessible from 2000 through 2012, can be found in the websites state tax policy section. The Tax Foundation has provided its own summary of the latest federal income tax data, available as a webpage or an 11-page PDF (http://taxfoundation. org/article/summary-latest-federalindividual-income-tax-data-0). The data tables cover the number of federal returns filed, total income tax after credits, average tax rates, and several other topics. The tax-by-state tool, found in a blue box on most pages, is a useful feature that summarizes basic tax information for each state and organizes the sites materialsarticles, blog posts, podcasts, and videosby state. The individual state pages also provide access to several data files on individual and corporate income taxes, sales taxes, and property tax information. 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
FOR

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

SALE l BUSINESS SERVICES l TAX CONSULTANCY

WALL STREET CPA looking for right individual to share and merge into my office space. Move in ready with ultra high tech hardware and software built in. info@goldfinecpa.com 212-714-6655. Two retirement-minded partners looking to affiliate with energetic sole practitioner for future buyout. Our firm is well established in Putnam County, with a diversity of clients. Contact: jeff@bolnickandsnow.com.

Small full service LI CPA firm looking to acquire practice with revenue of at least $250k. We are ready to help the right individual(s) in transition and acquisition of your practice. We have extensive experience in tax and financial statement reporting and will take great care of your clientele. Contact: Elitecpas@gmail.com. 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. Successful 2 partner firm in Midtown with quality infrastructure looking to merge for mutual benefit. CPA10040@gmail.com.

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OCTOBER 2012 / THE CPA JOURNAL

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

Westchester Junior Equity Partner (no capital investment needed) Long established & very successful firm seeks successor for founder. If you want to be an owner & are a manager or heavy senior with strong tax /audit & accounting skills, this could be an ideal situation. Nice offices and relaxed work environment. An attractive comp package will be designed for the right person. Please respond confidentially to cderian@sixdegreesresearch.com.

Are you an entrepreneurial CPA with quality public accounting, audit and tax experience? Would you like to acquire a $500,000 Long Island practice from a retiring CPA ratably over the next five years? If so, provide background for consideration to NassauCPAfirm@gmail.com. Established Long Island CPA firm seeks to expand. We are interested in acquiring a retirement-minded small to medium-size firm in the NY Metro Area. We have a successful track record of acquiring practices and achieving client retention and satisfaction. Please contact Andrew Zwerman at azwerman@wzcpafirm.com. Accounting practice for sale in Buffalo area. Gross 300-350K. Reply to pfswny@gmail.com.

MayerMeinberg, one of the fastest growing CPA firms with offices in New York City and Long Island is looking to continue expanding its practice through merger and/or acquisition opportunities. We are seeking entrepreneurial practices ranging from $500,000 to $3,000,000. Also considering firms with areas of specialization in Forensic and Litigation Support and other industry specialization. Please contact: rmayer@mayermeinberg.com.

Young, energetic and dynamic husband and wife accounting team seeks retirement-minded practitioner with write-up and/or tax preparation practice in New York City area for merger and eventual buy-out. Contact: anthony@c-allc.com. 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. Highly successful, $3.5 million, midtown CPA firm seeks merger with firm/practitioner grossing $1-7.5 million for continued growth and profitability. Steady growth and attractive offices make for unique opportunity. E-mail nyccpaoppty@yahoo.com. Accounting practice for sale in Buffalo area. Gross 300-350K. Reply to pfswny@gmail.com.

Central Jersey CPA firm seeks an individual, preferably with a small practice for future partnership with retirement minded partners. E-mail: bam4711@yahoo.com. Long Island CPA with solid diversified practice of $175,000 - $200,000 seeks affiliation with eventual buyout. Open to any agreement that is mutually beneficial. Practitioner to retire within 10 years. Practitioner has significant time available to work for new affiliated firm. If interested contact: hdf99@aol.com.

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.

SPACE FOR RENT

AAA PROFESSIONAL OFFICES FOR RENT. NASSAU COUNTY. 1-, 2-, 3-room suites facing Hempstead Tpke. FREE UTILITIES. FREE FRONT PARKING. 516-735-6681. 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. Windowed Office in CPA Suite, Plainview. Includes Secretary/Bookkeeping Services. NJR11804@aol.com. Midtown CPA firm has nicely decorated offices to sublet/share with us, fully furnished and computerized, for up to 20 people. All or part available. Convenient and cost effective. Merger possible. cparentalnyc@gmail.com. 650 rsf on 5th Avenue @ 34th St. $50 sf. 2 offices. Avenue views. 24/7 access. Elliot @ 212-447-5400. WALL STREET CPA looking for right individual to share and merge into my office space. Move in ready with ultra high tech hardware and software built in. info@goldfinecpa.com 212-714-6655.

CPA FIRMS OR PARTNERS We represent a number of quality CPA firms who would like to merge with other CPA firms or Partners with business. Offices are in the Metropolitan area. This is an opportunity to insure your future as well as help your clients by expanding your services to them. Why settle when you can select? For further info: please contact: Len Danon at D&R Associates Inc. 212-661-1090 ext 14 SERVING THE CPA COMMUNITY SINCE 1939

Established, Northern New Jersey and New York City, mid-sized CPA Firm seeks to merge with another like-minded CPA firm for mutually beneficial growth. We are seeking Firms in the $500,000 to $2,000,000 size in Northern or Central New Jersey or New York. This is your opportunity to expand without being gobbled up by one of the big guys. To confidentially discuss this opportunity please contact NYNJCPAS@gmail.com.

Successful Midtown NYC Firm (founded 1958) with $3M+ practice seeks a firm grossing $500K - $1M with retirement minded owners for merger and eventual transition. Contact in confidence. 212-901-6114.

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Sub-lease office space available. Utilities included. Short walking distance to LIRR Great Neck Station. contact: lisa@acmgmt.com. Buffalo, NY: Office in CPA suite. Per diem work available. Ken Weinstein - 716-837-2525. Office 10x12, available in Larchmont $650/month Furnished windowed office available for professional. Walking distance to Metro-North accountingfirm17@gmail.com, 914.815.2061.

Tax Manager/Reviewer, CPA, skilled preparer and reviewer, seeks 6-8 days/mo. per diem. indauditor@yahoo.com.

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

INNOVATIVE STRATEGIES

Jeffrey J. Coren, CPA

212-594-6970 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. PEER REVIEWS Providing Peer Reviews since 1990 Available for Consulting. Pre-Issuance Reviews and Monitoring Kurcias, Jaffe & Company LLP (516) 482-7777 ijaffe@kjandco.com emendelsohn@kjandco.com 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.

PEER REVIEW SERVICES

PEER REVIEW SPECIALIZING IN EMPLOYEE BENEFIT PLANS CIRA, BROKER DEALERS INSPECTIONS & REVIEW SERVICES JOHN M SACCO, CPA JMSacco@SAccoManfre.com 914-253-8757 SACCO MANFRE CPA PLLC 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 Yehuda@bunkercpa.com 718-438-4858 Yehuda Bunker, CPA 30 years not for profit accounting

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

SITUATIONS WANTED
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 516-448-3110. Small full service LI CPA firm looking to acquire practice with revenue of at least $250k. We are ready to help the right individual(s) in transition and acquisition of your practice. We have extensive experience in tax and financial statement reporting and will take great care of your clientele. Contact: Elitecpas@gmail.com. TAX PREPARER - EXPERIENCED (FLUSHING, NEW YORK) FLUSHING EA firm, seeks experienced tax preparer familiar with Lacerte for Tax Season. E-mail: richp@petrocelligroup.com or fax to: 718-961-4587.

HELP WITH PREPARING FOR PEER REVIEW.

Financial statement work, audit procedures, workpapers, drafting footnotes. Can fill audit engagement quality reviewer, manager, or senior roles. Many satisfied clients.

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

CALL SHIMON D. EINHORN, CPA

(917) 318-7498 s.einhorn@juno.com

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

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OCTOBER 2012 / THE CPA JOURNAL

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

THE BENEFITS OF EXPERIENCE

Do your clients require a Retirement Plan, 403(b) Plan and/or a Health & Welfare Plan Accountants Audit Report for Form 5500?

CONTACT US

Certified Public Accountants & Profitability Consultants Our Employee Benefits & Executive Compensation Accounting and Tax Services Group provides the experience and expertise your clients deserve Avery E. Neumark, CPA, JD, LLM Rosen Seymour Shapss Martin & Company LLP 757 Third Avenue, New York, NY 10017 Tel: 212-303-1806 Fax: 212-755-5600 aneumark@rssmcpa.com www.rssmcpa.com A Member of the AICPA Employee Benefit Plan Audit Quality Center

BUSINESS SERVICES
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 margenjid@yahoo.com

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

Now you can offer your clients multi-state tax consulting services.
Let us serve as your firms outsourced state & local tax / sales & use tax experts, behind the scenes or directly with you and your clients. Our team has over 100 collective years of state & local tax experience, including Big 4 firms and industry. Team includes former state sales & use tax auditors. Experience working with CPA and law firms. National firm experience at competitive rates.

MARKETING SERVICES
Is your website attracting enough business? Get practical tips for making your website part of a profit-building plan. For your free copy, call Mostad & Christensen at (800) 654-1654 or go to: www.mostad.com/kc/ss.

Nexus services Audit representation M&A transactions

Refund reviews Advisory services Research

Call Andy Toth, CPA, at 716.633.1373 or e-mail ajt@tsacpa.com to learn more.

BUSINESS OPPORTUNITIES
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.

Solutions Beyond the Obvious

www.tsacpa.com

OCTOBER 2012 / THE CPA JOURNAL

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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.

Greatland Sterling National Bank ADP Small Business Services Audimation Services, Inc. Accounting Practice Sales PNC Bank Camico

C2 01 05 23 29 31 37

www.greatland.com www.snb.com www.accountant.adp.com www.audimation.com www.accountingpracticesales.com www.pnc.com/cfo www.camico.com

Strategies for Wealth Rosenthal & Rosenthal

43 45 www.rosenthallinc.com www.LITPS.org www.transitionadvisors.com www.nysscpainsurance.com www.camico.com

Nassau/Suffolk Chapter NYSSCPA 47 Transition Advisors LLC Pearl Insurance Camico 74 C3 C4

Classified Rates
Rates & Word Count: Basic Rate: $4.00 per word; $56 minimum charge14 words. 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: jeff@leonardmedia.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 215-675-9208, ext. 201, fax: 215-675-8376, or E-mail: jeff@leonardmedia.com

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.

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OCTOBER 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 Dow Jones Total Stock Market Dow Jones Transports Dow Jones Utilities 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. 8/31/12 1,407 13,091 3,067 8,015 14,636 5,007 468 8/31/12 0.15% 0.41% 3.25% 2.90% 3.53% 4.12% 0.10% 0.60% 1.57% -0.70% YTD Return 11.80% 7.10% 17.70% 7.20% 11.60% -0.20% 0.80% 7/31/12 0.15% 0.44% 3.25% 2.97% 3.57% 3.54% 0.09% 0.61% 1.51% -0.71% Fort Capital's Proprietary Market Risk Barometer Market Valuation Monetary Environment Investor Psychology Internal Market Technicals Overall Short-Term Outlook Overall Long-Term Outlook 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 (Estimated 2011 EPS) 5.31 6.04 Bullish 10 9 8 7 Neutral 6 5 4 6 6 5 5 Bearish 3 2 1

As of 8/31/12 8/31/12 2.72% 13.60 2.69 7.02% 2.02% 14.25 13.85 7/31/12 2.73% 16.29 2.73 7.16% 2.24% 13.97 13.54

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 (monthly) Unemployment Rate NYS Index of Coincident Indicators (annual)

Most Recent

Prior Month

Chart of the Month

Durable Goods Orders (Percentage Change)

1.70% 0.60% 8.10% 49.60 53.70 96,000

0.30% 0.00% 8.30% 49.80 52.60 163,000

6.0% 4.0% 2.0% 0.0% -2.0% -4.0%

Mar 2012

Jan 2012

Apr 2012

May 2012

0.60% NA 1.80%

-0.20% 9.10% 1.70%

Source: Federal Reserve

Commentary on Significant Economic Data This Month For the month of July, durable goods orders grew by 4.2%, a large increase from the 1.6% increase in June, and the largest increase witnessed this year. Although the top line reported number looks good at first glance, digging deeper reveals issues that raise concerns for a weaker economic climate down the road. Excluding transportation orders, it actually fell by 0.4%. Core capital goods orders dropped 3.4% during the month, which is worse than the 2.7% drop seen in June. In addition, inventories increased for the 31st consecutive month, growing 0.7%. These declines in core capital goods and increased inventoriesalong with the recession in Europe and the looming threat of the fiscal cliff in the United Statesare all signs that the economy does face headwinds that could temper growth going forward.

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.

Feb 2012

Jun 2012

Jul 2012

-6.0%

OCTOBER 2012 / THE CPA JOURNAL

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

Whats Left in the Feds Monetary Policy Toolkit?

Bernanke Tests Version 3.0
he Federal Reserve System is the central bank of the United States, charged with formulating monetary policy to pursue maximum employment and price stability in our economy. On September 13, 2012, Federal Reserve Chairman Ben Bernanke announced that the Federal Open Market Committee (FOMC), the Feds chief policy-making group, was ready to provide a third round of quantitative easing (QE3)a plan to buy $40 billion of mortgage-backed securities every month for an indefinite period of time, while keeping interest rates near zerowith the intention of bringing the unemployment rate down to 7.6% by the end of 2013. The Fed has attempted to stimulate the economy twice before, with questionable results each timeQE1 (the 2008 Wall Street bailout) and QE2 (the 2010 purchase of Treasury bonds). When asked to explain how the policy of giving money to financial institutions on Wall Street could be expected to help Main Street, Bernanke described the rationale behind the plan: by making mortgage money readily available and keeping interest rates low, home prices will begin to rise, which will make homeowners feel more prosperous and consumers more willing to spend. This additional spending, in turn, will help businesses grow and hire more workersin summary, Bernankes version of trickledown economics.

load, especially in this economic environment. And keeping interest rates low will continue to discourage savings and will disadvantage retirees, many of whom depend on investment income to cover their living expenses. Although prior stimulus plans lifted stock prices, the market rush was shortlived, like a temporary sugar high. At the same time, gas prices also increased, leading some to wonder if this could be the beginning of the return of inflation. Has the Fed developed a tolerance for inflation, given the current condition of our economy? According to Bernanke, the Feds projections dont involve any inflation because the FOMC believes inflation will stay close to 2% through mid-2015.

Monetary Policy Limitations

It would be unrealistic to expect that the Fed could unilaterally solve our economys problems with the limited monetary policy tools it has at its disposal. In theory, QE3 should work; in reality, however, the funds often seems to get stuck in a money pipeline bottleneck before they can get into the hands of consumers and investors. Consider some additional economic complexities: the wild gyrations of the stock market in response to reports of trouble in the European Union, gas price increases whenever there is political instability or tension in the Middle East (a regular occurrence), and questions regard-

ing the adequacy of some of our largest financial institutions capitalization. Add to this the downgrades of U.S. government bond ratings by credit research firms (the latest was Egan-Joness downgrade of U.S. debt from AA to AA-), arguably a reflection of a dysfunctional federal fiscal process. The next crisis may be triggered by the so-called fiscal cliff the potential sequestration (automatic spending cuts) and the scheduled expiration of the Bush tax cuts that will occur if our legislatorswho seem to think compromise is a dirty word cannot reach an agreement on fiscal matters before the end of the year. Its no wonder that consumer confidence in the future of our economy has fallen, and with it, consumer spending. A recent study by the Fed showed that unemployment would fall to approximately 7% if consumers felt less uncertainty about economic issues. Unfortunately, I dont think the Fed has anything in its toolkit to fix that problem. As always, I welcome your comments. 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 The opinions expressed here are my own and do not reflect those of the NYSSCPA, its management, or its staff.
OCTOBER 2012 / THE CPA JOURNAL

Ben There, Done That

Although QE might seem like a good idea at first, it isnt a panacea; after all, wasnt excessive liquidity (that is, easy money) a contributing factor to the financial crisis that began in 2008 with the subprime mortgage scandals? Theres still too much debt in the private sector for QE3 to do much good, because most people are unable or unwilling to increase their debt

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