Pages

Plus• Changes in Pension Accounting• Economic Substance Doctrine• Questions on Outsourcing

Is Real Tax Reform

Realistic?

ESSENTIALS

24 Accounting & Auditing❙ Accounting

A New Reality Ahead for Pension Accounting?:The Recession’s Aftermath and IAS 19R Prompt Changes in Accounting Practices

By James M. Fornaro

❙ AuditingAudit Fee Patterns of Big Four and Non–Big Four Firms:

A Study of the Potential Effects of Auditing Standard 5By H. Leon Chan, David G. DeBoskey, and Kevin Hee

❙ Financial ReportingDisclosures on Derivatives and Hedging Transactions:

A Review of Best PracticesBy Ira G. Kawaller

40 Taxation❙ Compliance & Enforcement

The Economic Substance Doctrine:Understanding the IRS’s Guidance on its Proper Application

By Karyn Bybee Friske, Karen M. Cooley,and Darlene Pulliam

❙ State & Local TaxationMarriage Equality in New York and Beyond:

To Love, Cherish, and TaxBy David Spaulding and Jay Freeberg

50 Finance❙ Personal Financial Planning

Transfers for Valuable Consideration:Tax Issues when Transferring a Life Insurance Policy

By Andrew I. Shapiro

68 Technology❙ IT Management

10 Questions Audit Committees Should Ask:Managing Information Technology Risks

By Jeff Krull and Kevin Rich

❙ What to BookmarkWebsite of the Month: Tax Foundation

By Susan B. Anders

56 Management❙ Corporate Management

A Potential Resurgence of Outsourcing:Essential Questions Answered

By Charles E. Davis and Elizabeth Davis

62 Responsibilities & Leadership❙ Education

Multiple Financial Accounting StandardsIntensify the Dilemma of What to Teach:

Stalled Convergence PresentsChallenges for Educators

By Heather M. Lively and Nicholas J. Mastracchio, Jr.

❙ EducationMultiple Auditing Standards Intensify

the Dilemma of What to Teach:Diverging Guidance Presents Challenges for EducatorsBy Nicholas J. Mastracchio, Jr., and Heather M. Lively

C O N T E N T S

o c t o b e r 2 0 1 2

24

18

6 PerspectivesImproving Governance and Internal Control:

An Interview withCOSO Chairman David L. Landsittel

Publisher’s Column: Truth and Accuracy—in Words and Numbers

A Case-Based Approach to IntermediateAccounting Courses: New Hires Ready

to Hit the Ground Running

Five Tips to Reduce the Riskof 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 indeedbe reformed and how. The concept of tax reform might be

desirable, but the reality of accomplishing it less so, both forCongress 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.

IN FOCUS

v o l . L X X X I I / n o . 1 0

79 Economic & Market Data

80 EditorialWhat’s Left in the Fed’s Monetary Policy

Toolkit?: Bernanke Tests Version 3.0

74 Classified Ads

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OCTOBER 2012 / THE CPA JOURNAL6

Prior to his appointment to COSO,Landsittel spent 34 years with ArthurAndersen, and he has an extensiverecord of professional service. He isalso a former chair of the Illinois CPASociety. This interview took placeduring Landsittel’s visit to NorthernIllinois University, on April 25, 2012,to speak at the university’s Beta AlphaPsi (Gamma Pi Chapter) spring initia-tion banquet.

COSO’s Mission and Board MembersDonald E. Tidrick for The CPA

Journal: Would you share a histori-cal summary of COSO?

David L. Landsittel: COSO[www.coso.org] was formed in 1985,in connection with the NationalCommission on Fraudulent FinancialReporting—better known as theTreadway Commission, named forJames C. Treadway, Jr., a former SECCommissioner who chaired it. In the1970s, there were several instances ofimproper corporate payments that wereinappropriately accounted for, which ledto the passage of the Foreign CorruptPractices Act [1977]. In the 1980s, therewere several additional conspicuousinstances of outright fraud as somecompanies engaged in fraudulent finan-

cial reporting to manipulate their stockprices.

In 1985, five private-sector organiza-tions that had a stake in the credibilityof financial reporting came together toestablish the National Commission onFraudulent Financial Reporting. Thesefive sponsoring organizations were 1) theAmerican Accounting Association[AAA]; 2) the AICPA; 3) the formerFinancial Executives Institute, now theFinancial Executives International [FEI];4) the Institute of Internal Auditors [IIA];and 5) the former National Associationof Accountants, now the Institute ofManagement Accountants [IMA].Collectively, these organizations repre-sent about half-a-million members,including many outside the United States.

In October 1987, the TreadwayCommission issued its report, whichdetailed 49 specific recommendationsdesigned to improve the integrity offinancial reporting. These recommenda-tions were directed at a variety of stake-holders, including public companies,independent auditors, the SEC andother regulators, and even educators.Over time, these sponsoring organizationshave seen the benefits of cooperation, andthey have continued to believe in themerits of working together.

One of the Treadway Commission’srecommendations emphasized the needto study internal control in a compre-hensive manner, which gave the groupa specific project to pursue. With thesupport of Coopers & Lybrand as theproject manager, COSO published the Internal Control—IntegratedFramework in 1992. There have alsobeen other projects to make the con-trol framework more robust, including

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 man-

agement and control, his previous service as Chairman of the Auditing

Standards Board [ASB] ... [and] his leadership in the development of the

external auditor’s responsibility for detecting fraud ([Statement of Accounting

Standards] SAS 99 [Consideration of Fraud in a Financial Statement Audit]).”

Improving Governance and InternalControl

D

P E R S P E C T I V E S

v i e w p o i n t

(Continues on page 8)

An Interview with COSO Chairman David L. Landsittel

OCTOBER 2012 / THE CPA JOURNAL 7

p u b l i s h e r ’ s c o l u m n

Journalism is in trouble. In the past fiveyears, more than 39,800 newspaper jobs

have been eliminated in the United States,according to the Paper Cuts blog(http://newspaperlayoffs.com/), a website thathas kept track of the shrinking newspaperindustry since 2007. Already weakened bytaking on huge amounts of debt in a drivefor higher profit margins and strugglingagainst an emerging digital medium—whereaccording to a Federal CommunicationsCommission (FCC) report, “The InformationNeeds of Communities,” digital ad salesbring in only four cents out of every printadvertising dollar—newspapers were devas-tated when the recession hit, leaving thereporters who work for them jobless and thecoverage that the public depends uponthem to provide absent.

I’ve been struck more than a few timesby some of the similarities betweenCPAs—namely in the role of auditor—andjournalists, and how the current economicenvironment is having an impact on theseroles as protectors of the public trust.Both auditors and journalists require a highlevel of professional skepticism; both workthe “fairness and accuracy” beat: one mayattest to it, the other must provide it. Bothare public watchdogs; whose roles insociety are considered necessary in orderfor our democracy to thrive.

Of course, there are important differ-ences that set them far apart—namely, thatcertified public accounting is a professionand journalism is not. CPAs are licensedand bound by enforceable ethical standards;those who fail to meet those standards risklosing their license and the ability to prac-tice. There are established rules for CPAs,shaped and issued by federal and state reg-ulators; journalists have none. Journalists,long defined as practitioners of a trade thatrequired no formal education, face no realpenalty for failing to meet the public’sexpectations of objectivity in their work;the only standards they must meet are thecodes of conduct enforced by their employ-ers or professional associations.

As we watch newspapers fold across thecountry, it’s hard not to wonder what typeof long-term impact a diminished fourthestate will have on the ability of ourdemocracy to function and thrive. ThomasJefferson said no less in 1799: “Our citi-zens may be deceived for awhile, and havebeen deceived; but as long as the presses can

be protected, we may trust to them for light.”The presses are not being protected; in fact,they’re literally being sold as scrap metal,relics of a bygone era in our new, more self-contained digital environment. On top of that,more and more journalists and editors arebeing asked to cross what used to be a verywell-defined line between editorial andadvertising. Reporters are now concernedwith search engine optimization (SEO),increasing page views, and feeding the 24-hour news cycle that the Internet has creat-ed. They rely on press releases issued bygovernment entities and special interestgroups to fill the news hole left by the lay-offs of thousands of colleagues. This leavesthe public uninformed and unaware—a dan-gerous place for a democracy.

Shared Obligations and AimsAuditors also balance two interests,

and they always have: they are chargedwith meeting the CPA’s professional andindependence standards, as well as thoseof the client, who pays them for their ser-vices. The Public Company AccountingOversight Board (PCAOB) has taken agreater interest in auditor independencerecently, stating that in this environment ofquickly evolving accounting standards dueto “new economic realities … it is rea-sonable to ask again whether the current

combination of the auditor payment modeland independence rules, even coupled withindividual audit partner rotation require-ments, is adequate to deal with the poten-tial conflict of interest that appear[s] to beinherent in the auditor payment model”(Lewis H. Ferguson, PCAOB Open BoardMeeting, August 16, 2011).

The PCAOB continued its exploration ofthis issue through a concept release publishedlast year and roundtable discussions con-ducted across the country. (See the May2012 CPA Journal for a variety of perspec-tives on the topic.) The NYSSCPA hasalso issued a comment letter on thisrelease; although it agrees with thePCAOB that auditor independence andobjectivity is an important factor thatshould be strengthened and encouragedwherever possible, the Society believes thatmandating audit firm rotation is not the opti-mal way to address this problem because itcould have the unintended effect of reduc-ing overall audit efficacy. Engagementpartners, particularly those in smaller firms,need time to develop and maintain the nec-essary skill set to properly audit SEC-regis-tered issuers; this often becomes an indus-try-specific specialization that successor firmswould find difficult to pick up.

Regardless of your position on thePCOAB’s proposal, this is the rightconversation to be having right now. TheCPA profession is not journalism, but formore than 100 years, the profession hasshared its highest aim with that of jour-nalists: to provide a service that protectsthe public. As our economic and businessenvironments evolve (or diminish, in thecase of the press), it is necessary forCPAs, not only as a profession, but asAmericans, to defend and protect thedemocratic institutions that have for solong protected us. ❑

Joanne S. BarryPublisher, The CPA JournalExecutive Director, [email protected]

Truth and Accuracy—in Words and Numbers

Auditors also balance two

interests, and they always have.

Internal Control Issues in DerivativesUsage, which was published in 1996.

In 2004, we published a separate frame-work on enterprise risk management [ERM;Enterprise Risk Management—IntegratedFramework]. Some people might confusethe two frameworks or misperceive that theERM framework supersedes the internal con-trol framework, but in our view, they standon their own as separate documents.

In addition to the ERM framework, wesponsored two significant research studiesto investigate fraudulent financial report-ing. In recent years, we have published aseries of “thought papers” that havefocused on important issues related toERM in order to help stakeholders movealong the maturity curve.

CPAJ: How would you characterizeCOSO’s mission today?

Landsittel: COSO is a thought leader,not a standards setter. Our thought leader-ship focuses specifically on three interre-lated subjects: internal control, risk man-agement, and fraud deterrence. Basically,we view ourselves as a think tank inthose three areas.

CPAJ: Who are the other currentboard members of COSO? Do theybring any unique or institution-specificperspectives to the board?

Landsittel: The AAA is represented byDouglas F. Prawitt [PhD, CPA], who is arespected auditing professor at BrighamYoung University and remains active in theAAA and its auditing section. He has expe-rience on a couple of COSO task forcesthat involved internal control in smaller pub-lic companies and ERM, as well as withthe ASB.

The AICPA is represented by CharlesLandes [CPA]. He is the vice president ofthe AICPA’s Professional Standards andServices Group. In that role, he overseesthe technical activities of the AICPA’saudit and attest standards team, amongmany other responsibilities. Prior to join-ing the AICPA in 2000, Chuck hadextensive public accounting experience.

The FEI is represented by Marie N.Hollein [CTP(CD)], who has served as itspresident and CEO since 2009. She hasmore than 30 years of extensive corporateand financial services experience as a

senior financial executive at organizationsincluding Citibank and WestinghouseElectric Corporation, as well as atKPMG, where she was a managing direc-tor of financial risk management.

The IMA is represented by SandraRichtermeyer [PhD, CMA, CPA]. She isa former IMA chair [2010–2011], arespected accounting professor, and chairof the department of accountancy and busi-ness law at Xavier University. In additionto having specific institutional knowledgeof the IMA and being grounded in anacademic perspective, she also has publicaccounting experience.

The IIA is represented by Richard F.Chambers [CIA, CCSA, CGAP], who hasserved as the IIA’s president and CEO since2009. He has more than 30 years of exten-sive internal audit, accounting, and finan-cial management leadership experience inboth the private and public sectors. He hasworked with the U.S. GovernmentAccountability Office (GAO), served as thechief audit executive for several large fed-eral governmental entities, and workedwith PricewaterhouseCoopers, where heled the firm’s internal audit advisory servicespractice before taking the helm of the IIA.

These are all extremely capable and col-legial individuals, and it is a pleasure towork with them. They bring a wide rangeof informed perspectives to our discussions,but always focus on the broad mission ofCOSO and meeting the collective interestsof our many stakeholders without limitingtheir perspectives to that of any specificorganization.

CPAJ: How did you come to beappointed COSO chairman? What areyour responsibilities in that role?

Landsittel: I served on the advisory coun-cil for the 1992 internal control frameworkwithout further involvement with COSOuntil I served on a focus group involvingaudit committee chairs in 2008. A fewmonths later, I was contacted about my will-ingness to be considered for this position.Although I am retired, I do like to be pro-fessionally engaged, and I thought that thiswould be very interesting work. One thingled to another, and I was appointed as COSOchair in May 2009.

The chair’s fundamental responsibilityis to carry out the mission of COSO. Other

responsibilities include managing rela-tionships and assessing how COSO canbest serve our stakeholders' interests withrespect to internal control, ERM, and frauddeterrence. Because COSO is a “virtual”organization without employees or its ownresources, projects are largely outsourced.Consequently, the chair is also responsi-ble for finding opportunities for interestedorganizations to help us make progress onour projects. I am fortunate to have avery helpful part-time research assistant,Joanna Dabrowska, supported by COSOand DePaul University.

CPAJ: How long do you plan to serveas COSO chair?

Landsittel: Originally, I had a three-yearterm, which expired in May 2012, but Ihave agreed to an additional one-yearextension in order to see current work tocompletion. During this next year, wewill be looking for someone to take onthe role of the next COSO chair.

CPAJ: You described COSO as a virtual organization. How is COSO’s busi-ness conducted?

Landsittel: Normally, we meet face-to-face four times per year [for one day], withadditional meetings by phone on an as-needed basis. Although different points ofview are expressed in our discussions, theytend to result in consensus. On those occa-sions where we need to take votes, toapprove certain documents related to pro-jects, the votes tend to be unanimous.

Most of our revenues are generatedthrough our publications. Although theindividual thought papers are available forfree on our website, the frameworks andrelated documents have generated sufficientrevenues to fund our activities. The fivesponsoring organizations are extremelysupportive of COSO’s activities and provideessential support services. For example, theAICPA naturally handles the accountingfunction for COSO. The AICPA’s involve-ment with CPA2Biz [a subsidiary that mar-kets AICPA products and services] helpswith the marketing and sale of COSO pub-lications. The IIA is very helpful with pub-lic relations and our interface with the media.

We engage various parties to author mate-rials published by COSO. Twenty years ago,Coopers & Lybrand was the project manag-er for the original internal control framework,


(Continued from page 6)

and the contract stipulated that they had the“right of first refusal” on any updates to thatframework. We approached Pricewater-houseCoopers first, and they accepted the pro-ject. In other instances, we might solicitauthors through an invitation to bid. For someof our more recent thought papers, wemight target individual authors based on theirinterests and expertise. COSO oversees andapproves the final products and addresses anyissues that might arise, but someone else actu-ally authors those products. It is importantto note that, for the update of the internal con-trol framework, COSO reimbursesPricewaterhouseCoopers’s direct, out-of-pocket expenses, but the significant amountof time that their professionals devote to aproject such as this is pro bono.

This virtual organization model hasworked very well for COSO for severaldecades and, in my view, is unlikely tochange going forward.

Updating COSO’s Internal ControlFramework

CPAJ: Although not a standards-set-ting body itself, how does COSO interfacewith regulators and standards setters, suchas the Public Company AccountingOversight Board (PCAOB) and the SEC?

Landsittel: Although there is not muchinteraction with those organizations whenit comes to the thought papers, there hasbeen a lot of interface with regulators andstandards setters related to our update ofthe internal control framework. For thisupdate, COSO has formed an advisorycouncil that consists of about 15 members.There are also five observers, primarilyhaving a regulatory orientation: the SEC,the PCAOB, the FDIC [Federal DepositInsurance Corporation], the GAO, andIFAC [the International Federation ofAccountants]. Although the individuals rep-resenting these organizations are desig-nated observers, they do have the right tothe floor and they do participate. In addi-tion, we welcome their feedback outsideof the advisory council meetings. Theirinput has been highly constructive and veryhelpful, and we are grateful for their sup-port of our goal of developing high-qual-ity frameworks.

CPAJ: What motivated the “refresh”of the original internal control framework,

and how would you characterize theresults of that initiative to date? Werethere any surprises that have surfaced incomments received during the exposureperiod?

Landsittel: The environment in whichthe 1992 framework was developed wasvery different from today’s environment.The basic structure of the framework—including the definition, the three objec-tives, and the five components—remainsrelevant and effective, but we needed toupdate the framework to address signifi-cant changes in governance; in how busi-ness is conducted, including a lot more outsourcing and joint ventures; and infor-mation technology. The Internet and e-mailwere relatively unknown in 1992, where-as they are ubiquitous today.

Beyond those considerations, there wereother reasons to update the originalframework. For example, we have a doc-ument that addresses the application of con-trols for smaller businesses and identifiesa series of principles supporting the com-ponents; we believed that such principleswere applicable to the entire frameworkitself. The proposed updated frameworkidentifies explicit principles that supportthe applicable components. Those princi-ples were implicit in the 1992 framework,but making them explicit should be help-ful to stakeholders in understanding theassessment of the components. In addition,we wanted to make the commentary deal-ing specifically with the objectives

involving operations and compliance morerobust.

As for comments, we received almost100 comment letters; I was pleased thatthose letters were very thorough andthoughtful. Interestingly, there was a widediversity of viewpoints expressed in thoseletters, some of which advocated oppositepositions. That makes it incumbent on usto really think through a lot of issues thatwere identified in those letters. We decid-ed to extend the target date for delivery tothe first quarter of 2013 because we havea lot to do. We are also contemplatingwhether it might be beneficial to make anupdate of the document publicly availableto obtain further input on specific issues ofinterest.

CPAJ: How do you envision the tran-sition from the 1992 framework to theupdated framework?

Landsittel: We get a lot of questionsabout transition, and they generally fall intotwo basic categories. First, when wethought we might be able to release the fin-ished document before year-end, wereceived a lot of questions as to whetherusers would have to apply that 2012 frame-work. Of course, we never envisionedthat there would be instantaneous imple-mentation of the refreshed internal controlframework. Extending that delivery to thefirst quarter of 2013 should alleviatesome of those anxieties.

Second, it is important to remember thatCOSO is a thought leader, not a standardssetter. We are not in a position to tell userswhen to transition. The only thing we cancontrol is when we stop selling our docu-ments—and I assure you that we willcontinue to sell the 1992 framework untilthe marketplace moves on. The 1992document is still effective, but we think thenew control framework will be even bet-ter, so we hope that stakeholders willtransition as quickly as possible.Ultimately, as it relates to SEC registrantapplication of the framework in responseto the section 404 requirements of theSarbanes-Oxley Act of 2002 [SOX], theregulatory authorities might perhaps pro-vide guidance regarding when the transi-tion must be made.

CPAJ: COSO has indicated its inten-tion to release guidance on implementing


the revised framework for external report-ing. Are there any plans to issue addi-tional guidance on other aspects of therevised framework?

Landsittel: We do indeed plan to havea separate document that providesapproaches and examples related to finan-cial reporting that would be relevant toSOX issues, and we plan to expose thatdocument for public comment this fall. Wehave also discussed the longer-term possi-bility of developing a specific documentthat addresses compliance-related internalcontrol issues. And, although not current-ly under active consideration, we mighteventually develop a separate document tofocus on applying controls in an operationssetting.

The ERM FrameworkCPAJ: Everyone seems to be talking

about risk management these days. Howwould you assess the impact of the 2004ERM framework?

Landsittel: There are a number of dif-ferences affecting user application of ourERM and internal control frameworks. Theinternal control reporting requirementsmandated by SOX obviously spurred thevisibility and use of the internal controlframework, but that has not been a factorfor the ERM framework. The U.S. audit-ing profession has probably had standardsrelated to internal control for more than 60years, whereas risk management is a rela-tively recent construct. There is still a sig-nificant subset of companies that does notreally embrace the value proposition ofERM, and there is another group that has

taken steps toward ERM, but has notfully embraced our entire ERM framework.Of course, there are other risk-relatedframeworks that users might consider too,including ISO [International Organizationfor Standardization] 31000.

CPAJ: Is there a sense of competitionamong these various frameworks foracceptance in the marketplace?

Landsittel: We do not view this as acompetition because COSO’s role is thatof a thought leader. The fact that there isan ISO-level framework adds credibility tothe validity of the whole topic of ERM,which is helpful in making progress. ERMis young, and we still have a ways to go;it is an evolving environment, within whichthese concepts will continue to develop.

CPAJ: Do you envision future effortsto either combine the internal control andERM frameworks, or perhaps to con-duct a separate refresh of Enterprise RiskManagement—Integrated Framework?

Landsittel: In my personal view, COSOshould support the development of a stand-alone document that clearly explains thedifferences between the two frameworks;how they fit together; and how they fit intothe broader view of governance, organi-zational strategy, and operational process-es. Some people, particularly those outsidethe United States, advocate merging thetwo frameworks into one overarchingframework for purposes of coordination.In the United States, we have some uniquecircumstances associated with SOX, andthere are practical advantages to having aseparate framework that focuses exclu-sively on internal control. I would not besurprised if COSO refreshes the ERMframework someday, but we have no spe-cific plans to do that at the present time.

Preventing and Detecting Fraud CPAJ: In your previous role as chair

of the AICPA’s Auditing Standards Board(ASB), you were closely involved in thedevelopment of SAS 99, Consideration ofFraud in a Financial Statement Audit.Fraud continues to be a significant chal-lenge for the CPA profession. What morecan the profession do to provide greaterassurance 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 andlessons learned from prior frauds that haveoccurred. For example, whenever there is anairplane crash, the National TransportationSafety Board does a thorough investigationto identify causes and insights that can bebroadly communicated in order to reducesuch risks going forward. Having a processfor systematically investigating instances offraudulent financial reporting, with the pur-pose of sharing information more freely,would be a distinct improvement; however,there are many obstacles, not the least ofwhich are confidentiality and legal liabilityissues. With the support of regulatory author-ities, it would be constructive if we couldget some sort of safe harbor to focus on theunderlying causes of a fraud and ways itcould have been prevented or detected—without focusing on placing blame on theindividuals and organizations involved.

CPAJ: In 2008, two of the sponsoringorganizations—the IIA and AICPA—along with the Association of CertifiedFraud Examiners (ACFE), jointly issuedconceptual guidance related to fraudissues, “Managing the Business Risk ofFraud: A Practical Guide.” That soundssimilar to COSO’s core focus. Would youexpect such non-COSO collaborationsinvolving a subset of sponsoring organi-zations to increasingly occur when thereis mutual interest? Do you envision thatthe organizational affiliations represent-ed by COSO might expand beyond thepresent five?

Landsittel: COSO does not excludeother organizations from contributing theirthoughts that can be helpful to us. We wantto have a healthy working relationship witha lot of other organizations, and I have triedto facilitate those relationships during myterm. I do not anticipate expanding thenumber of organizations comprisingCOSO, because there is clearly some lega-cy associated with the five existing spon-soring organizations. It is important toCOSO’s progress, however, to furtherdevelop and maintain close working rela-tionships with other organizations who canhelp us better address our mission—forexample, with respect to issues like boardgovernance and IT, as well as global issuesthat relate to internal control, ERM, andfraud deterrence.


Thought Papers and Future ProjectsCPAJ: Since 2010, COSO has period-

ically issued thought papers, such as“Enterprise Risk Management—Understanding and Communicating RiskAppetite” and “Enhancing BoardOversight by Avoiding and ChallengingTraps and Biases in ProfessionalJudgment” in 2012. Going forward, isCOSO likely to release additional thoughtpapers?

Landsittel: Our primary purpose in issu-ing those thought papers has been to helporganizations implement ERM processes.They are available for free, and they havebeen well received. They address issuessuch as how to get started; achieving prop-er oversight, both from a management anda board perspective; establishing appro-priate risk appetites; and developing keyrisk indicators. A couple of new thoughtpapers are in process, and we will contin-ue to follow this approach to address spe-cific issues of the day—for example, appli-cation of our ERM framework to risks andopportunities related to cloud computingand sustainability.

CPAJ: You and your predecessor,Larry Rittenberg, commented that“COSO’s agenda of potential futureprojects 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 orenvisioned for the future?

Landsittel: Other than the thought paperstrategy I just outlined, COSO is limitedin the activities we can work on at this timeby the all-encompassing nature of the inter-nal control refresh. I also mentioned earlier the possibility of supporting thedevelopment of products dealing with theapplication of our internal control frame-work specific to compliance and opera-tional objectives—as well as the possibil-ity of developing a document discussinghow our internal control and ERM frame-works relate to one another and fit into abroader view of governance, organiza-tional strategy, and processes.

Longer term, I believe that COSOshould focus more on “behavioral” issuesthat are very important, but difficult todefine precisely. Think about issues like

overconfidence. I have talked with corpo-rate board members about the risk of man-agement override of controls. The usualresponse is, “Well, I know that is preva-lent among entities that commit fraudu-lent financial reporting, but it wouldnever happen at this company, because Iwouldn't be associated with this companyif anyone were untrustworthy.” And theremay be a different kind of overconfidencein ERM, where there may be a tendencyto systematically underestimate the likeli-hood of significant risks—that is, the“black swan” issue.

In the fraud research area, I think it wouldbe interesting to look at the impact of SOXon the occurrence of fraud. So, there are alot of possibilities for future projects.

CPAJ: Given COSO’s focus on inter-nal control, risk management, and gov-ernance, have recent events involvingapparent failures of such processes insome major companies caused COSO toconsider the need for further study orguidance?

Landsittel: Not in a way that is identi-fiable to any specific failure. But, for exam-ple, our ERM thought papers haveaddressed a board of director’s responsi-bility for oversight of the risks that orga-nizations have assumed—a frequent criti-cism associated with the financial crisis.We certainly link our thought papers to theenvironment within which our projects areconducted, and that environment—including the recent financial crisis—hascontributed to the visibility of COSO,underscored the relevance of our ERM andinternal control frameworks, and increasedour level of activity.

Ethical Standards and InternationalImpact

CPAJ: In the 1990s, COSO highlight-ed three topics of emphasis: corporategovernance, internal controls, and ethicalstandards. The emphasis on ethics seemsto have faded into the background. Doyou foresee a renewed emphasis on ethicsin the future?

Landsittel: It is true that the TreadwayCommission Report in 1987 includedseveral recommendations specificallyrelated to ethical issues. Perhaps it hasnot been as explicit as it should be, but

ethics is an integral part of the internalcontrol, risk management, and frauddeterrence topics that COSO emphasizes.For example, an entity’s control envi-ronment—the “tone at the top”—has apervasive effect on each of the other com-ponents of internal control. Ethics con-tinues to be an essential thread that iswoven throughout the fabric of all ofCOSO’s broader projects.

CPAJ: What impact has COSO hadoutside of the United States?

Landsittel: This is actually something thathas surprised me. A large amount of the hitsand downloads of the recent exposure drafton internal control occurred in countries otherthan the United States. I have spoken out-side the United States on a number ofoccasions in my role as COSO chairman,and I have been pleasantly surprised by thelevel of interest projected by audiences.Our internal control framework has beentranslated into seven languages, with requestsfor additional translations.

The concepts of effective control andgovernance are relevant around the world.IFAC has been particularly helpful to usin extending our relationships with othersinternationally, which we very much appre-ciate. From an international perspective,COSO is indeed widely known and, Ithink, well respected. With that said, weneed to continue to focus on developingand maintaining relationships that facilitatea global focus.

CPAJ: In closing, is there anything elsethat you want to say to CPA Journalreaders?

Landsittel: The opportunity to chairCOSO has been a very rewarding experi-ence, and I feel very fortunate to havehad the chance to interact with so manyoutstanding individuals. We have a fun-damental principle stating that effectiveinternal control and risk management areessential to the success of organizations—I believe that. It makes me feel good thatI have been privileged to chair a groupwhose mission is so committed to thesuccess of organizations. ❑

Donald E. Tidrick, PhD, CPA, CMA, CIA,is the Deloitte Professor of Accountancy atNorthern Illinois University, DeKalb, Ill.


f u t u r e o f t h e p r o f e s s i o n


A Case-BasedApproach toIntermediate

Accounting CoursesNew Hires Ready to Hit

the Ground Running

By Robert P. Derstine, James M.Emig, Thomas J. Grant, and Kenneth Hiltebeitel

Would you be pleased if your newhires, straight out of college, were

ready to be productive their first day onthe job—already possessing “seven yearsof experience providing review, audit,tax, and consulting services for a CPAfirm”? An intensive, case-based, two-semester intermediate accounting course,which also integrates components fromboth corporate tax and auditing classes, canprovide the profession with such new hires(Connie Esmond-Kiger, Business ActivityModel for Teaching IntermediateAccounting, 5th ed., 2009 [with continualupdates]). Both accounting graduates andtheir employers can benefit from thiscourse, described in further detail below.

Course Overview In this course, students “work” for a fic-

titious CPA firm and are assigned oneclient to advise for the first seven years ofits existence—from the start-up to publiccompany. Working in teams, students learnhow to identify opportunities and problemsencountered by the client; research possi-ble solutions; determine when and if it isappropriate to ask for help; make account-ing and financial suggestions; and effec-tively communicate their findings, bothverbally and in writing. The teams performreview engagements for the first threeyears, followed by audits during the lastfour years of the case study. New topicsare introduced each year, with criticalaccounting issues repeated until the stu-dents feel comfortable dealing with them.

This case-based approach enables stu-dents to “learn how to learn.” Providedonly with a partial set of client-prepared

financial statements, the student teamsresearch accounting issues; question theclient’s controller (played by the professor)in order to obtain additional information;develop necessary adjusting entries; draftcorrected financial statements and requirednote disclosures; and, finally, present theclient’s corrected financial statements at theannual stockholders’ meeting. This learn-ing experience more closely aligns with theskill set new hires need to “hit the groundrunning,” when compared to the tradition-al pedagogy of reading a chapter in atextbook, listening to a lecture, attemptinghomework problems, and then parrotingback the information on exam day.

Case ContentStudents are exposed to a variety of

accounting topics and issues during thecourse. The following sections describe someof the critical topics and issues addressed.

Financial accounting. The first severalweeks of intermediate accounting are spentreviewing financial accounting (includingthe four financial statements). Students alsoare introduced to U.S. GAAP, FASB’s con-ceptual framework and Accounting StandardsCodification (ASC), and InternationalFinancial Reporting Standards (IFRS).

Financial statements and balancesheets. For each of the seven years in thecase study, students must analyze client-prepared income/retained earnings state-ments and balance sheets, correct for errorsand omissions (i.e., determine any requiredadjustments), and “explain” the financialstatements at the client’s annual stock-holders’ meeting. Cash flow statements(both direct and indirect method for oper-ating activities) must be prepared by thestudents from scratch because the clientappears unable to do so.

Accounts receivable. This becomes anissue in the first year, when students mustrealize that they need to ask the con-troller: “Are all receivables collectible? Dothey require an allowance for bad debts?”Each year, students must evaluate theclient’s response; propose an appropriateadjusting entry, if necessary (and defendit); and again explain the receivables pre-sentation at the annual stockholders’ meet-ing. The very limited number of customersin the early years of the case (e.g., only six

in the first year) exemplifies the need toremain alert for risk situations requiringdisclosure.

Merchandise inventory. This requiresstudents to deal with first-in, first-out(FIFO) and last-in, first-out (LIFO) cost-ing; lower of cost or market; and ship-ping/receiving cut-off issues. A consult-ing engagement on the FIFO/LIFOchoice requires students to make a pre-sentation to the client addressing the advan-tages and disadvantages of each choiceunder various inflationary scenarios.

Property, plant, and equipment.Equipment, vehicles, land, and buildings areacquired throughout the case via cash pur-chase, bank loan financing, capital lease, orpart of net assets acquired in purchase of

another company. Students need to deter-mine whether expenditures should be record-ed as repairs and maintenance expense orcapitalized—including self-construction costsand any related interest cost. Varied lives anddepreciation methods on the books versustax return require students to generate work-paper documentation to support client’s bookand tax depreciation amounts. Students canuse these workpapers (and other workpaperscreated throughout the case) when they areexplaining the client’s financial statementsand disclosure notes at the annual stock-holders’ meeting. In addition, by requiringworkpaper documentation each year, stu-dents become familiar with utilizing the prioryear’s workpapers while maintaining aconstant vigil for changing circumstances.Consulting engagements requested by theclient require students to research and thenmake presentations on alternative financingopportunities available for asset acquisi-tions and for nonmonetary exchanges.

Intangible assets and goodwill.Intangible assets are introduced as the result

This case-based approach enables

students to “learn how to learn.”

of licensing costs and the client’s incorrectcapitalization of start-up costs. Studentsneed to account for goodwill resulting froman acquisition of the remaining net assetsof an “equity method” investee.

Liabilities. Accounting for and disclo-sure of typical current liabilities are encoun-tered throughout the case. Long-term lia-bilities include bank loan payables (withassociated loan covenants), capital leaseliabilities, and accrued pension liabilities.

Retroactive adjustment. Students needto recognize that a prior-period error cor-rection is necessary to retroactively adjustfor the warranty costs of an acquiredcompany. These previously unrecordedcosts require an adjustment to warrantiespayable and previously recorded goodwill.

Pension plans. A defined benefit pen-sion plan (including prior service cost)requires students to learn about pensionplans in general and how to handle theaccounting, funding, and disclosure issuesof the client’s pension plan, specifically.Students continually need to enquire aboutother post-retirement benefits being offeredto employees.

Earnings per share. Common stock isissued by the client both to raise cash andto acquire another company. Accountingfor accumulated other comprehensiveincome is required, due to unamortizedprior service costs. Basic earnings per share(EPS)—or, rather, loss per share in the firstyear—is required for the first four years ofthe case. As the client does not appear toknow how to calculate EPS, students mustresearch the topic, perform the calculations,put EPS on the face of the income state-ment, and draft the associated footnote dis-closure. Diluted EPS is required beginningin the fifth year, with the issuance of con-vertible preferred stock.

Investments. The client ultimatelymakes several investments in the case study.In addition to the portfolio of trading secu-rities, students need to analyze other invest-ments to determine whether the cost or theequity method of accounting is appropriate.Changing circumstances require alteringthe accounting treatment in subsequent years.

Revenue recognition. Such issues areintroduced early in the case as some of theclient’s customers pay for contracted servicesin advance. Students also encounter revenue

recognition for long-term construction projects in the last part of the case. Theyneed to revise three years of financial state-ments (and prepare correcting entries) dueto the client improperly accounting for long-term construction contracts.

Tax. Accounting for income tax issuesstarts in the first year of the case, with a netoperating loss and the determination ofwhether a valuation allowance is necessary.By the fifth year, students must document(via workpapers) 10 temporary differencesthat impact deferred income taxes. This isanother instance where students refine theirskills in workpaper preparation. Assignmentsrequiring corporate tax return preparation(and documentation linking audit workwith the client’s corporate tax return) arerequired in the later years of the case.

Disclosure notes. Students draft allrequired note disclosures for each year andexplain them at the annual stockholders’meeting. As an example, the fifth yearrequires students to draft 12 separate dis-closure notes. The first note of the 12—significant accounting policies—has 10individual disclosures.

CPAs Comment on Case ApproachIn order to determine if this case-based

approach is actually working, the authorscontacted CPAs at both large and medi-um-sized accounting firms. Open-endedquestions were asked concerning howstudents exposed to this case-based learn-ing approach are performing once theyenter the “real world.” The responses wereoverwhelmingly positive:■ “Once you’ve had this case-basedlearning approach, you already have one‘client’ experience under your belt.”■ “One of the biggest adjustments that stu-dents must make in practice is to learn toidentify the issues they’re facing. They mustalso learn to ask the right questions ratherthan simply be given answers. This case-based approach fulfills all of these criteria!”■ “This approach really allows the stu-dents to get a better understanding ofreal-life scenarios—it helps them under-stand and apply what they learned both inthe classroom and later on the job.”■ “This approach gives students experi-ence in addressing new accounting prob-lems in the manner in which they occur

in the ‘real world,’ as opposed to havinga professor lecture about a particular topicand then asking students to simply reciteback what they learned.”■ “The application of the principles in areal world setting is very beneficial. Itshows you how to put the principles intopractice, whereas in a traditional classroomsetting you would just need to know howto apply them on a test.”■ “The CPA exam is much easier to tack-le … some of this ease is attributable tohaving learned and worked with thetough accounting issues in more depth inthis case-based method.”

An Innovative Learning StyleWe echo the above observations about

this case-based learning approach. Webelieve students will have increased moti-vation for the accounting profession;enter the profession with technical com-petency in financial accounting (withintegrated audit and corporate tax skills);and will have developed critical-thinking,communication, and research skills rele-vant to real-world situations. It is not thetopical coverage of this case-basedapproach that differs from the traditionalpedagogy—it is the learning style. Studentsare required to learn just as they wouldon the job. As a result, they should be wellprepared for their first day on the job. ❑

Robert P. Derstine, PhD, CPA, is a pro-fessor of accounting at KutztownUniversity, Kutztown, Pa. James M. Emig,PhD, CPA, is an associate professor ofaccountancy and information systems andVillanova University, Villanova, Pa.Thomas J. Grant, CMA, is an associateprofessor of accounting, also at KutztownUniversity. Kenneth Hiltebeitel, PhD,CPA, is also an associate professor ofaccountancy and information systems atVillanova University.

Further information on how the authorsuse this case approach in their intermediateaccounting courses can be obtained by con-tacting the authors at [email protected],[email protected], [email protected], or [email protected].


f r a u d

Five Tips to Reducethe Risk of Internal

Fraud

Keeping Controls Current

By Ernie Rossi

Savvy business owners know the valueof internal controls and the critical

importance of reviewing those controlson a regular basis. Effective internal con-trol systems must be adapted to changes inbusiness practices and the global economy.How do today’s businesses keep up? Theanswers to the five questions below canhelp companies strengthen their controlsand prevent fraud.

1. Which Businesses Need to ProtectAgainst Fraud?

No company is completely immune tofraud; however, certain types of companiesare at greater risk. Small companies tend tohave limited resources, meaning that employ-ees perform multiple duties. This is a prob-lem because small businesses cannot easilyseparate what a good internal control struc-ture would call “conflicting tasks.”Properly separating tasks requires perpetra-tors to conspire in order to steal—and col-lusion is more difficult than acting alone.

Larger businesses might be more capa-ble of separating tasks simply because theyhave more staff, but their fraud risk canpotentially increase over time if theybecome lax in pinpointing loopholes intheir systems; given time, people can findweaknesses and exploit them.

One common denominator among com-panies is that few believe they are suscep-tible to internal fraud. But the statistics inthis area are clear: fraud is often perpe-trated by a long-term employee or friend.It is best to have well-designed andimplemented internal controls that reduce,as much as possible, the opportunities tocommit fraud in the first place.

2. Under What Conditions Does InternalFraud Occur?

Internal fraud can be compared to a“perfect storm”—that is, a motivated per-

petrator meets poorly designed or poorlyimplemented internal controls and little orno monitoring of those controls. Anemployee that perpetrates a fraud general-ly rationalizes the behavior. For example,the perpetrator might say, “The ownermakes way too much money,” or, “Iwork really hard, and the business doesn’tproperly reward me for my efforts.”

It is possible to distinguish between busi-nesses that have poorly designed internalcontrols and those where the controls arepoorly monitored. Internal controls mightbe in place, but sometimes the business’sculture evolves to a point where controlsare allowed to be ignored. One commonexample is an increasingly busy workplacewhere checks are signed without thor-ough review of supporting invoices.

Companies should not only design propercontrols but also remain vigilant andmonitor their effectiveness.

3. How Can Companies Prevent Internal Fraud?

Companies led by a management teamthat sets the “tone at the top” by modelingthe greatest degree of integrity might exhib-it less risk for internal fraud. Businessowners who play fast and loose with taxlaws, and company assets can expectemployees to feel comfortable doing thesame. While some business owners recog-

nize the risk of fraud, they are often unsureabout the steps required to prevent it.

Companies should start small; the firststep is to leverage a third party to reviewthe business and uncover potential prob-lems through an assessment of internal con-trols. This will help identify the areas ofbiggest risk—also known as “the low-hanging fruit.” The second step is to imple-ment controls, such as a separation ofduties of employees, in order to shore upvulnerabilities uncovered in the assessment.Next, periodic reviews by internal man-agers and external assessors will help tokeep controls sharp.

It’s also important that companies edu-cate employees about the purpose of thecontrols. Increased awareness, along withthe knowledge that internal controls are apriority, will serve as a strong deterrent toemployees who might otherwise commitfraud. Businesses should communicate thatinternal controls will ultimately protectemployees if and when a fraud is com-mitted by allowing them to quickly beeliminated from suspicion.

Financial audits can be helpful, butaudits alone cannot replace internal con-trols or a thorough risk assessment.Although an audit might catch errors, thereis no guarantee that such errors are theresult of fraud.

4. What Qualifies an Individual or aFirm to Assess Risk?

Businesses should consider hiring CPAswith fraud-related experience, such asauditing. They need not specialize in fraud,although that it helpful, but they should havelengthy experience in public accounting.Generally, CPAs with significant publicaccounting experience are well suited to eval-uate existing controls and assist in develop-ing additional or more effective controls.

Basic assessments can be conductedover a few days or weeks, depending uponthe size of the business and the amount oftime needed to document the business’sday-to-day practices. The assessmentdoes not need to be done all at once. Abusiness owner should meet with theselected professionals, perform a generalassessment, and then design a plan overtime to develop and implement a compre-hensive internal control system. After con-


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.

trols are implemented, periodic mainte-nance should be performed. Over time,even good controls will become less effec-tive; eventually people find their wayaround the controls, especially if they knowthey are not monitored regularly.

5. How Can a Service Provider Help?Any service provider should talk with

its clients about controls frequently—not

just during an annual audit or when prepar-ing the annual financial statements. Inevery meeting, a service provider shouldlisten for key phrases or changes to thebusiness; for example, the phrase, “We’rehaving cash flow problems,” might indi-cate a control issue.

In order to truly reduce the likelihood offraud, education and communication shouldbe top priorities on both sides of the table. ❑

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

This article has been adapted from theauthor’s article, “How to Reduce theRisk of Fraud by Keeping Internal Controls Current,” published in SmartBusiness (Northern California edition),April 1, 2012.


i n b o x : l e t t e r s t o t h e e d i t o r

Debating Auditors and Fraud

Iread with interest “Auditors’ Responsibilityfor Detecting Fraud: Putting Ethics and

Morality First,” by Richard H. Kravitz, and“Auditors’ Responsibility for Detecting Fraud:Applying Professional Judgment andMaintaining Integrity,” by Vincent J. Love(The CPA Journal, June 2012). I congratu-late the authors on an excellent analysis ofGenerally Accepted Auditing Standards(GAAS) vis-à-vis consideration of fraud.

When it comes to non-GAAS fraudexaminations, however, some clarificationsshould be made. First, the objective of afraud examination (Exhibit 2 in Love’s arti-cle) is not to “determine whether fraud hasor is occurring”; this task can only be adju-dicated by a judge and jury. Rather, theobjective of a fraud examination is toprovide all the relevant, reliable, and avail-able information, so that the legal processcan make its determination. As certifiedfraud examiners (CFE) and CPAs, we areprecluded from rendering an opinion onwhether a fraud has occurred. Renderingsuch an opinion would be paramount to alegal opinion.

Second, the authors somewhat looselyuse the word “auditor” to mean the per-son who performs a fraud examination.Performance of an audit implies perfor-mance of procedures that include a riskassessment, audit procedures, and arrivingat an opinion that can be relied upon.Accordingly, an auditor is someone whoperforms an audit; in contrast, a fraud

examiner is someone who takes all neces-sary steps to provide the information forthe legal process.

Third, a fraud examiner does differentwork than an auditor. A fraud examiner’sapproach is less of a “risk-based” approachand more of a methodical discovery basedon a theory of how a fraud occurred.Accordingly, the fraud examination’s cost-benefit analysis also differs from that of anaudit—and it is often much more expensive.

Taking a look at the big picture, the termaudit, in relation to fraud-related procedures,should be used strictly within the GAASframework. The use in other contextsmight confuse the general public, who couldhear the word audit or auditor in connec-tion with fraud and understand a level ofopining and reliance that is simply not there.

Yigal Rechtman, CPA, CFE, CITP, CISMDirector for technology assurance andforensic services Buchbinder Tunick & Company LLP

The Authors Respond

Igreatly appreciate the writer’s interest inthe articles and that he took the time to

closely read and comment on them; how-ever, his comments are close to, but off of,the mark. Both the AICPA and theAssociation of Certified Fraud Examiners(ACFE), when addressing the objectiveof a fraud examination, use the phrase“determine” or “determining.” For exam-ple, the 2012 edition of the FraudExaminer’s Manual states: “The fraud

examination’s goal is to determine whetherfraud has/is occurring and to determinewho is responsible” (ACFE, p. I-2). (Seealso, Considering Fraud in a FinancialStatement Audit: Practical Guidance inApplying SAS No. 82, AICPA, p. 43; “AnAudit Versus a Fraud Examination,” byAnnette Stalker and Mike Ueltzen, CPAExpert, Winter 2009, p. 4.) This describesthe object of the examination and not thetype of report rendered by the auditor orexaminer on the existence of a fraud.This is the point that I believe the writeris trying to make, and it is a good one.While the auditor or examiner’s objectivemay be to determine if fraud has or isoccurring, the auditor or examiner usuallydoes not give an opinion that a fraud hasoccurred because one element of fraud isintent, and that determination is better leftto a trier-of-fact in a legal proceeding.Moreover, the auditor’s or examiner’sreport is beyond the scope of the articles.

I have scanned the articles and havenot found any instance where the “auditor”or “examiner” designation is inappropri-ately used. “Forensic audit” and “forensicauditor” are perfectly proper designations,as are “fraud audit” or “fraud auditor.” Thefraud audit and fraud auditor terms havebeen around long before Joe Wells estab-lished the CFE designation; the designa-tion is a great one, but CPAs have con-ducted audits to find fraud and testifiedon the results in courts of law since thebeginning of the profession, and theycontinue to do so today. The articlesaddress auditing of financial statements and

the auditor’s responsibility for detectingfraud; consequently, any such audit,whether based on GAAS or a more inten-sive set of standards to detect fraud, willbe performed by an auditor in all instances.

The cost-benefit analysis discussed in thearticles is related to the cost and benefit ofperforming a GAAS audit versus a fraudexamination (or fraud audit, because therewould not be any predication) in all instanceswhen audited financial statements are pre-sented. Kravitz’s position is that the cost,when compared to the enormous lossesthat have occurred in the past, is justified.My position is that the cost and other atten-dant issues make auditing for fraud, in allinstances, uneconomical.

The risk-based approach in a GAASaudit and the predication and focus of afraud examination are beyond the scope ofthe article, but they are understood toexist and are at the heart of the point/counterpoint discussion.

Vincent J. Love, CPA/CFF, CFEManaging director of VJL ConsultingLLCNew York, N.Y.

Iam thankful to Rechtman for his con-structive comments. Although I do agree

with Love’s response, I would also like toadd my own comments: ■ Rechtman states, “As a CPA and CFE,we are precluded from rendering an opinionon whether a fraud has occurred.” Hestands behind semantics. My definition offraud is broader, and I assert that Rechtman’s“preclusion” is, in fact, our principal obliga-tion. As CPAs, in our professional judgment,we “certify” that, in rendering an unqualifiedopinion, the financial statements are free ofmaterial misstatement, free of false and mis-leading (i.e., fraudulent) financials, and fair-ly represent the condition of the enterprise.There can be no compromise in our respon-sibility to detect and report on misleading orfraudulent financials, regardless of whetherthey are intentional or unintentional. ThePublic Company Accounting OversightBoard (PCAOB) seems to be leaning in thisdirection as well; it requires auditors toidentify risk of material misstatement regard-less 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; mythesis is that public accountants—who aresanctioned; licensed; and provided legiti-macy, autonomy, self-regulation, and cer-tification by the public—have a responsi-bility to protect the public against fraud.As Nassim Taleb (author of The BlackSwan) argues, “fail early and fail often”in a capitalistic society is far more benefi-cial or desirable than creating enterprises“too big to fail” (and ultimately too big tobail), with adverse effects that are felt foryears. We have the responsibility todetect and uncover fraud, and to allowenterprises to fail early and often as a result.■ Rechtman argues that the “fraud exami-nation’s cost-benefit analysis also differs fromthat of an audit, and is more expensive.” Ihave argued that the added cost of anenhanced audit, the purpose of which is touncover fraud and disclose systemic risk, isa small price to pay when compared to a crip-pled financial industry with a meltdown costof $30 trillion—and even this cost might besmall compared to the loss of the public’s trustin our auditors, our financial institutions, andour government regulators. (See Richard H.Kravitz, “Socially Responsible Accounting:Protecting the Public Interest,” The CPAJournal, November 2009.)

Moreover, the cost of adding forensictechniques to financial audits is insignifi-cant if, as a result, hidden or systemic riskis uncovered—whether from off-balance-sheet financing, credit default swaps, spe-cial purpose entities, “repo 105 sales,” orcollateralized debt obligation (CDO) bun-dles. Federal backstopping of financialinstitutions under an emergency act dat-ing from the Great Depression is not a sub-stitute, nor is it desirable in a free and opendemocratic capitalist society—not whenCPAs, as the largest independent observersof corporate behavior, have the tools, tech-niques, and leadership skills to protect thepublic against fraud.

Richard H. Kravitz, MBA, CPAFounding director of Center for SociallyResponsible AccountingManaging director of R H Kravitz andCompanyIsland Park, N.Y.

When Strategic ConceptsMeet Practical Realities

Thomas Pressly’s article, “LinkingStrategic and Project Concepts to

Enhance Management Advisory Services”(July 2012) was an excellent overview ofhow to implement a project. Unlike manyarticles, it offered a step-by-step-approach,with all of the applicable templates for a suc-cessful project implementation. Being a CPA,a college instructor, and a six sigma–certifiedprofessional, I could relate very easily to allof the points that the author presented on whatmakes a project successful.

Unfortunately, the one item not includ-ed in the article was the intention of theparticipants. Senior management’s oremployees’ intentions are usually not com-municated to management consultants.They are usually very agreeable tochange when it does not affect them, andthey are usually very logical when plansare in a theoretical state. But when itactually comes into play, “all bets are off.”At this point, a person’s more primal naturetends to come out, and instead of a coher-ent, successful project, implementationbecomes a dysfunctional, failed project.

This has been proven over and over againsince CPAs became a licensed profession. Itis very rarely a problem of not knowing whatto do or not following templates that makesa project fail; the individuals performingthe tasks are more than qualified to do that.The issue is the desire to make things bet-ter when it has a direct impact on a per-son’s external or intrinsic needs. This prob-lem is not limited to project plans; it is pre-sent even among members of a departmentworking together.

Well-run companies are now imple-menting the 10% rule—that is, 10% ofemployees are assessed every year basedon performance evaluations. Companies’human resources (HR) departments nowdirect supervisors on how to “adjust” eval-uations so that it appears legal and properthat 10% of employees can be let go.This has no bearing on how competent orhow diligently one tries to follow thetemplate of being a good corporate citizen.The key premise that we are all in thistogether, which is the basis of project man-agement, is a fallacy—just like the notion



that Enron had fairly presented financialstatements.

In addition, because we live in anemployment-at-will state [New York], amanger can lie in performance evaluationsand get away with it. The HR manual hasa disclaimer in it that it is not to be fol-lowed if the company so deems. Thus,the rules of conduct or behavior thatemployees desire has been replaced byprofits at all costs; employees are reward-ed based not on whether they work hard,but on the number of hours that theyslave away at the company. Sadly, the tem-plates that are used for successful imple-mentation are a “tease” that has no bear-ing on the reality of the unforgiving busi-ness jungle that CPAs, along with manyother Americans, find themselves in.

I think a good place to start, with respectto a company’s project, is to have a more

open mission statement. The company’srole is to make money and employees’ roleis to support it—all the rest is mere com-mentary that does not much need to beadhered to.

Larry Stack, CPANew York, N.Y.

The Author Responds

The context of my article was to intro-duce basic strategic and project proce-

dural issues to those CPAs who are inter-ested in becoming more actively involved intheir clients’ business operations. Certainly,the general guidelines of the template pre-sented must be adjusted in practice to meetspecific purposes and clients needs.

Stack’s constructive comments improvethe practical usefulness of my article for

CPAs working with independent clients. Ibelieve that the issues he identified can beincluded in the early stages of negotiationswith senior management during the devel-opment of a common mission statement, fol-lowed by specific mutually agreeable per-formance goals and measures in the strate-gic formulation stage, and subsequently rein-forced with data retrieval and analysis inthe project implementation and control phase.

The incorporation of his insight of prac-tical realities into the procedural frameworkof the article represents the kind of thought-ful dialogue that has made The CPAJournal such a genuine service to account-ing practitioners.

Thomas R. Pressly, PhD, CPAPenn State University–ShenangoCampusSharon, Pa. ❑

18 OCTOBER 2012 / THE CPA JOURNAL

In Focus


The concept of reforming the current tax code hasgained traction in recent years. Every potential chal-lenger in the present presidential campaign has offereda tax reform proposal as part of their platform.President Obama put forth his own “Buffett Rule,”

spurred by an acknowledgement that one of the world’s richest menpays a lower tax rate than his secretary. The current economic cli-mate and the election campaign season have gotten people think-ing about the concept of fairness and equity within the existing taxcode. The following discussion looks at some of the issues involvedin reforming the present tax code and offers some insight as to thefeasibility of significant tax reform, defined as more than just theperiodic code revisions that happen regularly.

BackgroundBecause most of the calls for reform center on a desire for eco-

nomic stimulus and parity, it is necessary to look at both corporateand personal taxes. The U. S. corporate income tax rate, a combi-nation of both federal and state taxes, is one of the highest amongmembers of the Organization for Economic Cooperation andDevelopment (OECD), which comprises the world’s industrial-ized nations. But at the same time, U.S. corporate tax revenue asa percentage of GDP is well below the OECD average, in partbecause the U.S. tax code is full of deductions, credits, andexemptions. In addition, the United States is among a handful ofcountries that tries to tax multinational companies on their foreignearnings while allowing them to avoid these taxes by keeping theseprofits overseas. While the primary purpose of any country’s tax

code is to raise sufficient revenues to fund government expendi-tures, a reasonable assumption would be that this process shouldnot be detrimental to the country’s economic development.

Personal tax reform is no less complex and confusing than cor-porate tax reform. Anyone filing more than a Form 1040EZ faces aplethora of forms, regulations, and requirements so complex that mostsurrender and seek professional help. Options to address this com-plexity include commercial electronic filing packages, such asTurboTax; professional preparers like H&R Block; or CPAs andtax attorneys specializing in tax return preparation. The InternalRevenue Code (IRC) even allows a deduction for the cost ofpreparing a tax return by allowing it as a business expense for busi-nesses and as an itemized deduction for individuals, even thoughthe tax code is so complex that most taxpayers do not realize thatthe individual deductions rarely produce tax savings. The IRC hasbecome so complex that, in most instances, it can only be managedand interpreted by those who can afford to pay “experts” to charttheir course through the maze of law and regulations. For this andother reasons that will be explained in further detail below, makinga case for substantial revision to the present tax code is not difficult.Before changing it, however, it is important to have some under-standing of how the present tax structure arose, including congres-sional intent.

U.S. Tax HistoryIncome taxes were first constitutionally sanctioned by the ratifi-

cation of the Sixteenth Amendment to the United States Constitutionin 1913. Prior to this amendment, direct taxation was permitted by

The Election Season Raises a Familiar QuestionBy Michael E. Roach and William G. Jens, Jr.

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Is Real Tax ReformRealistic?

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Article I of the Constitution (in particular,sections 2, 8, and 9). The Constitution pro-vided that any direct taxes had to beapportioned among the various statesbased on census data and uniformly applied.Thus, while the concept of direct taxationhas been with us since the country’s begin-ning, the taxes assessed were either adirect tax on property or a capitation tax, themost common of which was the poll tax.

Prior to 1913, Congress had only imposeda direct tax on income during the Civil War(Ch.173, sec. 116, 13 Stat. 223, 281 [1864]),and again 30 years later when Congressimposed a 2% tax on any income inexcess of $4,000 (Ch.349, sec. 27, 28 Stat.509, 553 [1894], also known as the Wilson-Gorman Tariff). The assessment of incometaxes in 1894 was constitutionally chal-lenged on the basis that direct taxation wasunconstitutional. The U.S. Supreme Courtagreed with the assertion, and it held in thelandmark case of Pollock v. Farmers’ Loan& Trust Co. (157 U.S. 429 [1895]; 158 U.S.601 [1895]) that the taxes collected had tobe apportioned according to the Constitutionto the states based on the census. (It shouldbe noted that most tax protestors rely on thiscase in order to assert that income taxesare unconstitutional.) The Court concludedthat because the taxes were collected onincome on various property (includingsalary, dividends, interest, rents), the incomemust be apportioned.

As stated in Penn Mutual Indemnity Co.v. Comm’r (277 F.2d 16, 3rd Cir. [1960]),“[Pollock] only held that a tax on the incomederived from real or personal property wasso close to a tax on that property that it couldnot be imposed without apportionment.” Asthis proved to be administratively unfeasi-ble, the Supreme Court ruled, in a dividedopinion, that this form of taxation wasunconstitutional.

In the intervening years betweenPollock and the passage of the SixteenthAmendment, there were various attempts tocontinue some form of taxation by suchmeans 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 inheri-tance tax (Knowlton v. Moore, 178 US 41,20 S. Ct. 747, 44 L. Ed. 969 [1900]). Anexpansion of excise taxes and tariffs wasused in an attempt to collect revenue fromU.S. taxpayers. Congress decided to allow

a direct form of taxation by constitutionalamendment, which was originally proposedby President William Howard Taft and rat-ified by Congress four years later in 1909.

With the passage of the SixteenthAmendment, the limitation on direct taxesand the required apportionment ended, andthe federal government was entitled to taxall income from all sources, with only minorexceptions (e.g., state and municipal inter-est). The tax code further evolved whenthe United States Supreme Court stated,“Unquestionably Congress has power tocondition, limit, or deny deductions fromgross income in order to arrive at the netthat it chooses to tax” (Helvering v.Independent Life Ins. Co., 292 U.S. 371, 381[1934]). This congressional authority hasresulted in what is arguably one of the mostcomplex tax systems in the world.

The 1913 Revenue Act assessed all mar-ried taxpayers who made over $4,000($3,000 for single individuals) a normal1% tax. In addition to this tax, there weresix additional brackets with a maximummarginal tax rate of 7% (the 1% normal rate,plus an additional tax of up to 6% on allincome over $500,000). Other than theexemption of income, there were no otheroffsets or deductions allowed. Since 1913,the income tax brackets have been expand-ed and contracted on numerous occasions.In nearly half of the years that the incometax has been in existence, there have been24 or more separate tax brackets; from 1933to 1935, there were an incredible 55 brack-

ets. On the other hand, there were only twobrackets from 1988 to 1991. The marginalincome tax rate has varied from a low of 7%from 1913 to 1916 (the more recent low was28% from 1988 to 1991) to a high of 94%in 1944 and 1945. These brackets andmarginal rates have provided Congresswith a constant source of adjustment andmanipulation to allow it to achieve thedesired tax impact.

Economic Tax TheoriesThere are three primary economic theories

related to the impact of taxation on the indi-vidual taxpayer. The progressive tax systemis based on taxing income at a highermarginal rate as a taxpayer’s income increas-es; thus, the more income one makes, thegreater the tax burden. This approach isreflected in the tax tables used for calculationof individual and corporate taxation. Whilethe tables represent a true progressive tax, thedetermination of taxable income prevents thissystem from being a true progressive tax (dis-cussed below).

The second theory is the regressive formof income taxation, stipulating that tax ratesshould stay the same irrespective of the levelof income; as a person generates moreincome, the tax rate represents a lesser bur-den. The most common example of this isthe sales tax. Whether a person earns$10,000 or $100,000, a $500 purchase witha 5% sales tax still results in a tax burdenof $25 for each; however, this tax has agreater economic impact on the person mak-ing $10,000 because it represents a greaterportion of his income. Many states haveattempted to reduce this regressive nature byexempting food, pharmaceuticals, and othernecessities from taxation.

The third economic approach is the pro-portional tax, under which the tax rate isstatic but the amount to be taxed increases.In other words, the burden that each tax-payer pays is calculated in the same ratio astheir property bears to the total of propertyto be taxed; the higher the value of anindividual’s property, the higher the tax bill,but all taxpayers are taxed at an equal taxrate. Most excise taxes fit this description.For example, tax on the use of dieselremains .244 per gallon for 2011, but thisnumber is determined by the number of gal-lons used (Form 720, Quarterly FederalExcise Tax Return); thus, the tax is the samewithin its class, but as the volume of dieselincreases, so does the tax burden. Another

Identification of the inequities

is the easy part. The desire to

change them, however, is almost

certainly going to be uneven.

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example would be the assessment of realestate taxes. The millage remains thesame, but as the value of property increas-es, so does the tax amount.

The U.S. Tax SystemThe U.S. tax system utilizes a hybrid for-

mat that applies various elements of the pro-gressive, regressive, and proportionalapproaches. In certain circumstances, the taxapplication may be a hybrid format on thesame tax. For example, payroll taxes areassessed on the first $110,100 of earnedincome. The first dollar of wages earned isassessed at 7.65% (currently 5.65% for theemployee) and this continues in a regres-sive format until the upper limit is achieved.For an employee in the lower salary ranges,the tax operates as a regressive tax; theemployee will have fewer dollars to con-sume, while paying the same proportionatetax as an employee with a higher salary.

When the $110,100 salary level (6.2% ofthe total 7.65%) is achieved, the portionassigned to Social Security is capped, andonly the remaining 1.45% related to Medicarecontinues to be assessed. This tax is a pro-portional tax, but it becomes a regressivetax once the upper limit is reached. A per-son with a salary of $1 million pays the sameSocial Security tax as an individual making$110,100. So even though the tax’s regres-sive nature occurs at a higher rate, it is stillregressive in nature.

The U.S. tax system professes to adopta progressive format as it pertains to theassessment of income taxes, estate taxes,and gift taxation. All of these forms of tax-ation utilize a rate schedule in which the taxrate increases as the amount to be taxedincreases. But the facts suggest that this isnot a truly progressive tax system, due tothe existence of various tax incentives with-in the tax code.

Tax IncentivesMost tax incentives are designed to

encourage taxpayers to undertake certainactivities that they might not necessarily benormally inclined to do. Sometimes, the taxincentive is to encourage a taxpayer not totake some action. By rewarding behavior byallowing either a special deduction or taxcredit, the federal government can encour-age certain types of investments or socialbehaviors. The granting of tax incentives isnot generally intended to be a revenue-raising activity. Instead, such incentives redi-

rect what would be normal governmentresources into other areas that the govern-ment does not want to directly fund. Theseincentives represent a waiver of normal taxrules and allow the government to direct thetypes of activities to be undertaken.

Social considerations. Probably the bestexample of how the IRC provides taxincentives to encourage investment in areasthat the government believes should be fund-ed by the general public rather than by thegovernment lies in the area of charitablegiving. From a purely economic view, thereis no rational reason to exempt the taxationof charitable organizations. (Please note thatthis article is not about the separation ofchurch and state; the discussion is purelyabout possible sources of tax revenue.)

Almost all charities have the same goalas any for-profit organization—namely, toaccomplish their stated mission by maxi-mizing revenues and minimizing expenses.Such charities might, in fact, be as well orga-nized and efficiently run as any Fortune 500organization. Internal Revenue Code (IRC)section 501(c)3 specifies, however, that ifcertain “charitable” goals—religious, char-itable, scientific, public safety, literary,educational, amateur sports competition, pro-motion of the arts, or prevention of crueltyto children or animals—are achieved, thenthe entity will not be taxed on its grossreceipts. There is an exception when theorganization enters into direct competitionwith a for-profit organization (IRC section511 on unrelated business income). Theoverall structure is such that charitable orga-nizations pay no taxes on their primaryfundraising activities. Therefore, the gov-ernment does not receive any form of directtaxes from charitable organizations.

The government further compounds thisloss of revenue by allowing individual tax-payers several advantageous tax deduc-tions for making contributions to these char-itable organizations. For example, IRCsection 170 allows individuals to deductmost contributions to a qualified IRC sec-tion 501(c)3 organization.

In addition to allowing this tax deduc-tion for direct contributions, the govern-ment offers a further tax incentive if adonation of stock or tangible personal prop-erty (used by the charity for a two-yearperiod) is made to a charitable organiza-tion. The taxpayer receives a fair marketvalue deduction rather than the original taxcost to the donor. As a result of this, the

appreciation difference between the tax-payer’s basis and the fair market value alsoescapes taxation. This form of donation hasresulted in substantial tax benefits for indi-viduals like Ted Turner and Bill andMelinda Gates when they donated stocksin their respective organizations to chari-table foundations.

The government does not tax the rev-enue and also allows a deduction for thesame funding, thereby surrendering rev-enue on both sides of the transaction. Thedesire to achieve certain social considera-tions offers the only logical reason, fromthe standpoint of taxation, to enact any ofthese provisions.

Economic considerations. In theEconomic Recovery Act of 1981, depre-ciation on all fixed assets was substantial-ly modified by the adoption of theAccelerated Cost Recovery System(ACRS, the precursor of MACRS). Thistax act changed depreciation from a use-ful life concept with a salvage life com-putation to a mid-year convention using adouble-declining balance methodology.Perhaps reflecting the times, ACRSreduced the depreciation on real propertyfrom a normal useful life of 35–45 yearsto a flat 15 years. The committee reportsand the underlying congressional debatescontained discussions indicating that thereason for the change was that existingdepreciation methods were not able to pro-vide the investment stimuli necessary foreconomic expansion (Economic RecoveryAct of 1981, section 201).

More recently, Congress adopted theHousing and Economic Recovery Act of 2008(P.L. 110-289), which granted first-timehomeowners a $7,500 interest-free loan thatcould be paid back over 15 years. In addition,this act relaxed rules for mortgage lenders andincreased the insurance on Federal HousingAdministration (FHA) loans. Less than sevenmonths later, Congress adopted the AmericanRecovery and Reinvestment Act of 2009(Public Law 111-5; better known as theStimulus Act). A portion of this act allowedfirst-time homeowners a nonrefundable$8,000 credit for the purchase of a new home.While there may have been some slight socialconsiderations (because it was limited to first-time home buyers, the bill encouraged tax-payers that had not made a home purchaseto do so), the primary purpose—as set out inthe House and Senate comments on the bill—was to stimulate the housing market; thus, a


tax benefit was granted for the sole reasonof spurring the economy. Once again, therewas absolutely no pure tax logic to thistransaction, and it resulted in diminished fed-eral resources.

Credits and deductions. There are varioustypes of tax incentives, including tax creditsand deductions. A tax credit represents adollar-for-dollar reduction of the taxpayer’sincome tax liability, with some limitations.A deduction is allowed as an offset againstthe taxpayer’s revenue before the calculationof taxes owed. As stated previously, most ofthese factors include both social and economicfactors, so in discussing tax incentives, the dis-tinction is not critical.

Special tax incentives available for busi-nesses include several specialized account-ing benefits such as LIFO (last-in, first-outaccounting) and its related cousins. Otherbusiness incentives include IRC section179; the immediate deduction for researchand development costs, specializedaccounting in many industries, such asthe oil and gas business; international taxbenefits, including outsourcing and offshoreplanning; and others. For any kind of taxreform or tax simplification to be consid-ered, every deduction for business wouldhave to be reevaluated.

Other examples of business tax incentiveswould include the following:■ Low-income housing credits—to encour-age investment in low income housing■ Qualified school construction credits—to help schools rebuild and repair by thegranting of a credit in lieu of interest■ Work opportunity credits—tax rebatesfor those who hire high-unemploymentgroups■ Renewable energy credits—to encour-age investment in alternative energy sources.(Form 3800, General Business Credit, listsover 25 different business credits; eventhis list is not comprehensive.)

This same logic also applies on the stateand local tax levels, when a governmentagency agrees to forego taxation (usually onreal estate) in exchange for a business ororganization to locate in a particular site orjurisdiction. These abatements are justifiedas providing both an economic and socialboost, but at the cost of tax revenue.

There are numerous other tax incentives inthe area of individual taxation, including—■ the earned income credit, ■ the American opportunity tax credit (aswell as lifetime learning and hope credits),

■ the residential energy-efficient propertycredit, ■ 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 bothbusinesses and individuals not only result ina loss of revenue to the government, but canalso represent a negative cash flowbecause the credits might be refundable. Forexample, the earned income credit notonly generates no tax revenue, but also

refunds money to taxpayers who did notoriginally pay these funds to the govern-ment. This is not a waiver of tax; rather, itrepresents a negative tax. Credits like thisrepresent a form of social welfare because,while they reward work effort, they lack thecontrols of food stamps or other forms ofdirect welfare. Like this credit, several ofthe other credits and deductions have a“Robin Hood” impact, reallocating resourcesfrom high-income taxpayers to low-income taxpayers. In these situations, thegovernment’s purpose in foregoing tax

revenues through these tax advantages isto further social and economic goals as ameans of implementing public policy.

Stealth taxes. These disincentives arisefrom any action that creates an additionaltax burden without being included in anactual tax law or tax change that fails to notethat it results in a tax increase for certainclasses of taxpayers.

The most obvious example under the cur-rent tax structure is the alternative minimumtax (AMT). Inflation has always resulted ina kind of stealth tax increase through brack-et creep, as inflation eroded the amount ofconsumable funds, while static tax bracketsand rates caused taxpayers to suffer an effec-tive tax increase even though their real incomeremained the same. But as tax rates, deduc-tions, and other items are now generallyindexed to inflation, this form of stealth tax-ation has been minimized. (It has not beentotally eliminated, as the factors used for infla-tion adjustment do not always adjust to theactual inflation impact.) The AMT, howev-er, has not been indexed for inflation, and somany middle-income taxpayers are increas-ingly subject to the AMT for the first time, astealth increase.

Stealth taxes can also include the move-ment of particular funds—such as gasolinetaxes collected from a road and highwayfund—into a general fund. Whereas a mar-ried couple with two qualifying children canreceive a tax credit equal to $2,000, a mar-ried couple with no children can receive atax bill with no credit that is $2,000 high-er; this can also be considered a stealth tax.

Stealth taxes are not just limited to thelower brackets. There are many situationswhere a taxable deduction is phased outbased on income. Some of the phaseoutsinclude the child tax credit, excess item-ized deductions, personal exemptions, IRAdeductions, and others that are phased outfor high-income individuals. These adjust-ments are not recognized as a tax increase.

Penalty taxes. Penalty taxes exist toelicit certain behaviors from businesses orindividuals through tax incentives or disin-centives. Sometimes these taxes are assessedto curb consumption (such as limiting harm-ful emissions) or, alternatively, to help paya social penalty for the potential harm thatresults from certain types of behavior; exam-ples would include taxes on alcohol, tobac-co, gasoline, and luxury items. These taxesgarner an additional assessment above abasic sales tax.

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.

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Traditional thinking on penalty taxes holdsthat the tax will be progressive in nature; quiteoften, the actual application has a tendencyto be regressive in nature. In addition, someof these taxes may miss their mark: if thereis a luxury tax on a boat and a prospectivebuyer decides not to buy because of the addi-tional tax, the wealthy individual electing notto make the purchase does not suffer, butthe potential seller is the one suffering thelost sale. The government doesn’t only col-lect the revenue of the penalty tax; econom-ic activity is negatively impacted as well,because the sale does not occur.

Prospects for Reform During this election year, all the presi-

dential political candidates have called fortax reform of one type or another. The ques-tion is whether the current system shouldindeed be reformed and whether imple-menting significant tax reform is indeed fea-sible. As noted above, the U.S. Tax Codehas evolved over time, as Congress has usedit to encourage or discourage certain eco-nomic and social behavior by individuals orbusinesses.

As to whether reform is desirable, thereis no simple answer. If the objective of atax system is to be fair and equal to all, thenseveral factors suggest that this is not cur-rently being achieved. The present systemfavors people or companies who canafford to hire professional advisors withthe expertise to interpret a tax code thatexceeds 72,000 pages in length (notincluding regulations and other interpreta-tions). The system requires billions of hoursin preparation time, which engenders bil-lions of dollars of deadweight costs.People like Mitt Romney and WarrenBuffett have lower effective tax rates thanthose who work for them. Under the cur-rent system, almost half of the individualsearning income pay no tax at all.

While these factors seemingly point to alack of parity, there are other considerations.The tax rates that favor the Romneys andBuffetts exist, in part, to encourage them totake the kinds of risks that generate thecommensurate rewards. Although the taxcode has reached a level of complexity thatdiscourages the average person from attempt-ing a return without professional help, it hasalso created a significant closet industry thatsupports many professionals.

Identification of the inequities is the easypart. The desire to change them, however, is

almost certainly going to be uneven. Ifprior history is to be believed, any seriousattempt to remove “favored deductions” willresult in all sorts of protests. Change thatwould be viewed as favoring certaingroups would probably result in an expan-sion of the “class warfare” that the presentsystem has already engendered. The conceptof tax reform might be desirable, but the real-ity of accomplishing it less so.

To achieve a logical format of taxation,Congress would need to vote to remove allthe social and economic factors from theIRC. The list of provisions this entails is sub-stantial. Even if Congress agreed that this isa desirable goal—and agreement has notbeen the watchword of the political envi-ronment in Washington recently—it wouldrequire that Congress identify alternatives foraccomplishing the kinds of behavior that thepresent tax system engenders or acknowl-edge that such objectives are no longer desir-able. The deduction for charitable contribu-tions is a case in point. By promoting thecreation and underwriting of the funding ofcharities, the need for the government to stepin and “do good things” is reduced.

Even if the political environment inWashington were to change, such thatone party had sufficient control to enact itsplatform or both parties became willingto enact a compromise agenda, the issuesinvolved are so far-reaching that the authorsdo not believe that substantive tax reformis a possible outcome. For that matter, itis equally difficult to believe that the major-ity of the electorate would approve of sucha drastic revision because practically everytaxpayer would be faced with the loss ofsome favored tax treatment in some formor another. For these reasons, the authorsconclude that significant tax reform has noreal chance of being implemented—nomatter the results of the upcoming elec-tions. As a concept, this is probably goingto be relegated to campaign rhetoric thatsurfaces every four years, only to disap-pear until the next election cycle. ❑

Michael E. Roach, JD, is an instructor, andWilliam G. Jens, Jr., PhD, is an assistantprofessor, both at McNeese State University,Lake Charles, La.

The accounting for defined benefit pension plans has been thesubject of contentious debate for nearly three decades. Disparatestakeholders—regulators, academics, analysts, investors, pre-parers, and others—have criticized the complex assumptions,

arcane rules, and techniques used to minimize the inherent volatil-ity of pension assets and obligations. Many claim that these prac-tices produce an opaque and misleading portrayal of a sponsor’s true

obligations and negatively impact the quality of reported earnings.Many companies that sponsor defined benefit plans have long advo-cated for the delayed recognition techniques and other mechanismsto reduce earnings volatility. In Statement of Financial AccountingStandards (SFAS) 87, Employers’ Accounting for Pensions (par.177–178), FASB acknowledged that particular conclusions on theseissues were “pragmatic” and “without conceptual basis.” Most

A New Reality Ahead for PensionAccounting?

A C C O U N T I N G & A U D I T I N G

a c c o u n t i n g


By James M. Fornaro

The Recession’s Aftermath and IAS 19R Prompt Changes in Accounting Practices

now agree that an overhaul of existingaccounting practice is long overdue, andFASB is proceeding with a phased approach,in tandem with the International AccountingStandards Board (IASB).

During 2010 and 2011, several promi-nent U.S. companies (AT&T, VerizonCommunications, UPS, and others)changed their longstanding accountingpractices from the delayed recognition ofpension costs to a fair-value approach thatnow provides immediate recognition ofmost changes in plan assets and liabilities.These changes appear to be motivated bytwo key factors. First, plan sponsorsexperienced a significant buildup of unrec-ognized losses during the depths of therecession, which had a devastating impacton the health of such plans (particularlyin 2008). The accounting changes result-ed in retrospective adjustments to prior-year financial statements for these unrec-ognized net losses and eliminated a “drag”on future earnings. Second, recent revisionsto International Accounting Standard (IAS)19, Employee Benefits, will dramaticallychange existing practices used by compa-nies reporting under International FinancialReporting Standards (IFRS). Essentially,IAS 19R (effective in 2013) will elimi-nate all delayed recognition mechanismsand require a fair-value approach to therecognition of changes in plan assets andliabilities. The most far-reaching change isthat actuarial gains and losses will beimmediately reported in other compre-hensive income (OCI) and will no longerbe amortized to earnings. Several U.S.companies have pointed to the fair-valueapproach under IAS 19R as support fortheir accounting changes.

The following is an examination ofemerging issues in U.S. GAAP and IFRS,with respect to defined benefit pensionplans. First, an overview of existingaccounting practices under U.S. GAAP andIAS 19 is provided, with a particular focuson delayed recognition mechanisms present in both sets of standards. Particularprovisions of IAS 19R are discussed andcontrasted with existing standards, alongwith consequences for U.S. companies ifconvergence with IFRS is achieved. Recentaccounting changes by certain U.S. com-panies are examined, including likely moti-vations and related financial impact.Finally, a snapshot of the health of U.S.

defined benefit pension plans is provided,along with strategies that may warrant con-sideration.

In the near term, more U.S. companieswith accumulated unrecognized losses willlikely contemplate a change to a fair-valueapproach for pension accounting. GivenFASB’s commitment to convergencewith IFRS, and despite the lack of a for-mal decision by the SEC regarding the tim-ing or method of incorporating IFRS intothe U.S. financial reporting system, U.S.companies should consider the impact ofIAS 19R on their financial condition andfuture earnings.

Overview: Expense Recognition forDefined Benefit Plans

One of the overriding objectives ofaccounting for defined benefit pensionplans, under both U.S. GAAP and IFRS,is to recognize compensation cost in theperiods in which the eligible employee ren-ders services. Inherent in this process is abenefit formula that provides the basis fordetermining the amount of payment towhich a participant may be entitled, and anumber of actuarial and other underlyingassumptions about future events, includingmortality, employee turnover, retirementdate, changes in future compensation, andother factors. The long-term nature ofdefined benefit plans, coupled with amultitude of assumptions that are oftenbeyond a sponsor’s control, can producevolatility in the reported annual cost of suchplans. Moreover, retroactive plan amend-ments, revisions to underlying assumptions,and differences between actual experienceand expectations can complicate the pre-dictability of annual costs.

In reaction to constituents’ concernsabout these uncertainties, FASB incorpo-rated provisions for the deferral or delayedrecognition of particular changes in planassets and liabilities. SFAS 87 (par. 85)describes the delayed recognition featureas a concept where “certain changes inthe pension obligation (including thoseresulting from plan amendments) andchanges in the value of assets set aside tomeet those obligations are not recognizedas they occur but are recognized system-atically and gradually over subsequent peri-ods.” These mechanisms are discussedbelow. Though this discussion is particu-lar to defined benefit pensions, the con-

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

U.S. GAAP: Net Periodic Pension Costand Delayed Recognition Mechanisms

Accounting Standards Codification (ASC)715-30-35 identifies the components of thenet periodic cost of defined benefit pensionplans. Below is a brief description of eachcomponent followed by the relevant provi-sions, where applicable, that permit delayedrecognition or “smoothing” of costs overfuture periods.

Service cost. This cost component rep-resents the actuarial present value of ben-efits computed using the plan’s benefit for-mula related to services rendered byemployees during the period.

Interest cost. This cost component repre-sents the increase in the projected benefitobligation (i.e., the actuarial present value ofaccrued benefits at a point in time) duringthe period, due to the passage of time. It iscomputed using a discount rate multipliedby the balance of the pension benefit obli-gation at the beginning of the period. Thisdiscount rate should reflect current pricesof annuity contracts or rates on high-quali-ty, fixed-income investments at which thepension benefits could be effectively settledat the measurement date.

Return on plan assets. For a fundedplan, the actual return on plan assets rep-resents the difference between the fair valueof plan assets at the end of the period andthe fair value at the beginning of the peri-od, adjusted for employer contributions andbenefit payments made during the period;however, ASC 715-30 permits companiesto smooth period-to-period fluctuations inplan assets by using the “expected returnon plan assets” in computing net periodicpension cost. The expected return is usedby most companies and is computed usingtwo components. One is the “expectedlong-term rate of return on plan assets,”which reflects expectations of the averagerate of earnings on existing plan assets, aswell as related reinvestment rates. The sec-ond is the “market-related value of planassets,” in which companies can use thefair value of plan assets or, more com-monly, “a calculated value that recog-nizes changes in fair value in a systemat-ic and rational manner over not morethan five years” (ASC 713-30-20). Forexample, it can represent a moving aver-

25OCTOBER 2012 / THE CPA JOURNAL


age of fair values for up to five years basedon the composition of the portfolio ofplan assets. The difference between theactual and expected return on plan assetsis also recognized as a gain or loss in accu-mulated OCI, and it is included in theamortization of gains and losses discussedbelow.

Amortization of prior service cost (orcredit). Plan amendments (or the initia-tion of a plan) generally provide increasedbenefits that are associated with employeeservices rendered in prior periods. Thisresults in an immediate increase in the pen-sion benefit obligation and an offsettingdebit to OCI. Plan amendments can alsoreduce benefits and have the oppositeeffect. ASC 715-30-35 stipulates that priorservice cost should be amortized over theremaining service period of participantsexpected to receive benefits under the plan.Other amortization approaches are per-mitted, depending upon whether plan par-ticipants are active or inactive when anamendment is made. A company is alsopermitted to choose a less complexapproach that amortizes the cost of retroac-tive amendments more rapidly, providedthat the method is used consistently and is

properly disclosed. ASC 715-30-35-16 pre-cludes a policy of immediate recognition.

Gain or loss. These represent changesin the value of either the projected benefitobligation or plan assets resulting from 1)differences between actuarial assumptionsand actual experience, or 2) a change inactuarial assumptions (e.g., retirement age,mortality, employee turnover, discountrate). The difference between the actual andexpected return on plan assets (notedabove) is also included.

Gains and losses are initially recognizedin OCI. The cumulative amount of thesegains and losses impact future net pensioncost through an amortization process. ASC715-30-35-24 requires that the minimumannual amortization of the net gain or lossbe computed using the “corridor approach.”Amortization under the corridor approachis required “if, as of the beginning of theyear, that net gain or loss exceeds 10 per-cent of the greater of the projected bene-fit obligation or the market-related valueof plan assets.” If such an excess exists,“the minimum amortization shall be thatexcess divided by the average remainingservice period of active employees expect-ed to receive benefits under the plan.”

The corridor approach is used by most enti-ties, and it often results in amortization overperiods of 10 to 15 years. (A calculationof the minimum amortization using the cor-ridor method is illustrated in Exhibit 1.)Alternative approaches are permittedincluding—■ immediate recognition of gains andlosses in annual defined benefit cost, or■ another systematic approach that amor-tizes gains and losses more rapidly thanunder the corridor approach, provided thatthe alternative is consistently used and isapplied similarly to both gains and losses(ASC 715-30-35-20 and 25).

IAS 19 and Differences from U.S. GAAPUnder IAS 19, the annual expense of

defined benefit plans consists of five maincomponents. Two elements—current servicecost and interest cost—have equivalent coun-terparts under U.S. GAAP. The other threeelements, existing delayed recognition pro-visions, and pertinent differences from U.S.GAAP are discussed below.

Expected return on plan assets. Thisvalue is computed using an expected long-term rate of return, multiplied by the fairvalue of the plan assets. Unlike U.S.GAAP, however, use of the market-relat-ed value of plan assets to smooth assetgains and losses is not permitted. The dif-ference between the actual and expectedreturn on plan assets is an actuarial gainor loss (see below).

Past service cost. Changes in past ser-vice costs (prior service costs under U.S.GAAP) from the initiation of a plan or aplan amendment are expensed immediate-ly for fully vested employees and amor-tized into income on a straight-line basisover the remaining period for employeeswho are not vested. U.S. GAAP providesdelayed recognition of both vested andnonvested benefits.

Actuarial gains and losses. Similar togains and losses under U.S. GAAP, actu-arial gains and losses under IAS 19 includedifferences between actuarial assumptionsand actual experience, changes in actuari-al assumptions, and differences betweenthe actual and expected return on planassets. Entities are permitted to chooseamong three alternatives to recognize actu-arial gains and losses to profit or loss. First,the corridor approach to amortization (sim-ilar to U.S. GAAP) may be used to delay

Nanco Inc. sponsors a defined benefit pension plan that covers substantially allfull-time employees. In computing the amortization of gains and losses for 2013,the company uses the corridor approach. The following information is available asof January 1, 2013 (all figures in thousands of dollars):

Market-related value of plan assets (MRVA) $ 2,500,000Projected benefit obligation (PBO) 3,200,000Unrecognized net (gain) or loss in other comprehensive income 750,000Average remaining service life of active employees 10 years

Amortization of net loss for 2013 is computed as follows:Greater of the MRVA or the PBO $ 3,200,000

Corridor (10% × $ 3,200,000) $ 320,000

Unrecognized net loss as of January 1, 2013 $ 750,000Less corridor 320,000Excess over corridor 430,000Average remaining service life of active employees ÷ 10 Amortization for 2013 included in defined benefit cost $ 43,000

EXHIBIT 1Amortization of Gains and Losses: The Corridor Approach


recognition until future periods. Second,any systematic method that results in fasterrecognition than the corridor approach isacceptable, including immediate recogni-tion. A third alternative—not permittedunder U.S. GAAP—is to recognize allactuarial gains and losses in OCI in theperiod they occur, without subsequentamortization to the income statement. Thisalternative serves to reduce the volatilityof defined benefit costs in the income state-ment, as compared to U.S. GAAP.

IAS 19 does not require that the com-ponents of pension cost be reported as a

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

IAS 19R: A New Direction?FASB and the IASB have comprehen-

sive projects on their respective agendasconcerning particular aspects of postre-tirement benefits. Phase 1 of FASB’s pro-ject was completed in 2006 with theissuance of SFAS 158, Employers’Accounting for Defined Benefit Pension

and Other Postretirement Plans—AnAmendment of FASB Statements No. 87,88, 106, and 132(R), which requires thatthe funded status of postretirement plansbe recognized on the balance sheet.Meanwhile, the IASB agreed to addressrecognition, presentation, and disclosureissues in phase 1 of its agenda. Phase 1 ofthe IASB’s project was concluded in June2011 with the issuance of IAS 19R, whichis effective beginning January 1, 2013(early application permitted).

FASB has indicated that the conclusionsreached by the IASB will provide a

Delayed Recognition Provision U.S. GAAP IAS 19 (Present) IAS 19 (Revised)

Prior (Past) Service Cost Vested and unvested benefits Expensed immediately for Delayed recognition attributable are generally amortized over employees who are vested. For to unvested benefits is the remaining service period nonvested employees, amortized eliminated. All past service of participants expected to on a straight-line basis over the costs are expensed in the receive benefits under the plan. remaining vesting period. period the plan is amended or

curtailed.

Market-Related Value of Used to compute the expected Use of a calculated market- Use of a calculated market-Plan Assets return on plan assets. related value of plan assets is related value of plan assets is

Represents either the fair value not permitted. The fair value of not permitted. The fair value of plan assets, or a calculated plan assets is used. of plan assets is used.value that permits gains and losses on plan assets to be smoothed for up to five years.

Expected Return on Calculated as the expected Calculated as the expected Expected return on plan Plan Assets long-term rate of return on long-term rate of return, assets and interest cost on

plan assets, multiplied by the multiplied by the fair value of the pension benefit obligation market-related value of plan plan assets. have been eliminated. Interest assets. on the net defined benefit

liability or asset (using the discount rate) is introduced.

Gains and Losses Permitted Alternatives Permitted Alternatives Single ApproachRecognized in defined benefit Recognized in profit or loss All actuarial gains and losses cost under alternative using the same alternative (i.e., remeasurements) are approaches: approaches permitted under recorded in OCI in the period • Corridor approach U.S. GAAP they occur, without subsequent • Immediate recognition of all or amortization to profit or loss.gains and losses Recognized in OCI in the period • Any other systematic method they occur, without subsequent that results in faster amortization to profit or loss.amortization than under the corridor approach.

EXHIBIT 2Summary of Delayed Recognition Provisions: U.S. GAAP, IAS 19, and IAS 19R


roadmap for future changes to U.S. GAAP.At its August 29, 2007 meeting, FASBdecided to “leverage the IASB’s work,”and it indicated that once the IASB com-pleted phase 1 of its project, it “will con-sider whether adopting similar measure-ment requirements would improve report-ing in the United States.” The final step isa joint project to comprehensively recon-sider the current accounting model for pen-sions and other postretirement benefits.

IAS 19R eliminates the delayed recogni-tion mechanisms, reconfigures the compo-

nents of defined benefit cost, and enhancesdisclosures concerning the characteristics andrisks associated with defined benefit plans.Selected changes included in IAS 19R arebriefly discussed below. Exhibit 2 comparesthe delayed recognition provisions under U.S.GAAP and IAS 19 as well as the changesin these practices included in IAS 19R.

New Components of Pension CostNet interest on the defined benefit lia-

bility or asset. IAS 19R eliminates theinterest cost component and the expected

return on plan assets and introduces a sin-gle “net interest” component. This is cal-culated as the discount rate times the netdefined benefit liability (if underfunded) orplan asset (if overfunded). Accordingly, netinterest expense is recognized if the planis underfunded or net interest income isrecognized if the plan is overfunded. TheIASB views the net pension liability (orasset) as the equivalent of an amountpayable to (or receivable from) the plan.The elimination of the expected return onplan assets will result in higher annual

EXHIBIT 3Changes 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 theaccounting change(s) and the impact on after-tax net income for the year of the change and three prior years are provided. Thehighlighted areas reveal the impact of 2008, when many corporate plans experienced significant unrecognized losses during thedepths of the recession. All figures are in millions of dollars.

After-Tax Increase (Decrease) in Net Income *

Year of Change Prior year Two Years Prior Three Years Prior

Year of Type ofCompany Name Change Change§ $ %‡ $ % $ % $ %

AT&T Inc. 2010 1, 2 ($1,644) (8%) ($ 397) (3%) ($15,492) (120%) $5,081 43%

Honeywell International Inc. 2010 1, 3 $ 57† 3% ($ 605) (28%) ($ 1,986) (71%) $ 150 6%

Verizon Communications Inc. 2010 1, 2 $ 531 26% $1,243 34% ($ 8,621) (134%) $1,691 31%

Fortune Brands Home & Security Inc. 2011 1, 3 ($ 41.6) (693%) $ 6.6 12% $ 2.9 7% ($ 57.8) (9%)

Kaman Corporation 2011 1 $ 2.4 5% ($ 2.7) (7%) ($ 7.6) (23%) $ 2.8 8%

PerkinElmer Inc. 2011 1, 2 ($ 39.3) (84%) $ 7.1 2% ($ 3.5) (4%) ($ 57.1) (45%)

PolyOne Corporation 2011 2 ($ 45.3) (21%) $ 0 0% $ 57.2 116% ($156.8) (60%)

Reynolds American Inc. 2011 1, 3 $ 20 1% $ 8 1% ($ 7) (1%) ($ 894) (67%)

United Parcel Service Inc. 2011 1, 3 ($ 409) (10%) ($ 150) (4%) ($ 184) (9%) ($2,348) (78%)

Windstream Corporation 2011 2 ($ 77.6) (31%) $ 1.9 1% $ 64 19% ($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 expectedreturn on plan assets2. Discontinued the use of the corridor approach (10% or other percentage) and immediately recognized all gains and losses3. Continued the use of the corridor approach, but immediately recognized gains and losses in excess of the corridor


expenses compared to U.S. GAAP andexisting IAS 19 because the expected long-term rate of return on plan assets will bereplaced with the lower discount rate.

Past service cost. IAS 19R eliminatesthe delayed recognition for the unvestedportion of past service costs and requiresthat all past service costs be recognizedwhen a plan is amended or curtailed.Compared to U.S. GAAP and existing IAS19, this change will increase the volatilityof profit or loss for those companies withsignificant plan amendments.

Actuarial gains and losses. As men-tioned above, IAS 19R eliminates thecorridor approach and other amortizationalternatives. All actuarial gains and lossesare immediately recognized in OCI and notamortized or “recycled” into income insubsequent periods. Accordingly, IAS 19Rwill result in greater volatility of OCI butwill reduce volatility of profit or loss com-pared to U.S. companies and those com-panies that presently recognize profits orlosses under IAS 19.

Presentation of Defined Benefit CostIAS 19R introduces changes in termi-

nology and definitions that impact finan-cial statement presentation; however, itdoes not require that net pension cost bereported as a single component on theincome statement, but suggests that pre-sentation be consistent with prior practice(par. BC201). Defined benefit cost willconsist of three components:■ Service cost. This component consistsof current-period service cost, past servicecosts, and certain gains and losses onnonroutine plan curtailments. It is report-ed in profit or loss. ■ Net interest on the net defined benefitliability (asset). The component (discussedabove) is also reported in profit or loss. ■ Remeasurements of the net definedbenefit liability (asset). This componentprimarily includes 1) actuarial gains andlosses on the defined benefit obligation,and 2) the difference between the actualreturn on plan assets and the interestincome included in the net interest com-ponent. It is reported in OCI.

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

Under U.S. GAAP, companies mayelect to change certain existing practices

related to the delayed recognition provisionsof defined benefit costs. One option is tochange the method used to determine themarket-related value of plan assets bysmoothing asset gains and losses over a peri-od shorter than five years, or by changingfrom a calculated value to the fair value ofplan assets. Entities may also elect to changefrom the corridor approach to a policy thataccelerates the amortization of gains andlosses. Examples include changing the sizeof the corridor (e.g., from 10% to 5%), rec-ognizing all gains and losses in excess of thecorridor, or eliminating the corridor com-pletely and immediately recognizing all gainsand losses in the year they occur. Each rep-resents a change in accounting principleunder ASC Topic 250, “AccountingChanges and Error Corrections,” and requiresretrospective application of the newmethod to all prior years. A preferability let-ter from the external auditors is also required.

During 2010 and 2011, certain U.S.companies changed their longstandingaccounting policies related to the recogni-tion of defined benefit costs. Each com-pany had employed some variant of thedelayed recognition provisions related togains and losses. One key factor prompt-ing these changes appears to have been thedesire to eliminate the precarious accu-mulation of unrecognized losses experi-enced in 2008 during the depths of therecession and to avoid the related drag onfuture earnings. For example, AT&T Inc.implemented the following two account-ing changes at the end of 2010: it discon-tinued use of the corridor method and theuse of a calculated market-related fair valuein order to smooth asset gains and lossesand to compute the expected return on planassets. The company adopted a fair valueapproach to immediately recognize allgains and losses in the income statement.The after-tax impact of the changesamounted to a $1.64 billion (8%) reduc-tion in net income for the year endedDecember 31, 2010. In accordance withASC 250, prior-year financial statementswere also retrospectively adjusted to reflectthe impact of the change. The previouslyreported net income for 2008 was reducedby $15.5 billion (120%).

Verizon Communications Inc. reportedaccounting changes in 2010 similar to thoseadopted by AT&T; however, the after-taxamount 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 retro-spectively adjusted, with a reduction in pre-viously reported net income for 2008 of$8.6 billion (134%).

Honeywell Inc.’s management noted thatits accounting practices were more conser-vative than its peers. Previously, Honeywellhad smoothed asset gains and losses overthree years (compared to five years for mostcompanies) using a calculated market-relat-ed fair value of plan assets. Gains and loss-es in excess of the corridor were previouslyamortized over a shorter period of six years.Though Honeywell discontinued the smooth-ing of asset gains and losses using a market-related fair value of plan assets, the compa-ny elected to retain the 10% corridor butimmediately recognize gains and losses inexcess of the corridor each year. On a retro-spective basis, the reduction in after-tax netincome totaled $605 million (28%) for2009 and approximately $2 billion (71%) for


2008. Other companies that also changedtheir pension accounting practices during2011 included Reynolds American Inc. andUnited Parcel Service Inc. Exhibit 3includes a sample list of companies, thechanges made, and the impact to previouslyreported net income.

In corporate announcements, press releas-es, and investor presentations, the manage-ment of such companies explained the natureof the accounting changes and the impact onfinancial results. The following were com-mon themes in their rationales:■ Existing accounting practices are simplified.■ Accounting is now better aligned withpreferable fair value concepts. ■ Gains and losses due to market fluctua-tions are recognized in the period they arise.■ Expense recognition is better alignedwith current market returns, interest rates,and actuarial assumptions.■ There is consistency with new inter-national accounting standards.■ Current period results have improvedtransparency. ■ There is no impact to cash flows, planfunding, employee benefits, or dividendpolicy.■ There is minimal impact to the balancesheet. The change is reflected as a reduc-tion in retained earnings and an increase toaccumulated OCI.

Some corporate announcements referredto the fair value approach in IAS 19R intheir explanations. In its press releaseannouncing the change, Honeywell notedthat “independent auditors have agreed asto the preferability of this change, andimportantly International FinancialReporting Standards (IFRS) utilize a MTM[mark-to-market] methodology for pensionaccounting” (November 16, 2010).Similarly, in an analyst call to explain theaccounting change, Verizon CFO FrancisJ. Shammo indicated: “This is actually apreferable accounting method and one thataligns with the fair value accounting con-cepts and current IFRS proposals” (January21, 2011).

The benefits of these changes, howev-er, must be weighed against concomitantrisks. The predictability of annual definedbenefit cost from existing smoothingtechniques will be replaced with increasedvolatility in earnings and added difficultyin accurately forecasting future results. In

fact, during several investor conferencecalls held by companies to explain theirrecent pension accounting changes, ana-lysts appeared to be more interested in theimpact on forecast accuracy and the risk of“surprises,” since the fair value adjustmentsfor gains and losses will be reported onlyin the fourth quarter of the year.

The Economic Crisis and its Aftermath Standard & Poor’s (S&P) reported that

defined benefit pension plans for compa-nies in the S&P 500 were overfunded by$63.4 billion at the end of 2007—that is,before the global economic crisis hit (S&P500 2011: Pension and Other Post-Employment Benefits, July 2012). Sincethen, the recession and other factors havehad a devastating impact on the health ofcorporate pension plans. The S&P 500index had a negative total return of 37%in 2008, and the pension plans of S&P 500companies experienced (on average) “a43% gap” between expected and actualreturns. Total plan assets declined by26.9%, or approximately $400 billion, con-tributing to a record underfunding of$308.4 billion at the end of 2008. The S&P500 index rebounded with total returns of26.5% in 2009 and 15.1% in 2010, butthese gains were on a significantly lowerasset base. Further complicating this situ-ation is that the historically low interest rateenvironment has resulted in a drop in theaverage discount rates used to measure pen-sion liabilities, from 6.3% in 2008, to 5.8%in 2009, and 5.3% in 2010. Unfortunately,lower discount rates serve to increase thepresent value of existing pension liabilities,generate additional unrealized losses, andexacerbate the funded status of plans.

At the end of 2010, the pension plans ofS&P 500 companies had an aggregateunderfunding of $245 billion. During 2011,a further decline in the average discountrate to 4.7%, coupled with a meager totalreturn of 2.1% for the S&P 500 index,helped increase aggregate pension under-funding to a record $354.7 billion.Accordingly, higher future pension contri-butions will be necessary, either from exist-ing resources or additional borrowing.

These economic results present a uniquesituation for companies with defined bene-fit pension plans. Moreover, given the sig-nificant overhang of unrecognized lossesfrom prior years, the continued use of the

calculated market-related value of plan assetsand the corridor method will have a nega-tive impact on earnings for years to come.

What’s Ahead?The recent accounting changes and revi-

sions to IAS 19 have provided U.S. com-panies with a preview of the challengesahead. Some may view this as an oppor-tunity to eliminate the overhang of unrec-ognized losses and the drag on future earn-ings. But the risks of increased volatility inearnings and forecasting difficulties shouldnot be dismissed.

Now is the time to examine long-termstrategies. Although the SEC final staffreport (Work Plan for the Consideration ofIncorporating International FinancialReporting Standards into the FinancialReporting System for U.S. Issuers, issuedJuly 13, 2012) does not clarify the timingor method of incorporating IFRS intoU.S. GAAP, U.S. companies should con-sider the impact of IAS 19R on their finan-cial condition and future earnings. IAS 19Rwill likely reduce volatility in earnings, butincrease volatility in OCI. Moreover, theelimination of the expected return on planassets will likely increase defined benefitcosts, because returns in excess of the dis-count rate will be reported in OCI—notearnings. Current investment strategies tosupport a higher long-term rate of returncould warrant a shift away from equitiesand riskier assets to a portfolio bettermatched to the plan’s liabilities. Finally,companies anticipating future plan amend-ments should also consider the immediaterecognition of vested and unvested bene-fits, as provided in IAS 19R.

Overall, the movement toward a fairvalue model and away from delayed recog-nition represents a major step towardimproving accounting practices that havelingered for the past 25 years. But it doesnot settle the broader issue concerning themeasurement of defined benefit costs,which represents the next step for FASBand the IASB in their long-term effort tooverhaul pension accounting practices. ❑

James M. Fornaro, DPS, CPA, CMA,CFE, is an associate professor in thedepartment of accounting, taxation, andbusiness law at SUNY at Old Westbury,Old Westbury, N.Y.


By H. Leon Chan, David G. DeBoskey,and Kevin Hee

The PCAOB’s replacement inNovember 2007 of AuditingStandard (AS) 2, An Audit of

Internal Control Over Financial ReportingPerformed in Conjunction with an Audit ofFinancial Statements, with AS 5, An Auditof Internal Control Over FinancialReporting That Is Integrated with an Auditof Financial Statements, created an inter-esting opportunity to explore the longer-term impact of AS 5 on the characteris-tics of Big Four and non–Big Four auditfees. Has AS 5 had the same impact on theaudit fees charged by both types of auditfirms? How can the differences in the feetrends be interpreted by policy makers,clients, and firm management?

In recent years, BDO Seidman, GrantThornton, and other non–Big Four firmshave gained market share in the auditing ser-vices market for small and medium-sizedpublic companies. Thus, there is a greaterneed for information concerning relativeauditor quality among the non–Big Four. Inparticular, there has been little focus on theaudit fee trends of non–Big Four firms,which provides additional motivation forexamining the impact of AS 5 on the behav-ior of non–Big Four firms, as well as the BigFour, with respect to audit fees.

The following is a comparison of theaudit fee trends of both Big Four andnon–Big Four audit firms, and it revealssimilarities and differences in the auditfee behavior of these firms. Policy mak-ers should be interested in the data show-ing the long-term effects of auditing stan-dards. In addition, the discussion belowcontains information that is relevant tomanagement at both small and large com-panies who might find the results useful innegotiating audit fees in the future.

OverviewThis empirical examination focused on

the following two questions:■ What has been the overall impact ofAS 5 on the audit fee behavior of non–BigFour and Big Four audit firms?

■ Does the resultant change in auditfees apply equally to Big Four andnon–Big Four auditors?

These questions have been left largelyunanswered in practitioner-focused publi-cations. Although recent studies have point-ed to a reduction in audit fees followingthe implementation of AS 5, the longer-term impact on audit fees has remainedmostly undocumented.

In their April 2009 article, Wei Jiangand Jia Wu demonstrated only a smallincrease in audit fees in the post–AS 5 era(“The Impact of PCAOB Auditing Standard5 on Audit Fees,” The CPA Journal, pp.34–38). The authors indicated that thisfinding was significant because “audit feestended to rise at a relatively steady pace.”This implies that AS 5 had an impact onreducing actual audit costs in the first yearof its adoption. A review of the most recentdata indicates that the favorable trend in auditfees has continued in earnest through 2011.

In their November 2009 article, AlokeGhosh and Robert Pawlewicz documentedthat the Big Four increased audit fees by 42%more than non–Big Four firms (“The Impactof Regulation on Auditor Fees: Evidence fromthe Sarbanes-Oxley Act [SOX],” Auditing:

A Journal of Practice& Theory, vol. 28, no.2, pp. 171–197). Theauthors suggested thatduring the post-SOXera (the AS 2 period)the Big Four weresubjected to a dispro-portionately greaterexposure to litigationrisk. They also foundthat only the non–BigFour firms continuedto discount fees oninitial engagements inorder to attract new

clients in the post-SOX years. In addition,Ghosh and Pawlewicz suggested that theirfindings were consistent with arguments thatcompetition for new clients among the BigFour is low and that client turnover for theBig Four is relatively low. To date, howev-er, it is unclear how this pattern of audit feescould have changed following the passageof AS 5.

The following is a detailed analysis ofaudit and nonaudit fee data since 2003 forBig Four and non–Big Four audit firms.Moreover, the sections below address whythe cost-savings trends anticipated by AS 5might have a different trajectory for BigFour and non–Big Four audit firms. Theanalysis reveals at least three practicalimplications for policy makers, clients ofaudit firms, and the audit firms themselves.

Data Sources and Variable MeasuresThe sample below was drawn from the

Audit Analytics database (www.audit

Audit Fee Patterns of Big Four and Non–Big Four Firms


a u d i t i n g

A Study of the Potential Effects of Auditing Standard 5

analytics.com) and included all firms withinformation on audit and nonaudit fee datafrom 2002 to 2011 (although 2011 onlyincludes partial-year observations). Theaudit fee variable captures both audit feesand other fees related to an audit. (Forfurther clarification on the distinction anddefinitions of the various types of auditfees, see Jiang and Wu 2009.) For the pur-poses of this analysis, audit fees are cate-gorized as follows: ■ Audit fees■ Audit-related fees■ Other fees (i.e., nonaudit services otherthan tax)■ Tax fees.

Annual audit fees are calculated as theaverage audit fees for each year in the sam-ple. The total fees represent the mean oftotal audit fees (including audit and non-audit) over all firms in each year includedin the sample. Finally, abnormal audit feesare calculated as the mean of the differ-ence between average annual audit feeseach year and a three-year moving aver-age (where available) of annual audit feesfor each firm in the sample.

Nonaudit Fee Data AnalysisEver since regulators expressed concern

over the possibility that auditors’ inde-pendence is impaired when they also pro-vide nonaudit services to clients (see“The Numbers Game,” by Arthur Levitt,

The CPA Journal, December 1998), theeffect of nonaudit fees on audit quality hasbeen examined closely. Although priorresearch findings have been mixed, manybelieve that “audit quality will always besomewhat suspect if other services are pro-vided” (Jere R. Francis, “What Do WeKnow About Audit Quality?” The BritishAccounting Review, vol. 36, no. 4, pp.345–368). Thus, it is not surprising tofind that auditors have scaled back thescope of nonaudit services in the post-SOXperiod. As Exhibit 1 demonstrates, theoverall trend in the ratio of nonaudit feesto total fees has significantly decreased,from 46.4% in 2002 to 18.4% in 2011. Theauthors attribute this decline to SOX andsubsequent SEC regulations that greatlyrestricted the provision of nonaudit servicesby a firm’s auditor.

While the overall trend in the ratio ofnonaudit fees to total fees has decreasedfor both Big Four firms and non–BigFour firms, average annual nonaudit feeshave increased 7.49% for non–Big Fourfirms and have decreased 14.92% for BigFour firms. The authors suggest the fol-lowing two plausible explanations for thisphenomenon:■ Big Four auditors are more likely thannon–Big Four auditors to be concernedabout a loss of reputation and litigationexposure; therefore, the Big Four are morewilling to reduce economic bonding with

their clients through the provision ofnonaudit services. This argument is con-sistent with the findings of Chee-YeowLim and Hun-Tong Tan (“Non-AuditService Fees and Audit Quality: TheImpact of Auditor Specialization,” Journalof Accounting Research, vol. 46, 2008, pp.199–246) that the effect of nonaudit ser-vices on audit quality depends upon audi-tor industry specialization. ■ Non–Big Four firms are more likelythan Big Four firms to be asked by theirsmall to medium-sized clients to providenonaudit services in order to meet the SOXrequirements because “non–Big Four audi-tors have superior knowledge of local mar-kets and better relation with their clients”(Louis Henock, “Acquirers’ AbnormalReturns and the Non–Big Four AuditorClientele Effect,” Journal of Accountingand Economics, vol. 40, no. 3, pp. 75–99).

Audit Fee Data Analysis:Big Four versus non–Big Four firms.

Exhibit 2, Exhibit 3, and Exhibit 4 depictthe trends in fees charged by audit firmsduring the sample period. The exhibitsclearly illustrate that average annual totalfees (audit and nonaudit) and average auditfees have declined from 2007 (well docu-mented in prior studies) through 2011 (newinformation not previously documented).The decline in audit fees between 2007 and2011 is most likely due to the implemen-


EXHIBIT 1Nonaudit Fees as a Percentage of Total Fees

90.0%

80.0%

70.0%

60.0%

50.0%

40.0%

30.0%

20.0%

10.0%

00.0%2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Ratio of nonaudit fees to total fees Average annual non-audit fees

81.6%79.0%80.2%79.6%78.4%79.5%77.6%71.6%

59.0%

53.6%

46.4%

41.0%

28.1%22.4% 20.5% 21.6% 20.4% 19.8% 21.0% 18.4%

tation of AS 5. The reduction of averageaudit fees by the Big Four during the AS 5period has actually brought the averageback to the pre-SOX (2002) level.

This decline in fees from 2007 to 2011,however, appears to take on a differentmeaning for non–Big Four firms. This isimportant because prior research (Jiang andWu) implied that these audit fee decre-ments would most likely continue asauditors became more comfortable with therisk-based, top-down approach. Theauthors’ updated data set indicates thatthese declines in audit fees have continued

through 2011; however, the change in aver-age annual audit fees seems to have sloweddramatically for non–Big Four firmssince 2009.

AS 5’s impact on audit fees found inacademic research appears to be drivenby Big Four clients (Exhibit 3), asopposed to non–Big Four clients (Exhibit4). Exhibit 3 clearly shows a decreasingtrend in audit fees paid by Big Fourclients, compared to the relatively flattrend in fees paid by non–Big Fouraudit clients. Given the relative size ofthe Big Four firms, it is expected that

they will drive the overall audit fee trend;thus, this analysis also includes the per-centage change in audit fees over thesample period to allow for a more infor-mative comparison. Exhibit 5 provides acomparison of the year-to-year percent-age change in audit fees for Big Fourfirms and non–Big Four audit firms.Specifically, Big Four firms started toreduce their audit fees in 2007 by 3.76%,and the passage of AS 5 helped to fur-ther reduce their fees in 2008 and 2009by 4.27% and 13.54%, respectively.

In addition, nonaudit fees, as a percent-


EXHIBIT 2Total Average Annual Fee Trends (Big Four and Non–Big 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 3Total Average (Big Four) Annual Audit Fee Trends

$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)

Total Fees ($000s)Nonaudit Fees ($000s)


age of total fees, have been relatively flatsince 2004. From 2002 to 2008, audit firmscharged higher-than-expected (i.e., abnor-mal) audit fees (based on a three-year mov-ing average). In 2009, however, abnormalaudit fees decreased below zero; thisimplied that, compared to prior years, auditfirms were charging less than expected.Furthermore, the ratio of audit fees toclients’ sales revenue—a measure ofaudit efficiency—increased by 13% for BigFour firms and 8.85% for non–Big Fourfirms from 2007 to 2010. This indicatesthat both Big Four and non–Big Four firmswere able to perform audits more effi-ciently in the AS 5 era. Lee Duran, a man-aging partner at BDO’s San Diego office,has proffered that potential pricing pres-sure, leading to both Big Four and non–BigFour firms charging lower overall auditfees to gain client share, is the main driv-er behind this trend (November 2011).

Non–Big Four firms. As previouslynoted, although the audit fee trend for theoverall sample is driven by the Big Four—mostly due to the differences in scale—theimpact of AS 5 on non–Big Four firms isstill extremely important, given their small-er size and the importance for these firmsto control audit costs. In addition, in anontabulated analysis, the authors calcu-lated that the percentage of all audited com-panies in the sample with non–Big Fourauditors increased from 13.7% in 2003 to39.5% in 2011, while the percentage withBig Four auditors correspondingly declinedfrom 86.3% to 60.5%. Based on these

numbers, one could argue that any changesin audit standards is of increasing impor-tance for these smaller audit firms that aregaining more clients.

Exhibit 4 shows the significant increas-es in audit fees from 2003 to 2006(post-SOX, pre–AS 5 era); this trend con-tinued into the beginning of the AS 5 era.Exhibit 5 provides the quantitative sup-port for the graphical trends portrayedin Exhibits 2–4. Specifically, the non–BigFour firms increased their audit fees in2007 and 2008 by 21.03% and 15.15%,respectively, and only started to reducetheir fees in 2009 by 1.10%. (The aver-age client size, proxied by total assets andmarket capitalization, of the non–BigFour firms increased by 1.3% in 2008 anddecreased by 13.2% in 2009; the decreasein average audit fees in 2009 mighthave been affected by economic factorsand the size of clients.) This could lenditself to an interpretation that AS 5 hashad less of an impact on non–Big Fouraudit fees than Big Four audit fees. Theauthors speculate that the non–Big Fourfirms might follow a more prescriptiveapproach than the Big Four, leading tofewer opportunities to benefit fromeconomies of scale.

Until 2007, the growth in annual auditfees paid by non–Big Four clients had beenstronger; from 2007 to 2009, non–Big Fouraudit fees have declined at a slower pace.Finally, both Big Four and non–Big Fourfirms have been charging lower audit feesthan expected since 2009. Although the

exact causes of this trend cannot be cer-tain, the authors speculate that downwardpricing pressures for both large and smallaudit firms is a major contributing factor.Moreover, 2008 marked the beginning ofthe financial crisis; it is possible that pric-ing power was limited during these tighteconomic times.

Implications SOX and the resulting AS 2 standard

have been controversial ever since their ini-tial implementation. Much of that contro-versy has focused on the increased finan-cial burden felt by the companies that hadto deal with the new financial reportingrequirements that accompanied the legis-lation. In response, the PCAOB imple-mented AS 5, with a focus on a morecustomized audit that could potentially easethe burden on smaller companies that didnot require many of the audit processescalled for under AS 2.

While existing research on AS 5 hasfound that audit fees, decreased in thefirst several years of implementation, therehas been little to no research on the cur-rent effects of AS 5 on audit fees, now thatcompanies have had enough time to getcomfortable with its requirements (i.e., fivefiscal years have passed since 2007).Undoubtedly, the use of non–Big Fourauditors is pervasive, and many private andsmaller public companies employ the audit-ing expertise of these firms; thus, theimpact of AS 5 on the audit fees fornon–Big Four auditors can shed light on

EXHIBIT 4Total Average (Non–Big 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) Abnormal Audit Fees ($000s)

Total Fees ($000s)Nonaudit Fees ($000s)

the differential impact AS 5 has had onlarger versus smaller audit firms. This isparticularly important because AS 5 wascreated in direct response to the complaintsby smaller companies that the costs ofSOX and AS 2 were too high; most small-er companies employ a non–Big Four audi-tor to attest their financial statements andinternal controls.

The findings show that there has certain-ly been a change in the trend in audit feescharged by both Big Four firms and non–BigFour firms during the switch from the AS2 era to the AS 5 era. Most notably, non–BigFour audit fees have remained mostly flatover the last three years, after steadilyincreasing since 2002; audit fees for theBig Four, on the other hand, have steadilydecreased since 2007. One plausible expla-nation for these trends is that AS 5 empha-sized the need to customize audits and makeaudits less prescriptive in order to better fitthe specific characteristics of the companybeing audited. Given the economies of scaleand resources available to the Big Four, theseauditors might have been able to adjust their

audits more quickly and decrease feeswhen compared to the non–Big Four auditfirms. But this potential explanation requiresadditional research, because one could alsoargue that the trends should be attributed tothe systematic differences between clients.

Although prior research suggests that thecompetition for new clients and clientturnover among Big Four firms is relativelylow, the results of this analysis suggest thatAS 5 and the economic environment mightchange the Big Four’s pricing behavior. Itseems that, from 2008 to 2011, the BigFour reduced average audit fees by 12.43%annually. While these findings provide pre-liminary evidence of some type of pricingpressure, it should be noted that thedecrease in audit fees for Big Four firmsduring the sample period could have result-ed from factors beyond pricing pressurefrom non–Big Four firms (e.g., macro-economic factors, less negotiating leverage,stronger internal controls across theboard, more efficient audits). In any event,it appears that non–Big Four audit feeshave stabilized, and management should

take these market-wide audit fee trends intoconsideration during audit price negotia-tions with their auditors.

For now, AS 5 appears to have curtailedthe unbridled audit fee increases during thepost-SOX and post–AS 2 eras. The impli-cations of the data extend to all companiesin the midst of their audit fee negotiationsand should provide a platform fromwhich to understand the latest audit feetrends. In addition, policy makers shouldbear in mind that audit standards and reg-ulations have a different impact on BigFour firms and non–Big Four firms; there-fore, they should adopt a balancedapproach when setting such standards. ❑

H. Leon Chan, PhD, is an assistant pro-fessor; David G. DeBoskey, PhD, CPA(N.J. inactive), is an assistant professorand KPMG Faculty Fellow; and KevinHee, PhD, CPA, is an assistant profes-sor, all in the Charles W. Lamden Schoolof Accountancy, San Diego StateUniversity, San Diego, Calif.


Comparison of year-to-year change in total fees (includes audit and nonaudit fees):2003 2004 2005 2006 2007 2008 2009 2010 2011

Overall -- 13.11% 26.78% -- 0.49% 2.21% -- 1.68% -- 5.19% -- 13.66% -- 2.59% -- 28.82%Big Four -- 13.26% 26.46% -- 1.10% 1.68% -- 2.17% -- 5.79% -- 0.92% -- 2.76% -- 30.01%Non–Big Four 4.83% 57.69% 47.09% 2.21% 18.20% -- 5.19% -- 13.66% -- 2.59% -- 1.31%

Comparison of year-to-year change in audit fees:2003 2004 2005 2006 2007 2008 2009 2010 2011

Overall 10.49% 54.68% 7.33% 4.77% -- 3.13% -- 3.65% -- 13.07% -- 4.03% -- 26.47%Big Four 10.44% 54.52% 6.69% 4.14% -- 3.76% -- 4.27% -- 13.54% -- 4.22% -- 27.68%Non–Big Four 14.78% 68.05% 54.19% 36.42% 21.03% 15.15% -- 1.10% 0.32% -- 0.96%

Comparison of year-to-year change in nonaudit fees:2003 2004 2005 2006 2007 2008 2009 2010 2011

Overall -- 33.51% -- 13.32% -- 20.57% -- 6.66% 3.96% -- 10.78% -- 15.99% 3.24% -- 37.64%Big Four -- 33.62% -- 13.62% -- 21.03% -- 6.82% 3.99% -- 11.26% -- 16.37% 3.07% -- 38.66%Non–Big Four -- 14.51% 30.65% 23.26% 3.34% 2.53% 15.84% 0.20% 9.47% -- 3.39%

Audit fees scaled by millions of dollars in client revenue, year-to-year:2003 2004 2005 2006 2007 2008 2009 2010 2011

Overall 353 480 496 504 461 457 483 415 237 Big Four 355 481 500 514 472 465 480 411 199Non–Big Four 1,308 1,690 1,696 1,751 1,764 1,535 1,873 1,608 1,084

EXHIBIT 5Annual Percentage Changes in Fees


By Ira G. Kawaller

FASB’s disclosure requirements providea fair amount of detail about deriva-tives and hedging transactions; yet,

despite efforts by auditors to comply withthem, readers of financial statements often findthat these disclosures are not entirely satisfy-ing. Some of the required information mightbe presented in a manner that is misleadingor confusing. Perhaps more importantly, thediscussion might fail to appropriately or ade-quately describe the nature or scale of theactivities under consideration. The best prac-tices described below can make disclosureson derivatives and hedging transactionsmore helpful to financial statement users.

Disclosure PitfallsU.S. GAAP requires a host of disclosures

related to derivatives, irrespective of 1) thetype of derivative, 2) whether it is used forhedging or speculative purposes, and 3) thetype of accounting treatment applied—forexample, nonhedge accounting, cash flowhedge accounting, fair value hedging, orhedges of net investments of foreign invest-ments. The following nonexhaustive listhighlights the disclosures required in all ofthe aforementioned circumstances:■ The context needed to understandintended hedge objectives (i.e., how thederivatives affect the entity’s financial posi-tion, financial performance, and cash flows)■ The accounting treatment applied in con-nection with derivative transactions, forboth the hedged item and the hedging deriva-tive when hedge accounting is applied■ The location of the fair value of theamounts of derivatives reported on agross basis, presented as assets or liabili-ties, and segregated by market segment(e.g., interest rate, foreign exchange, com-modity, or other)■ The location and amount of the gainsand losses on any hedging derivative and

related hedged items reported in the incomestatement or balance sheet■ Identification of effective versus inef-fective outcomes, as well as componentsof results that had been excluded from con-sideration of hedge effectiveness■ The net gain or loss recognized in earn-ings when a firm commitment no longer qual-ifies as a hedged item in a fair value hedge■ For cash flow hedges, a description ofthe conditions that will result in thereclassification of accumulated othercomprehensive income (AOCI) into earn-ings and a schedule of the estimated reclas-sification expected in the next 12 months■ For cash flow hedges, except hedges ofvariable interest rate exposures, the maximumlength of time that hedging is anticipated■ The amount reclassified into earningsas a result of discontinued cash flow hedgesbecause associated forecasted transactionsare no longer probable.

Not all of this list is straightforwardand unambiguous. Two of the precedingpoints are particularly prone to misinter-pretation—the requirements relating tothe disclosures of ineffective earnings andprospective reclassifications.

One of the critical preconditions for hedgeaccounting to be applied is that hedgeshave to be shown to be “highly effective” inoffsetting the effects of the risks beinghedged. If these offsets don’t occur with suf-ficient closeness, hedge accounting is sim-ply disallowed. Presumably, if the high-effec-tiveness hurdle has been satisfied, theseimpacts on ineffective earnings would beof a relatively minor magnitude. The amountof ineffective earnings is a specific disclo-sure requirement; however, the value ofthis disclosure is questionable.

How should readers of the financial state-ments interpret this disclosure? One of thetwo following assumptions could be made: ■ Ineffective earnings could simply reflect atransitory hiccup in a reasonably robust

hedge relationship, in which case the ineffec-tiveness recorded in the current period wouldlikely be reversed in subsequent periods.■ Ineffective earnings could be an indi-cator of things to come.

Without added discussion by preparers,readers might not know which interpreta-tion is correct. Unfortunately, even thehedging entity might not have a clue as towhether the ineffectiveness is temporary orpermanent. Given this inherent uncertain-ty and the fact that the magnitude of theineffectiveness is necessarily constrained,why bother with this disclosure, aside fromthe obvious fact that it’s mandated? Theprospect of the disclosure providing anyinformation of value is limited, whilesimultaneously opening the door for mis-

interpretation. And if this is the case, per-haps the reporting entity should cautionusers about making an inappropriatejudgment. To FASB’s credit, these kindsof qualitative disclosures are encouraged.

The second disclosure pitfall relates to therequirement to disclose the amount that isexpected to be reclassified out of AOCI intoearnings in the upcoming 12 months.Consider two companies, identical in everyway except for this disclosure value. The firstreports an expected gain of $X in the upcom-ing 12 months from this reclassification pro-cess, while the second projects a loss of

Disclosures on Derivatives and Hedging Transactions


f i n a n c i a l r e p o r t i n g

A Review of Best Practices

The “check the box” approach that

satisfies FASB’s disclosure requirements

for derivatives serves readers of

financial statements poorly.

$Y. (While hypothetical, this situation couldarise if the two entities entered into theirrespective hedges at different times and dif-ferent prices—for example, if one entityentered into the hedge when prices werehigh, and the other entered into the hedgewhen prices were low and then quarter-endprices moved to a midrange value.)

Most readers of the two respective dis-closures would likely judge the first compa-ny (i.e., the one reporting deferred gains) tobe in the more favorable circumstance.Unfortunately, just the opposite is likely tobe the case. At first blush, financial statementusers need to be reminded that this reclassi-fication relates to an effective hedge, suchthat the earnings or losses associated with thederivative should be expected to be equal toand opposite of the earnings impact relatingto the risk being hedged. That considerationmight make it seem as if neither the magni-tude nor the direction of the disclosed, pro-jected reclassification amount would be rel-evant. That conclusion would only hold, how-ever, if the entirety of the exposure werebeing hedged, which is rarely the case.Typically, companies hedge only a portionof their exposures, rather than the whole; inthose cases, the preferred outcome wouldbe one where the company could claim ahuge loss due to reclassification as goodnews, because it could expect an even larg-er positive earnings effect coming from itsoverall (hedged plus unhedged) exposure.

A Better Disclosure?The consideration above highlights what

might be the most critical omission of thedisclosure requirements: the rules fail torequire a transparent presentation of thescope of the hedging activity—that is, theportion of the company’s exposure that isbeing hedged. Ideally, this informationshould be presented according to market andtype of derivative. It would certainly berelevant to discussions about hedging activ-ity (the first point in the list provided above),but it is not explicitly required; as a conse-quence, it is often difficult to discern.

At present, reporting entities must dis-close the fair values, earnings, OCI allo-cations, and reclassifications for theirderivative positions. This content isrequired to be broken down by the asso-ciated market segment (e.g., interest rate,foreign exchange, commodity contracts)and whether the positions are designated

as hedging instruments. The way this infor-mation is presented generally followsexamples offered in the AccountingStandards Codification (ASC), particular-ly ASC 815-10-55-182; however, these dis-plays fail to show the portion of exposurescovered by hedging contracts. This infor-mation is critical to understanding the com-pany’s risk orientation and, thus, itsprospects for future performance.

In order to provide the proposed infor-mation, reporting entities would have tooffer a more detailed breakdown of the var-ious instruments in use, reflecting the expo-sures for which hedging is intended. Thefollowing are the predominant interest raterisk exposures for interest rates, foreigncurrencies, and commodity price risk: ■ Uncertain interest rate payments onexisting or planned assets and liabilities■ Price risk associated with recognizedfixed-rate assets and liabilities■ Foreign currency risks■ Anticipated transactions with foreigncounterparties■ Existing assets or liabilities denomi-nated in foreign currencies ■ Net investments in foreign operations■ Commodity price risk■ Uncertain payments for commoditypurchases or sales■ Inventory price risk.

In a limited number of cases, derivativesmay be acting as hedges without hedgeaccounting being applied, either becausethe prerequisite qualifying conditions werenot satisfied or because the entity simplyelected not to seek hedge accounting.Nonetheless, readers of financial statementsshould be informed about the hedgingobjectives associated with any contractsthat are designed as an economic hedge.

For each of the categories mentionedabove, it would seem reasonable andappropriate to disclose information aboutthe associated hedging relationships. Forthose exposures relating to uncertain futureprices (most likely, but not necessarily,cash flow hedges), an improved disclosurewould segment exposures into appropri-ate risk horizons and detail the portion ofrisks being hedged by existing derivativepositions. For example, a company thatmanages prospective foreign currency pur-chases or sales may hedge (and disclosethat it is hedging) approximately 35% to50% of purchases anticipated in the most

immediate six-month horizon, and 20%to 30% of such exposures for the subse-quent 18-month period. Some lack of pre-cision in these proportions should beexpected, however, because the volumeof forecasted business activity will gener-ally not be known with certainty. As a con-sequence, a given hedge could end uphedging a higher or lower portion ofprospective transactions, depending uponwhether the volume of those transactionsrises or falls from some initial estimate.

An analogous volumetric uncertainty doesnot arise for hedges of existing price risk (nor-mally fair value hedges, but not necessari-ly). In these cases, the risk is associatedwith recognized assets or liabilities, or withfirm commitments. The portion of these risksbeing hedged should be more readily andmore precisely discernible. For such hedges,disclosures would be improved by detailingthe portion of any balance sheet price riskthat is currently hedged with derivatives.

Best PracticesBesides disclosing the percentage of

hedge coverage in identified exposureareas, reporting entities should also offergreater detail about the types of derivativesthey use—those with symmetric payofffunctions (e.g., futures, forwards, swaps),where gains or losses accrue in magnitudesconsistent with price changes in eitherdirection, or those with asymmetric pay-offs (e.g., options, caps, floors, combina-tions of each), where payoffs are con-strained in some fashion. A company thatenters into an interest rate swap has a muchdifferent character from one that enters intoan interest rate cap. Depending on theextent of the hedging activities, these dis-tinctions could have material effects thatwould be relevant to discerning analysts.

The “check the box” approach that sat-isfies FASB’s disclosure requirements forderivatives serves readers of financial state-ments poorly, especially in light of cur-rent disclosure rules that require virtuallyno directives relating to the portion ofexposures being hedged. Businessescould—and should—do better. ❑

Ira G. Kawaller is the founder of Kawaller& Co., a consulting company based inBrooklyn, N.Y., that assists companies inusing derivative instruments.


Even though the concept of economicsubstance has been codified, con-cern about the proper application ofthis doctrine still exists. Thus, the IRS

has released administrative guidance clar-ifying when the application of this doctrineis appropriate. Rigorous conditions mustbe met before a transaction can be treatedas lacking economic substance, therebysubjecting it to the penalties for theunderpayment of taxes that stem from sucha transaction.

BackgroundIn its war on tax shelters, the Treasury

Department has aggressively pursued tax-payers in the courts. One of the most com-mon ways to attack these transactions hasbeen the economic substance doctrine. TheTax Court in ACM Partnership v. Comm’rdescribed the economic substance doctrineas follows:

The tax law, however, requires that theintended transactions have economic sub-stance separate and distinct from economicbenefit achieved solely by tax reduction.The doctrine of economic substancebecomes applicable, and a judicial reme-dy is warranted, where a taxpayer seeksto claim benefits, unintended by Congress,by means of transactions that serve noeconomic purpose other than tax sav-ings. (T.C. Memo 1997-115)But the courts have, over time, used var-

ious and often inconsistent interpretationsof the doctrine. (For a comprehensive dis-cussion of this legal history, see Karyn A.Friske, Karen M. Cooley, and Darlene A.Pulliam, “Economic Substance Codification:Clarification or Convolution,” Practical TaxStrategies, December 2010.)

The Health Care and EducationReconciliation Act of 2010 codified theeconomic substance doctrine in InternalRevenue Code (IRC) section 7701(o),which specifies a conjunctive two-prongtest for determining whether a transactionis treated as having economic substance.First, under IRC section 7701(o)(1)(A), the

transaction must change the taxpayer’s eco-nomic position in a meaningful way (apartfrom the federal income tax effect).Second, under IRC section 7701(o)(1)(B),the taxpayer must have a substantial pur-pose for entering into the transaction (apartfrom the federal income tax effect).

IRC section 7701(o) resolved existing

The Economic Substance Doctrine

T A X A T I O N

c o m p l i a n c e & e n f o r c e m e n t


By Karyn Bybee Friske, Karen M. Cooley, and Darlene Pulliam

Understanding the IRS’s Guidance on its Proper Application


conflicts among the various courts abouthow to apply the doctrine. According toCongress’s Joint Committee on Taxation,the “codification was not intended tochange present law standards, except toclarify that the test is conjunctive”(“Technical Explanation of the RevenueProvisions of the Reconciliation Act of2010, as Amended, in Combination withthe Patient Protection and Affordable CareAct,” JCX-18-10, March 21, 2010).

The Health Care and EducationReconciliation Act also introduced IRC sec-tion 6662(b)(6), which imposes a penalty of20% if an underpayment is attributable tothe application of the economic substancedoctrine. (This penalty increases to 40% ifthe transaction is not adequately dis-closed.) The filing of an amended return isnot taken into account if it is filed after thetaxpayer has been contacted. IRC section6664 was amended to disallow the reason-able cause exception for transactions disal-lowed under IRC section 7701(o); conse-quently, the penalty is a strict liability, orno-fault, penalty. IRC section 6676 was alsoamended to include a penalty for erro-neous refund claims attributable to a trans-action’s lack of economic substance. BothIRC section 7701(o) and the penaltiesdescribed above apply to transactionsentered into after March 30, 2010.

IRS GuidanceAlthough IRC section 7701(o) is titled

“Clarification of Economic SubstanceDoctrine,” it leaves many questions unan-swered. According to IRC section7701(o)(5)(C), the determination ofwhether the doctrine is relevant to a trans-action should be made in the same man-ner as before the section was enacted.The law is clear, however, about the needto apply the conjunctive test to determinethe economic substance and any onerouspenalty provisions that may be imposed.

Notice 2010-62. The IRS issued Notice2010-62 in September 2010 to provide inter-im guidance on the codification of the eco-nomic substance doctrine and the relatedamendments to the penalties (“InterimGuidance under the Codification of theEconomic Substance Doctrine and RelatedProvisions in the Health Care and EducationReconciliation Act of 2010,” IRB 411,http://www.irs.gov/pub/irs-drop/n-10-

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

doctrine in applying the two-prong con-junctive test. Although it will continue toanalyze when the economic substance doc-

■ 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 arm’s length with unrelated third parties■ Transaction creates a meaningful economic change on a present value basis(pre-tax)■ Taxpayer’s 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 equivalenteconomic loss or expense (including artificial creation or increase in basis of an asset)■ Taxpayer does not hold offsetting positions that largely reduce or eliminate theeconomic risk of the transaction■ Transaction does not involve a tax-indifferent counterparty that recognizes sub-stantial income■ Transaction does not result in the separation of income recognition from arelated deduction either between different taxpayers or between the same taxpayerin 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 taxpayer’s ordinary business operations.

In addition, it is likely not appropriate to raise the economic substance doctrine ifthe transaction being considered is related to the following circumstances.■ The choice between capitalizing a business enterprise with debt or equity ■ A U.S. person’s choice between utilizing a foreign corporation or a domesticcorporation to make a foreign investment ■ The choice to enter into a transaction or series of transactions that constitute acorporate organization or reorganization under subchapter C ■ The choice to utilize a related-party entity in a transaction, provided that thearm's length standard of [Internal Revenue Code] section 482 and other applicableconcepts are satisfied.

Source: “Step 1: Doctrine Likely Not Appropriate,” Guidance for Examiners andManagers on the Codified Economic Substance Doctrine and Related Penalties,LB&I-4-0711-015, July 15, 2011, http://www.irs.gov/Businesses/Guidance-for-Examiners-and-Managers-on-the-Codified-Economic-Substance-Doctrine-and-Related-Penalties

EXHIBIT 1When the Economic Substance Doctrine Is Likely Not Appropriate


trine is relevant in the same manner asbefore the enactment of IRC section7701(o), the IRS expects that the case lawregarding the circumstances in which thedoctrine is relevant will continue to evolve.The Treasury Department and the IRS donot intend to issue general administrativeguidance on the types of transactions thatwill be subject to the application of the eco-nomic substance doctrine.

Furthermore, the IRS will not issue pri-vate letter rulings or determination letterson whether the economic substance doctrineapplies or whether a transaction complieswith the requirements of IRC section7701(o). Notice 2010-62 provides some clar-ification on the disclosure requirements,which will be satisfied by transactions that

are not reportable transactions if the disclo-sure is adequate under IRC section6662(d)(2)(B), regarding substantial author-ity and reasonable basis, and is filed on Form8275, Form 8275-R, or as otherwise pre-scribed. For reportable transactions, disclo-sure is adequate if it meets the above require-ments, as well as those of IRC section 6011.Notice 2010-62 also indicates that therewill not be safe harbors.

The first directive. Also in September2010, the commissioner of the IRS’s Largeand Mid-Size Business Division—now theLarge Business and International Division(LB&I)—issued a directive to ensureconsistent administration of the penaltiesrelated to application of the economic sub-stance doctrine (“Codification of the

Economic Substance Doctrine and RelatedPenalties,” LMSB-20-0910-024, http://www.irs.gov/Businesses/Codification-of-Economic-Substance-Doctrine-and-Related-Penalties). The primary purpose ofthe directive was to notify examiners thatany proposal to impose a penalty under thenew law required prior approval by theappropriate director of field operations(DFO)—that is, an LB&I executive whosupervises territory managers within acertain area of responsibility (Exhibit4.46.1-1, “Glossary of LB&I Terms,”Internal Revenue Manual, http://www.irs.gov/irm/part4/irm_04-046-001.html#d0e127). DFOs report directly tothe deputy commissioner of operations andhold high positions of responsibility with-in the IRS (http://www.irs.gov/pub/irs-utl/lbiorgchart.pdf).

The second directive. The second direc-tive, “Guidance for Examiners andManagers on the Codified EconomicSubstance Doctrine and Related Penalties,”

was issued on July 15, 2011 (LB&I-4-0711-015). It aimed to instruct examinersand their managers on how to determinewhen it is appropriate to seek the approvalof the DFO in order to raise the econom-ic substance doctrine. This directive wasintended to ensure consistency in applica-tion of the doctrine and to prevent its asser-

■ Transaction is promoted/developed/administered by tax department or outsideadvisors■ Transaction is highly structured■ Transaction includes unnecessary steps■ Transaction is not at arm’s length with unrelated third parties■ Transaction creates no meaningful economic change on a present value basis(pre-tax)■ Taxpayer’s 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 economicloss or expense (including artificial creation or increase in basis of an asset)■ Taxpayer holds offsetting positions that largely reduce or eliminate the economicrisk of the transaction■ Transaction involves a tax-indifferent counterparty that recognizes substantialincome■ Transaction results in separation of income recognition from a related deduc-tion either between different taxpayers or between the same taxpayer in differenttax 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 taxpayer’s ordinary business operations.

Source: “Step 2: Doctrine May Be Appropriate,” Guidance for Examiners andManagers on the Codified Economic Substance Doctrine and Related Penalties,LB&I-4-0711-015, July 15, 2011, http://www.irs.gov/Businesses/Guidance-for-Examiners-and-Managers-on-the-Codified-Economic-Substance-Doctrine-and-Related-Penalties

EXHIBIT 2When the Economic Substance Doctrine Might Be Appropriate

The IRS will not issue private letter

rulings or determination letters

on whether the economic

substance doctrine applies.


tion in inappropriate situations. It containsa series of questions for an examiner todevelop and analyze after an initial deter-mination that the doctrine should be raised.In addition, the directive requires that thepenalties under IRC sections 6662(b)(6)and (i) and IRC section 6676 may beimposed only upon the application of theeconomic substance doctrine. These penal-ties cannot be imposed based upon theapplication of another “similar rule of law”or judicial doctrine until further guidanceis issued. This precludes penalties for issuesinvolving the step transaction doctrine, sub-stance over form, or a sham transaction,according to the directive.

Furthermore, this second directiveincludes a four-step process for determin-ing whether the economic substance doc-trine should be applied. Before beginningthe analysis described below, the examin-er should notify the taxpayer that the appli-cation of the economic substance doctrineto a specific transaction is under consider-ation. The four steps are as follows:■ Step 1. The examiner should evaluatewhether the circumstances in the case arethose where application of the economicsubstance doctrine to the transaction is like-ly not appropriate (Exhibit 1). If some ofthese factors cause the examiner to believethat the doctrine should be applied, theexaminer should continue to analyze thesituation using Steps 2–4. At this point,taxpayers should try to show that theeconomic substance doctrine is not appli-cable; if a taxpayer can demonstrate thatnone of the factors in this step are satisfied,the examiner cannot consider the economicsubstance doctrine, and the remaining stepscannot be completed.■ Step 2. An examiner should evaluatewhether the circumstances in the case arethose where application of the economicsubstance doctrine to the transaction maybe appropriate (Exhibit 2). ■ Step 3. If an examiner determines thatthe application of the doctrine is appropri-ate, the guidance provides a series ofinquiries that the examiner must makebefore seeking approval to apply the doc-trine (Exhibit 3).■ Step 4. If an examiner, along with amanager and territory manager, determinesthat application of the economic sub-stance is merited, the directive providesguidance on how to request approval

from the DFO. An examiner, in consulta-tion with a manager or territory manager,must describe in writing the process com-pleted in order to determine that the doc-trine should be applied. The DFO shouldreview the material and consult with legalcounsel before making a decision. If theDFO believes that the issue should be pur-sued, the taxpayer should be given theopportunity to explain his position, either

in writing or in person. The DFO’s finaldecision must be communicated to theexaminer in writing.

Coordination with Other Judicial Doctrines

The interaction between the applicationof the economic substance doctrine (andrelated penalties) and the application ofother judicial doctrines, such as substance


over form or step transaction, should beconsidered before seeking a DFO’sapproval. An examiner should use thestrongest argument available to challengethe transaction. Generally, the provisionsof the economic substance doctrine will notbe applied when another judicial doctrineis more appropriate. The most important

direction contained in the guidance is thatthe penalties discussed above only applyto underpayments or refund claims whenthe economic substance doctrine is raised.The 20% and 40% penalties discussedabove will not apply if the deficienciesare the result of another judicial doctrineor similar rule of law.

Chief Counsel NoticeIn April 2012, the IRS Office of Chief

Counsel (OCC) issued Notice 2012-008,providing coordination procedures toensure that the economic substance doc-trine and related penalties are only raisedin appropriate cases (“CoordinationProcedures for the Economic SubstanceDoctrine and Related Penalties,” CC-2012-008, April 3, 2012, http://www.irs.gov/pub/irs-ccdm/cc-2012-008.pdf). The noticeincorporates the two previously issued IRSdirectives on this matter and details the pro-cedures as follows:

Examination. The OCC should providetimely assistance regarding common lawor the codified economic substance doc-

trine and related penalties, as requested dur-ing an examination. It should consider thefactors outlined in previous directives aswell as relevant case law. If a taxpayer haspreviously received a favorable private let-ter ruling or determination letter withrespect to the transaction, the OCCshould request the Associate Chief Counselto review—and, if appropriate, revoke—theruling or letter. This procedure is requiredeven if the ruling or letter did not addressthe economic substance doctrine. Thisrevocation must occur before the IRSproposes an adjustment asserting the eco-nomic substance doctrine.

Statutory notices of deficiency andnotices of final partnership administrativeadjustment. If a proposed statutory noticeor notice of final partnership administra-tive adjustment concludes that a transac-tion lacks economic substance, the OCCwill coordinate with Division Counselheadquarters and the Office of theAssociate Chief Counsel (Procedure andAdministration), which will then coordi-

■ Is the transaction a statutory or regulatory election? If so, then the applicationof the doctrine should not be pursued without specific approval of the examiner’smanager 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 doc-trine should not be pursued without specific approval of the examiner’s managerin consultation with local counsel. ■ Does precedent exist (judicial or administrative) that either rejects the applica-tion of the economic substance doctrine to the type of transaction or a substan-tially similar transaction or upholds the transaction and makes no reference to thedoctrine when considering the transaction? If so, then the application of the doc-trine should not be pursued without specific approval of the examiner’s managerin consultation with local counsel. ■ Does the transaction involve tax credits (e.g., low income housing credit, alter-native energy credits) that are designed by Congress to encourage certain trans-actions that would not be undertaken but for the credits? If so, then the applica-tion of the doctrine should not be pursued without specific approval of the exam-iner’s 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. Todetermine whether another judicial doctrine is more appropriate to challenge atransaction, an examiner should seek the advice of the examiner’s manager inconsultation with local counsel. ■ Does recharacterizing a transaction (e.g., recharacterizing debt as equity,recharacterizing someone as an agent of another, recharacterizing a partnershipinterest as another kind of interest, or recharacterizing a collection of financialproducts as another kind of interest) more appropriately address the noncompli-ance that is being examined? If so, recharacterization should be applied and notthe economic substance doctrine. To determine whether recharacterization ismore appropriate to challenge a transaction, an examiner should seek the adviceof the examiner’s manager in consultation with local counsel. ■ In considering all the arguments available to challenge a claimed tax result, isthe application of the doctrine among the strongest arguments available? If not,then the application of the doctrine should not be pursued without specificapproval of the examiner’s manager in consultation with local counsel.

Source: “Step 3: Development of Case for Approval,” Guidance for Examiners andManagers on the Codified Economic Substance Doctrine and Related Penalties,LB&I-4-0711-015, July 15, 2011, http://www.irs.gov/Businesses/Guidance-for-Examiners-and-Managers-on-the-Codified-Economic-Substance-Doctrine-and-Related-Penalties

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

It appears that the IRS intends to

proceed carefully and ensure that a

determination of lack of economic

substance will hold up in court.


nate the National Office review with allof the Associate Chief Counsel offices thathave jurisdiction over the relevant issues.

Litigation. Before raising the economicsubstance doctrine as a new issue in aTax Court case or in a defense or suit let-ter to the Department of Justice, the OCCwill coordinate with Division Counselheadquarters and the Office of theAssociate Chief Counsel (Procedure andAdministration), which will then coordi-nate the National Office review with allAssociate Chief Counsel offices that havejurisdiction over the relevant issues. Thesame procedures as those required in theexamination stage regarding revocation offavorable rulings or letters also apply.

Administrative pronouncements. Anydivision or associate offices that have juris-diction over administrative pronouncementswill, in coordination with the AssociateChief Counsel (Administration andProcedure), make sure that any discussionof economic substance in these pro-

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

Implications Chief Counsel Notice 2012-008 adds

new layers to the process of asserting theeconomic substance doctrine. In addition,it strengthens the importance of the guid-ance provided in the directives. The sec-ond directive provides very specific guid-ance for examiners to follow before theymay assert the economic substance doc-trine. It appears that the IRS intends to pro-ceed carefully and ensure that a determi-nation of lack of economic substance—andthe associated penalties—will hold up incourt. Although the IRS has clearly statedthat these directives are not official pro-nouncements of law and cannot be used,cited, or relied upon as such, they do seemto clarify the IRS’s approach and mightlimit the application of the doctrine. Theadded transparency of the IRS process pro-

vided by the second directive should helpinform taxpayers and their advisors.

The discussion of the revocation of favor-able rulings or letters in Notice 2012-008suggests new opportunities for asserting theeconomic substance doctrine. It might besome time before the ultimate effects of thecodified economic substance doctrine arethoroughly fleshed out. For now, taxpayersand their advisors should consider the guid-ance and include protective disclosures intax returns in order to preempt the oner-ous penalty provisions. ❑

Karyn Bybee Friske, PhD, CPA, is theSchaeffer Professor of Business Ethics anda professor of accounting; Karen M. Cooley,CPA, is an instructor of accounting; andDarlene Pulliam, PhD, CPA, is a RegentsProfessor and the McCray Professor ofBusiness, all in the department of account-ing, economics, and finance at West TexasA&M University, Canyon, Tex.


By David Spaulding and Jay Freeberg

The New York State MarriageEquality Act (MEA) of 2011 haslittle more than the word “mar-

riage” in common with the Defense ofMarriage Act (DOMA) of 1996. And eventhis term takes on two different meaningsin each act: New York’s law was specifi-cally written in gender-neutral language,whereas the federal statute defines marriageas 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 politicalsubdivision is required to recognize a same-sex marriage treated as a marriage in anoth-er state. Advisors of same-sex couplesshould become familiar with the tax, gift,and estate planning issues raised by theenactment of MEA, key equality issues inother states, and the differences that existbetween various local statutes and DOMA.The discussion below will address thesetopics, as well as two serious court chal-lenges to the constitutionality of DOMA.

A Survey of the StatesSeveral currents drive the legal differences

that exist from state to state. A total of 37states ban same-sex marriage or refuse torecognize it, either by constitution or statute.(While there are currently six states thatallow same-sex marriage, two other states—Maryland and Washington—have approvedlegislation allowing it. Those laws are notyet in effect, however, and might be sub-ject to voter referendum.) In the six states(and the District of Columbia) that present-ly issue and recognize same-sex marriages,some clergy do not feel bound to sanctify orrecognize it. These jurisdictional differ-ences make it more difficult to advise domes-tic partners on legal, tax, and legacy issuesthan traditionally married couples. (See thesidebar, Legal Definitions of Same-SexRelationships, for distinctions between same-

sex marriages, civil unions, and domesticpartnerships.)

To highlight some of the hazards, oneshould examine the Northeast Corridor (i.e.,the stretch of the East Coast fromWashington D.C. to Maine). It begins on anisland of marriage equality in the nation’scapital, the only jurisdiction below theMason-Dixon Line that allows same-sexcouples to marry. It is surrounded by alter-native positions. Virginia has an opposing

definition of marriage in its constitution,while Maryland only recognizes same-sexmarriages from other states. In Delaware,civil unions are the law. (Farther south,North Carolina joined the ranks of stateswith a constitutional ban on same-sex mar-riage in May 2012.)

Each of these states provides differingspousal rights to unmarried couples ordomestic partners. Furthermore, these rightsare less than the fully equal rights grantedby either Washington D.C.’s marriage anddomestic partnership laws or New York’sMEA. The General Accounting Office(GAO) has determined that there are morethan 1,100 rights and protections conferred

on U.S. citizens upon marriage, encom-passing health insurance, veterans’ andSocial Security benefits, estate taxes,retirement savings, and immigration.

Continuing up the coast, Pennsylvania’sstatutes define marriage as a union betweenone man and one woman. New Jerseygrants most, but not fully equal, rights underits Civil Union Act of 2006. New York doesnot recognize civil unions under MEA, butit will recognize same-sex marriages fromneighboring Connecticut, Massachusetts, NewHampshire, and Vermont. Rhode Islandrecently added a civil union statute to itsbooks. Finally, Maine serves as a reminderthat state law prevails; it has a statute thatdefines marriage in a similar fashion asPennsylvania, while granting some state-levelspousal rights to domestic partners.

Of the 13 jurisdictions along a nearly12-hour train trip through the NortheastCorridor, one passes through six jurisdic-tions that allow gender-neutral marriage(with varying rights), three states that rec-ognize civil unions, and four others thatwon’t recognize any rights beyond thosedefined in DOMA.

Looking west, Iowa is the only state tooffer and recognize same-sex marriage. In2008, a majority of California votersapproved Proposition 8, which repealedthat right and adopted language fromDOMA into the state constitution. Theremaining West Coast states—Washington,Oregon, and Nevada—offer domestic part-nerships that grant nearly all state-levelspousal rights. Hawaii similarly grantssome (though reduced) state-level spousalrights under its domestic partnership law.

Parsing the DifferencesWhat do all of these different laws and

rights mean? Tax professionals advisingunmarried life-partners or united couplesliving under a domestic partnership, civilunion, or gender-neutral marriage have a

Marriage Equality in New York and Beyond

T A X A T I O N

s t a t e & l o c a l t a x a t i o n

To Love, Cherish, and Tax

Advisors of same-sex couplesshould become familiar with the

tax, gift, and estate planning issuesraised by the enactment of MEA,

key equality issues in other states, and the differences that exist between various local statutes and DOMA.

tremendous responsibility to keep up withthese laws and the spousal rights grantedunder each, as well as to understand therelated tax codes. An advisor’s knowl-edge of these jurisdictional issues must thenbe reconciled with DOMA, at the nation-al level, for each couple because there isultimately no recognition of any rights orsubstantial benefits to these unions by thefederal government. (Portions of DOMAhave been deemed unconstitutional by tworecent federal district court decisions thatwill be discussed later.)

Some relevant issues for tax profes-sionals to follow include income taxes, giftand estate taxes, dependent relations, com-munity property, immigration, healthcarebenefits, the Employee Retirement IncomeSecurity Act (ERISA) of 1974 and pensionbenefits, Social Security benefits, adoptioncredits, and domicile and residency ques-tions. Legal, financial, and risk mitigationissues that require the services of other pro-fessional counsel, such as attorneys,financial advisors, or insurance special-ists, are beyond the scope of this article.Tax counsel must take a multidisciplinaryapproach in order to suitably carry out theirprofessional responsibility.

Case StudySpecific issues can be demonstrated

through a case study concerning a hypo-thetical couple. Mike and Adam are bothin their mid-forties and tied the knot inCentral Park last September. They reside

in New York, where they jointly own acondominium. They have a school-agechild, Sophia; Mike is her biological par-ent. Because both are executives in thefinancial sector, they have substantialincome and a combined net worth inexcess of $6 million. Adam owns a beachhouse in Asbury Park, New Jersey, and,via family bequest, Mike owns a beachhouse in North Carolina’s Outer Banks.

Their advisor should examine the fol-lowing key tax issues in order to provideguidance for the family and its individualmembers:■ The advisor needs to confirm thatthey are, in fact, domiciled in New Yorkin order to know which state law and taxcode to follow for income tax reporting.■ The advisor needs to determinewhether Sophia was adopted by Adam,which is both a legal concern and a taxquestion because it can impact how one ofthe partners reports the dependent on thefederal Form 1040. (The advisor might alsowant to ask how much time the couplespends in each of the other states wherethey hold property, in order to explore theirpotential exposure with respect toparental healthcare issues in case some-thing should happen to the child while out-side New York State.) ■ For federal purposes, it might be advan-tageous to have Sophia listed as a depen-dent on one or the other’s parental Form1040, depending upon the effective house-hold benefit.

■ The legal recommendation might be tohave Adam (the nonbiological parent)adopt Sophia in order to secure parentalrights in both New Jersey and NorthCarolina (as well as other states) becausesuch rights cannot be assumed in otherjurisdictions.■ Under MEA, this couple must file aNew York tax return as either married fil-ing joint (MFJ) or married filing separate-ly (MFS).■ The resulting New York returns mustbe prepared as if the same status wereapplied at the federal level—in spite ofDOMA—but separate individual federaltax returns must be filed for each partnereither as single or head of household,depending upon dependency.

Tax planning for New York couples likeMike and Adam requires professionals toprepare multiple versions of a return inorder to get to the required filings foreach federal and state jurisdiction.

Work travel. If Adam has to travel toHoboken, New Jersey, on a regular basisin order to work in his employer’s backoffice, he might have to file an additionalstate tax return in New Jersey, whichwould likely match the status filed inNew York because New Jersey’s civilunion law recognizes the New York mar-riage for tax-filing purposes. This mightrequire Adam to report Mike’s nonresidentincome on the New Jersey return.

Homeowner expenses. For a joint tax return, homeowner expenses are ordi-


narily itemized deductions on the federalSchedule A; however, for domestic partners,tax advisors must look more closely at howto allocate those deductions on both the jointstate and separate federal returns in order toensure the maximum family tax benefit.

Healthcare. Healthcare expenses anddomestic partner health insurance cover-age are additional areas that tax profes-sionals must examine. In this case study,Adam’s employer has the better plan andoffers family coverage for domestic part-ners. The additional income that Adamreceives from this benefit is not taxable atthe state level in New York, but it is fullytaxable at the federal level and must beadded to his wages on Form 1040. In addi-tion, Mike’s constructive receipt of thevalue of those benefits could be areportable gift to Mike, thus requiringAdam to file a gift tax return.

In addition to Mike and Adam’s keyincome tax considerations and compli-ance issues, they would also have financialplanning concerns (and opportunities).

Gift tax. Under MEA, Mike and Adamhave unlimited spousal gifting in parity

with traditionally married couples at thestate level; however, there is no suchright at the federal level, where gifts inexcess of $13,000 in any calendar yearmust be reported to the IRS. As onemight imagine, this requires the taxpayersto track two sets of basis for such gifts,with implications later on for each oftheir respective estates.

Estate tax. Under MEA, Mike andAdam have all the same spousal estaterights as traditionally married couples, butthe death of one spouse is treated verydifferently for federal purposes. If Mikepredeceases Adam, Mike’s estate is imme-diately subject to estate tax at the federallevel; conversely, Mike’s New York estatecan flow directly to Adam, and the statewould have to wait until Adam passesaway before any tax is due on the (total)estate.

Other concerns. Additional planningconcerns must take into account whoSophia’s legal parents are. Mike is bio-logically related to Sophia; therefore, heis a legal parent. But if Adam did notcodify his parenthood by legal adoption,

upon Mike’s death Sophia may not be con-sidered his daughter for any purpose. Evenif it is so stated in Mike’s will, Adam mightnot be appointed her guardian by the court.

Advisors who represent couples acrossthe country must consider several other taxand estate issues. The IRS has recentlyissued new guidance for domestic partnersand same-sex spouses in community prop-erty states, such as in California, Nevada,Washington, and Wisconsin (ChiefCounsel Advice 201021050, September 22,2011). For tax years beginning afterDecember 31, 2005, in states that haveextended full community property treat-ment to registered domestic partners (civilunions and marriages assumed), federal taxtreatment of community property shouldapply. This means that domestic partnersliving in these states must recognize theprinciple of community income, salariesand services by either or both spouses,where such income and expense (includ-ing community business property) arereported on their respective federal taxreturns (IRS Revised Publication 555,“Community Property”; Chief CounselAdvice 201021050).

Advisors must also consider the incometax ramifications related to a state’s recog-nition, or nonrecognition, of a gender-neu-tral marriage from another country.Canada and the federal district of MexicoCity both issue gender-neutral marriages.Likewise, several European Union countries,as well as South Africa, Iceland, andArgentina, issue and recognize same-sexmarriage. (Israel does not perform gender-neutral marriage but does recognize suchunions.) Some states will recognize mar-riages performed in these countries, neces-sitating the filing of a joint tax return at thestate level. This could then impact the tax-ability of foreign income at the state level.

Relevant Case LawA May 30, 2012, decision by the U.S.

Court of Appeals for the First Circuit inBoston ruled that DOMA discriminatesagainst gay couples (Commonwealth ofMassachusetts v. U.S. Dep’t of Health andHuman Services [No. 10-2204]). (Theappeals case was, in part, related to a suitbrought by the Boston-based legal groupGay and Lesbian Advocates andDefenders.) Agreeing with the lowercourt judge, the appeals court upheld a


LEGAL DEFINITIONS OF SAME-SEX RELATIONSHIPS

While New York’s Marriage Equality Act (MEA) will recognize andbestow all of the rights of marriage in New York to a same-sex cou-ple that was legally married by any foreign or state governmentwhere such marriages are performed, civil unions and domestic

partnerships are not covered under the law. The following are the legal defini-tions of these relationships:■ Same-sex marriage—A legal marriage between people of the same sex (i.e.female-female, male-male). Most of the jurisdictions that have legalized marriagein this manner use the term same-sex marriage, but New York has removed gen-der from the term entirely.■ Civil union—A specific class of law that was created to extend certain rightsto same-sex couples. These rights are recognized only in the state where thecouple resides and the extent of those rights, though they may closely approxi-mate those bestowed upon legally married couples in that state, differ substan-tially between these states.■ Domestic partnership—A category of law that has been around for the longestamount of time—San Francisco and New York City formally recognized suchrelationships for benefits purposes as far back as 1982 and 1997, respectively.Domestic partnerships can be determined at either the local or state level andcan apply to either same-sex couples or opposite-sex couples that choose not toget married. This category of law is the most varied in the benefits extended tosuch couples ranging from access to healthcare coverage by a partner’s employ-er to nearly full marital rights and responsibilities under California’s DomesticPartnership Rights and Responsibilities Act of 2005.

2010 ruling claiming that DOMA interfereswith the right of a state to define marriage;it denies married gay couples federal ben-efits given to traditionally married couples,including the ability to file joint tax returns.The First Circuit followed closely on theheels of four other federal courts that hadsimilarly stated that DOMA was indefen-sible; however, the court went on to saythat its ruling would not be enforced untilthe U.S. Supreme Court decides the case.

More importantly, the June 6, 2012,the U.S. Court of Appeals for the SecondCircuit—in Windsor v. United States (833F. Supp. 2d 394), which followed similararguments on Fifth Amendment andFourteenth Amendment (equal protection)grounds as Pedersen v. Office of PersonnelManagement (10 CV 1750, July 31,2012)—ruled that section 3 of DOMA isunconstitutional because it disallows thesurviving same-sex spouse a marital deduc-tion that would be allowable if the unionwas a heterosexual marriage.

As a direct result of these recent rulings,advisors in the field are now recommendingthat, in addition to filing the required feder-al income or estate tax returns under currentlaw, adversely affected same-sex couples orsurviving spouses should file protectiverefund claims with the IRS. The IRS willhold the protective claims in abeyance untilthe Supreme Court makes a final decision onthe matter. (In amending any tax return, thestatute of limitations to make a claim forrefund is generally three years from the duedate of the original return.)

An Evolving LandscapeTax professionals who counsel in this area

have an enormous responsibility to knowthe myriad and conflicting tax codes, as wellas their consequences on domestic partners.This advisory role is further complicated bythe dynamic political, religious, and socialpressure on lawmakers as the movement forsame-sex marriage continues to evolve fromstate to state. Nothing illustrates the shifting

sands more than California voters’ contro-versial adoption of DOMA’s core lan-guage into their constitution, overturning thestate’s short-lived marriage equality law.In New York, an organization called NewYorkers for Constitutional Freedoms is sim-ilarly pursuing a lawsuit to overturn NewYork’s MEA.

The key to planning for domestic partnersis to ensure a current and complete under-standing of each state jurisdiction that thecouple 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 princi-pal and Jay Freeberg, CPA, CFP, is apartner at Janover LLC, New York, N.Y.They are both members of the DomesticPartners Network, a multidisciplinarynetwork of professionals founded by DavidSpaulding in 2009.



By Andrew I. Shapiro

Many people believe that life insur-ance proceeds are received by abeneficiary free from income tax

(Internal Revenue Code [IRC] section101[a][1]), regardless of whether the under-lying policy is an individual policy, a grouppolicy, a cash value policy, or a term poli-cy. Although individuals rarely look to seeif there are exceptions to this rule, they dooccur—most frequently through violationsof the transfer-for-value rule. Recently, thisauthor has seen an increase in inquires con-cerning the transfer of ownership of a lifeinsurance policy, thereby increasing the pos-sibility of subjecting the death benefit toincome taxation. Some of these inquiriesconcern individuals exploring the option oftransferring ownership of a policy becauseof the impending reduction in the estate taxexemption; some involve transferring poli-cies owned by a business or used to fund abuy-sell agreement; and others are just run-of-the-mill policy transfers that wouldn’t oth-erwise merit a second glance.

Many individuals concerned with thechange in the estate tax exemption are con-sidering a sale of the policy, rather than agift, in order to avoid the three-year rule(IRC section 2035). This rule brings cer-tain gifts—specifically, life insurance onthe life of the party making the transfer—back into the taxable estate for a periodof three years from the date of the trans-fer. Regardless of the reason, violating thistransfer-for-value rule subjects a portion ofthe death proceeds to income taxation,which can easily result in individuals fail-ing to achieve their financial objectives andcan possibly subject both insurance and taxprofessionals to litigation.

The Transfer-for-Value RuleTransfer for valuable consideration—

often referred to as the transfer-for-value

rule—states that if the policy, or any inter-est in the policy, is transferred for valu-able consideration, then the proceedsreceived by the beneficiary shall only beexempt from income tax to the extent ofthe beneficiary’s cost basis (IRC section101[a][2]). But this rule can potentiallycome back to haunt an individual any timethe owner transfers ownership of a lifeinsurance policy, or designates or changesa beneficiary, in exchange for anythingthat has value. While a sale for cash isan obvious example, there are many oth-ers, discussed below. This issue is evenmore complicated because IRC sections101(a)(2)(A) and (B) provide exceptionsto the transfer-for-value rule itself, suchas—■ transfer to the insured;■ transfer to a partner of the insured (i.e., alegal business partner, not personal partner);■ transfer to a partnership in which theinsured is a partner;

■ transfer to a corporation in which theinsured is a shareholder or officer; and■ perhaps the most confusing, a transferwhere the basis of the policy in the hands ofthe transferee (the party receiving the bene-fit) is determined in whole or in part by ref-erence to its basis in the hands of the trans-feror (the party releasing the benefit).

The sidebar, Scenarios Where Transfer forValue Could Apply, provides examples of sit-uations that might be subject to the transfer-for-value rule.

Transfers of Personally Owned PoliciesThe situation seen most often with

respect to transfers of personally ownedpolicies is a transfer between spouses. Ifthe transfer is an outright gift or is madefor valuable consideration, it does notviolate the transfer-for-value rule. In sucha situation, the basis carryover exceptionapplies. There is no gain or loss recognizedon transfers between spouses, and the basis

Transfers for Valuable Consideration

F I N A N C E

p e r s o n a l f i n a n c i a l p l a n n i n g

Tax Issues when Transferring a Life Insurance Policy

of the transferee remains that of the trans-feror (IRC section 1041[a] and [b]). Thisexception will not apply if the transfereeis a nonresident alien (IRC section1041[d]). Currently, transfers for valuableconsideration between same-sex marriedpartners are not treated as transfers betweenspouses for federal tax purposes and aresubject to the rules for transfers betweennonspouses, according to the 1996 Defenseof Marriage Act.

Another question arises, however: whatif the transfer is the result of a divorceand the individuals are no longer marriedon the date of transfer? If the transfer isincident to a legally recognized separationagreement or divorce decree, then there isno transfer-for-value violation and there isa carryover basis (IRC section 1041). Evenif the transfer is not directed by a court, thetransfer will be treated as “incident to thedivorce” and not subject to transfer forvalue, as long as it takes place within oneyear of the termination of the marriage

(Treasury Regulations section 1.1041-1T,A-1, A-6).

Transfers to other family members typ-ically occur when the original owner of alife insurance policy gifts or sells it in orderto remove it from the taxable estate.Other than spouses, family members haveno exempt status under the transfer-for-value exceptions, and thus such transac-tions are fraught with possibilities to trig-ger taxation. If the transaction qualifies asan outright gift, the transferor needs to beconcerned about the three-year rule underIRC section 2035. If the transfer does notqualify as a gift and is, in fact, a “bona fidesale for an adequate and full considera-tion in money or money’s worth” (IRCsection 2035[d]), then it will be subject tothe transfer-for-value rule (IRC section101[a][2]). But what if it is a part-gift, part-sale transaction? Related parties transfer-ring an asset for something less than fullconsideration will find themselves havingmade a gift, possibly subjecting the trans-

action to gift tax and the three-year rule,and having made a sale. Because the costbasis of this transaction is partially deter-mined by the transferor’s basis, however,the transaction is not subject to the trans-fer-for-value tax (IRC section 2512[b]).

Transfers of Business-Owned PoliciesOne common transaction is the distri-

bution of business-owned policies to indi-vidual owners in order to fund a cross-pur-chase buy-sell agreement. This can arisedue to a switch from an entity purchaseto a cross-purchase, or simply from a deci-sion to repurpose existing business-owned coverage for the cross-purchaseagreement. The proper structuring of across-purchase involves each owner own-ing a policy on each other owner’s life, asshown in Exhibit 1.

This transaction requires the business todistribute a life insurance contract on thelife of Owner A to Owner B, and on thelife of Owner B to Owner A. Each


owner is the beneficiary of the policy heowns on the life of the other owner.Whether the policies are characterized asa distribution or purchased by the ownersof the business does not change the factthat there is a transfer for value. If the pol-icy transfer was through a cash sale, thenthe trigger is the sale and no exceptionapplies. If the transfer was characterizedas a distribution, then the trigger is that thetransfer was done in exchange for reliev-ing the company from the obligation tocontinue the contract and the promise con-tained in the buy-sell agreement to use thedeath benefit to complete the agreement.

These promises constitute valuable con-sideration.

There is one exception: if the owners arepartners, the transaction falls under the“partners’ exception” to the transfer-for-value rule. Identical issues exist if the own-ers attempt to repurpose individuallyowned policies to fund the cross-purchaseby exchanging, purchasing, or otherwisetransferring ownership of the policies toeach other.

Another scenario that occurs whenattempting to avoid a transfer for value ina buy-sell agreement is to have each ownerpurchase a policy on her own life. They

are the owner and the insured, but theyhave named the other business owner asbeneficiary. Typically, this is presented asa way to avoid a policy exchange at a laterdate, when the owner no longer believesshe will need the buy-sell agreement, andwhen each owner would like to startaccessing the cash value in her own poli-cy to supplement retirement income on atax-preferred basis (IRC section 72[e]).At this point in time, they would simplychange the beneficiary designation back totheir family, trust, or other party. The prob-lem here is, once again, an exchange ofvaluable consideration for the naming of


SCENARIOS WHERE TRANSFER FOR VALUE COULD APPLY

Example 1Mother (M) owns a life insurance policy with a current death benefit of $1 million. M sells the policy to her son (S) for its fairmarket 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 ofInternal Revenue Code (IRC) section 101(a)(2)(A) or (B). At M’s 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 costbasis) will be subject to ordinary income tax under the transfer-for-value rule.Example 2This example follows the same fact pattern as Example 1, but with one twist—M and S are partners in a business at the time ofthe transfer. In this case, transfer for value does not apply because the transfer was to a partner of the insured. Example 3M owns a life insurance policy with a current death benefit of $1 million. It has a cost basis of $50,000 and has an outstandingloan 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 S—she was relieved from the loan obligation, which was greater than her cost basis—and 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 uponM’s death (the $1 million death benefit minus the loan amount, assuming it has not been repaid prior to death). S has a totalcost basis of $150,000; $750,000 will be subject to ordinary income tax under the transfer-for-value rule.Example 4This example has the same fact pattern of Example 3, but with one twist—the outstanding loan is $40,000. Transfer for valuedoes not apply in this situation. Because S received the policy with a cost basis greater than the value of the loan, this trans-fer would fall under the basis transfer exception because it would be deemed a part-gift, part-sale transaction. Example 5A 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. Thosepolicies had been viewed as key person policies, but A and B decide to repurpose them for the benefit of the buy-sell agree-ment. Knowing that the proper structure of the cross-purchase buy-sell agreement requires A to own the policy on B and viceversa, they distribute the policies correctly and recognize the proper income taxation on the distribution. The taxable value ofeach 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 aperson other than the insured. Second, the transfer occurred for the purpose of securing the buy-sell agreement, which hasvalue 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.

the owner/insured’s co–business owner asthe beneficiary. And yet again, the part-ners’ exception or the “transfer to theinsured exception” might be available.

What would otherwise appear as a prop-erly designed life insurance fundingarrangement can still go wrong if there arethree or more owners and each owns a pol-icy on the others. Upon the first death,the buy-sell agreement is triggered. Thepolicies owned by the survivors on the lifeof the decedent pay to the survivors. Thedeath benefit is used to purchase thedecedent’s share of ownership.

One problem that might arise concernsthe policies owned by the decedent on thelives of the survivors; for example, A, B,and C each own equal parts of a $3 mil-lion business and have a cross-purchasebuy-sell agreement funded with life insur-ance. Policies owned by A insure B andC for $500,000 each; B owns identicalpolicies insuring A and C, and C ownsidentical policies insuring A and B.

Assuming that A dies first, the policies onA’s life—owned by B and C—pay out,and the proceeds are used to purchaseA’s ownership interest.

What happens to the contracts on the livesof B and C that were owned by A? If thepolicies are transferred to the insured, theyare no longer useful for the buy-sell agree-ment because they will be owned by theinsured. While this is an exception to thetransfer-for-value rule under the transfer tothe insured exception, it renders theremaining portion of the buy-sell agree-ment underfunded. If the policies are trans-ferred in a manner that continues the prop-er funding of the cross-purchase agreement(B obtains ownership of the policy on C; Cobtains ownership of the policy on B), thenthe transfer-for-value rule is once againviolated, because the policies were obtainedfor the purpose of utilizing the death bene-fit to complete the buy-sell agreement.

This situation demonstrates twopotential exceptions to the transfer-for-

value rule: the first would be the previ-ously discussed partners exception, andthe second would be to transfer the poli-cies owned by A on the lives of B and Cto the corporation previously owned byA, B, and C—now owned only by Band C—and create a combination cross-purchase/stock redemption buy–sell agree-ment. B and C would still use the lifeinsurance contracts they own to fund aportion of the buy-sell agreement, and thecorporation would use the policies it ownsto fund the remaining portion of the agree-ment. This structure falls under the “trans-fer to a corporation in which the insuredis a shareholder exception” to transferfor value. Once again, the partners’ excep-tion could apply if—and only if—there isan existing partnership that included A,B, and C at the time of A’s death. It isimportant to remember that the partner-ship does not have to be the business con-cern that is involved in the currentbuy–sell agreement.


Businesses with multiple owners oftenlook to a trusteed cross-purchase buy-sellagreement (sometimes described as an“escrowed” buy-sell agreement). While thereare several advantages to the basic cross-pur-chase structure, ease of administration isnot one of them if there are more than twoowners. The number of policies needed isN(N−1), where N is equal to the number ofowners; for example, a business with fiveowners would require 20 policies to fund theagreement. In an attempt to mitigate theadministrative issues associated with alarge number of policies, businesses have atrustee own one policy on each owner andauthorize the trustee to administer thecross-purchase buy-sell agreement. This sig-nificantly eases administrative issues.

On the other hand, this strategy doesnothing for the transfer-for-value issue thatexists when existing policies are transferredto facilitate a cross-purchase agreement. Inthe previous example—where A, B, and Ceach own an equal interest in a businessworth $3 million—the appointed trusteewould receive the funds from A, B, andC required to purchase one $1 million pol-icy on each owner. Assuming the deathof A, the trustee receives the proceeds ofthe life insurance policy on A and usesthose proceeds to purchase A’s ownershipinterest from A’s estate. The trustee thenevenly distributes the ownership to B andC, thus keeping their ownership interests

equal. From a transfer-for-value perspec-tive, the problem occurs because the ben-eficial interest in the remaining policies isnow modified. B and C each now have agreater interest in each policy for the solepurpose of using the proceeds to com-plete the remaining portion of the buy-sellagreement; again, the one clear exceptionis if there was an existing partnershipamong A, B, and C.

Because the partners’ exception contin-ues to pop up in each example, one mustask: is there a way to integrate a partner-ship into the buy-sell agreement itself? TheIRS has issued private letter rulings(PLR) that have concluded that a partner-ship may be created for the sole purposeof completing the buy-sell agreement (PLR9042023, PLR 9309021). If there is a con-cern that state law might not recognize apartnership designed solely to complete abuy-sell agreement, then another recog-nized business activity could be housed inthe partnership, such as owning or man-aging real estate or leasing office equip-ment to the primary business.

Split-Dollar AgreementsSplit-dollar agreements can be another

source of frustration in the transfer-for-value arena. One component of many split-dollar agreements is either transfer of own-ership or the naming of a beneficiary inexchange for something of value. As dis-

cussed above, such events can have nega-tive results under the transfer-for-value rule.Although a discussion of the tax issues spe-cific to split-dollar plans is beyond thescope of this article, many articles haveappeared in The CPA Journal specificallyaddressing the subject.

The most common structure of split-dol-lar agreements today is the “economic ben-efit endorsement split-dollar agreement.”In this structure, the life insurance policyis owned by the business, and theemployee or owner is given the right todesignate a beneficiary for some or all ofthe death proceeds. The typical agreementgives the company the right to receive anamount of the death proceeds equal to thegreater of premiums paid or cash value;however, other variations exist.

The most common alternative is togive the owner or employee the right toname the beneficiary for the nonbusinessportion of the death proceeds. This wouldnot result in a transfer for value under thetransfer to the insured exception. But some-times the right to name the nonbusinessportion of the death benefit is given to adifferent party. This party could be atrust, drafted with the desire to prevent anincident of ownership in an attempt to keepthe death proceeds out of the individual’staxable estate under IRC section 2035. Butunless that third-party owner is a partnerof the insured or can be treated as theinsured, such as a grantor trust (IRC sec-tions 671–677), the proceeds will be sub-ject to the transfer-for-value tax.

A newer type of split-dollar agreementcreated under the final regulations, knownas a loan regime split-dollar agreement,provides for a policy owned by an employ-ee or owner to have some or all of the pre-mium paid by the company as a loan, withthe policy itself being transferred under acollateral assignment in order to secure theloan (Treasury Regulations sections 1.61-22, 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-for-value tax issue for any death benefitreceived by the company, because a col-lateral assignment is not deemed a trans-fer for value (Treasury Regulations section1.101-1[b][4]). This extends to old grand-fathered economic benefit collateral assign-ment split-dollar plans as well.


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

Business

Owner A Owner B

Cross-Purchase Buy-Sell Agreement

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.


In an attempt to avoid split-dollar issues,the parties will sometimes enter into ashared or split ownership agreement. In thisform, the company’s premium paymentsare secured through an absolute assignmentin the policy. Because this type of assign-ment is not protected under TreasuryRegulations section 1.101-1(b)(4), there isno exemption from transfer for value, andit will exist from the inception of theplan. The only remaining possible excep-tions to the transfer-for-value rule wouldbe if the insured is a shareholder or offi-cer of the company, or—much less like-ly—if the employer is a partner of theinsured. It is important to keep in mind thatthe party being subjected to the transfer-for-value tax here is the employer: it isthe party who is exchanging something ofvalue for the right to receive death bene-fit. This is one of those issues where theresulting tax is usually minimal and, there-fore, acceptable to the parties involved. Thereason for this is that the transfer-for-value

tax is applicable only to the benefitreceived in excess of the party’s cost basis.Because most shared ownership agree-ments stipulate that the employer willreceive the greater of the premium paidor the cash value, there is rarely significanttax exposure.

Other ConsiderationsRegardless of how many transfers a pol-

icy goes through or how many times it isexposed to the transfer-for-value tax, it isthe last transfer before death that ultimatelydetermines whether the proceeds will besubjected to the tax. If a policy is current-ly positioned in such a way that the taxwould be triggered, it should be reviewedin light of the proscribed exceptions tothe rule.

While the focus of this article is trans-fer for value, it is also important to remem-ber that whenever a life insurance policyis being transferred, either through a giftor sale, the proper valuation is the fair mar-

ket value. In conjunction with the transfer-for-value discussion, a common questionis whether the cash value is an appropri-ate value for the policy. The IRS has madeit abundantly clear that it is not (RevenueProcedure 2005-25).

It is also important to remember thatother IRC sections might inadvertently trig-ger taxation of the death benefit, such asIRC section 101(j), which addresses thetreatment of certain employer-owned lifeinsurance contracts. Furthermore, the saleor purchase of life insurance by a grantortrust, from the grantor on the life of thegrantor, will be treated as a sale to thegrantor, thus circumventing both the three-year rule and the transfer-for-value prob-lem (Revenue Ruling 2007-13). ❑

Andrew I. Shapiro, MSM, CLU, ChFC,holds the title of director–advanced con-sulting group, Nationwide Financial,Columbus, Ohio.

For some, the word “outsourcing” conjures thoughts of domes-tic jobs transferred overseas. For others, it calls to mindimages of potential bottom-line improvement. And for atleast one company—Renesas Electronics Corp., which pro-

duces 40% of the microprocessors used by automakers aroundthe world—it is a way to hedge against supply-chain interrup-tions; the company recently reported plans to outsource 25% ofits production by 2013 (up from 8% currently) in response to theearthquake and tsunami that hit Japan in March 2011 (ChesterDawson, “Even Japan Inc. Looks Offshore,” Wall Street

Journal, April 11, 2011). Regardless of one’s personal view onoutsourcing, it is a business practice that is here to stay—and itis likely to increase in the future. Businesses and their advisorsshould keep the following considerations in mind when lookingto outsource operations.

Overview of OutsourcingAlthough outsourcing started in earnest in the late 1970s as a

business strategy that allowed companies to focus on their corecompetencies while moving noncore competencies to providers

A Potential Resurgence of Outsourcing

M A N A G E M E N T

c o r p o r a t e m a n a g e m e n t


By Charles E. Davis and Elizabeth Davis

Essential Questions Answered

with relevant expertise, businesses relied onoutsourcing much earlier than that. ADP,for example, began offering payroll servicesto companies in the 1950s; today, the com-pany is among the world’s largest providersof outsourced business processes.

In its most basic method of implementa-tion, outsourcing is the use of an externalservice provider to perform functions that acompany prefers not to perform internally.For example, a company located in Waco,Texas, might choose to contract with a com-pany in Seattle, Washington, for Internetsales, fulfillment, and shipment services; acall center in Toronto, Canada, for telephonecustomer support; and a computer servicescompany in Bangalore, India, for applicationdevelopment and programming services. Asshown in Exhibit 1, each of these threearrangements illustrates a different, specificcategory of outsourcing, based on the geo-graphical distance between the service buyerand the service provider.

In an onshoring arrangement, a companyoutsources work to a service provider in itshome country, as illustrated by the Wacocompany’s use of a service provider inSeattle. Offshoring, on the other hand, isthe general term used for outsourcing acrossnational borders. These types of arrange-ments are often referred to differently,depending upon the distance between thedomestic service buyer and the internation-al service provider. For example, if the inter-national service provider is geographically

close to the service provider, the arrange-ment is referred to as “nearshoring”; whenthe international service provider is geo-graphically distant from the service buyer,the arrangement is referred to as “farshoring.”

There is no single outsourcing solutionthat is ideal for all companies; rather,each company must consider which com-bination of onshoring, nearshoring, and

farshoring will allow it to best accomplishthe strategic and operational goals set bymanagement—a practice that is sometimescalled “rightshoring.” This article, howev-er, will use the generic term—outsourc-ing—rather than distinguish between thevarious specific methods.

While not technically outsourcingarrangements, shared service centers and


EXHIBIT 1Three Categories of Outsourcing Arrangements

WACO TO SEATTLE:ONSHORING

Using a service providerin one’s home country

WACO TO TORONTO:NEARSHORING

Using a service provider inan adjacent or relatively

close foreign country

WACO TO BANGALORE:FARSHORING

Using a service provider ina distant foreign country

EXHIBIT 2Areas of Information Technology (IT) Outsourcing

Website/e-commerce systems

Network operations

Help desk

Desktop support

Data center operations

Application development

0% 10% 20% 30% 40% 50% 60% 70%

43%58%

28%24%

21%31%

22%21%

28%38%

51%

Percentage of surveyed organizations outsourcing IT functions

OFFSHORING

Software as a service

IT security

Disaster recovery services

Database administration

Application maintenance

Source: Computer Economics, IT Outsourcing Statistics, 2010/2011

Toronto

Bangalore

Seattle

Waco


captive centers represent alternatives thatcompanies might consider. A shared ser-vice center is an internal business unitthat provides services across a company,such as information technology (IT) sup-port or procurement services; this allowsthe company to reduce redundancies byconsolidating functions into a single loca-tion. Bain & Company’s “ManagementTools & Trends” 2011 survey found that

the use of shared service centers is declin-ing, and some early adopters of this busi-ness model have turned to outsourcing. Acaptive center is basically a shared servicecenter that is located in a foreign country,often one with lower wages, in order torealize cost savings without having todeal with a middleman outsourcingprovider. First seen in the 1980s, the useof captive centers has grown more than

300% since 2003 (Jan Erik Aase, “FourNew Offshore Captive Center Models,”July 27, 2011, http://www.cio.com/article/686791/4_New_Offshore_Captive_Center_Models). But some companies have begunto sell off these centers to reduce fixedcosts and free up invested capital, asCitibank did when it sold captive centersto Tata Consultancy Services and Wiproin 2008 and 2009, respectively.

Who Is Outsourcing?There are two sides to an outsourcing

partnership—the service buyer and the ser-vice provider. A company of any size canact as an outsourced service buyer, andcompanies in any industry can outsourcetheir operations. As an example of the vari-ety of industries that participate in out-sourcing arrangements, Verizon, Procter &Gamble, Catholic Health Partners,Barclays, and Thames Water have allsigned new outsourcing agreements in thepast several months. There are myriad out-source service providers, and theInternational Association of OutsourcingProfessionals (IAOP) compiles an annuallist of the best outsource serviceproviders—The Global Outsourcing 100.The IAOP’s 2012 full list can be foundonline (http://www.iaop.org/content/19/165/3437).

Why Are Companies Outsourcing?The main reason that companies turn to

outsourcing is to reduce operating costs. Ina survey by AMR Research, 78% of mid-dle-market companies and 79% of enter-prise companies stated that this was the pri-mary reason for outsourcing (Josh Hyatt,“The New Calculus of Offshoring,”CFO.com, October 1, 2009). Secondarydrivers for outsourcing differ, however,depending upon the size of a company.Enterprise companies are more likely touse outsourcing in order to make globaloperations more effective and to transformor reengineer existing processes. Middle-market companies, on the other hand, aremore likely to see outsourcing as an oppor-tunity to gain access to new skill sets ortechnology that the company doesn’thave in house.

When it comes to outsourcing financeand accounting operations, cost savingswere the primary driver of future financeand accounting outsourcing deals for 92%

EXHIBIT 3Globally Outsourced Finance and Accounting Functions

85%69% 69%

Procure to Pay Order to Cash Record to Report

100%

80%

60%

40%

20%

0%Perc

enta

ge o

f Org

aniz

atio

ns

Outs

ourc

ing

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

EXHIBIT 4Top 10 Global Outsourcing Locations by Attribute

Financial People Skills Business Rank Attractiveness and Availability Environment

1 Vietnam United States* Singapore

2 Indonesia India Germany*

3 Senegal China Canada

4 Pakistan United Kingdom* Estonia

5 Ghana Germany* United Kingdom*

6 Sri Lanka Canada Australia

7 Philippines France* France*

8 India Brazil Ireland

9 Egypt Spain United Arab Emirates

10 Tunisia Australia Czech Republic

* “Second-tier” locations in the countrySource: A. T. Kearney Global Services Location Index, 2011


of companies that took part in a recent sur-vey, Global Finance and AccountingOutsourcing Service Provider Performanceand Satisfaction Survey 2010, conductedby outsource advisor EquaTerra (whichwas acquired by KPMG in February 2011).The next three most important drivers werequality improvement (49%), financial flex-ibility (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 out-sourcing, as long as the decision to out-source makes strategic and operationalsense. The most commonly outsourcedfunctions are IT, human resources, financeand accounting, procurement, and facilitiesmanagement, according to an EquaTerrareport, 4Q10 Advisor and Service ProviderPulse Survey Results.

One major area that is frequently out-sourced is IT. A company might choose tooutsource all of its IT operations or it mightchoose to outsource one or more discreteareas. These outsourcing arrangements canbe large, as evidenced by the recent five-year,$200 million contract for ACS to providemanaged IT services for MGM Resorts Intl.Exhibit 2 gives a snapshot of the extent andforms of IT outsourcing, as recently report-ed by a Computer Economics survey of210 IT organizations in the United States andCanada. Software as a service (SaaS), a rel-atively recent phenomenon, has beenembraced by 58% of the surveyed organi-zations. As the use of cloud computingincreases, it is likely that even more compa-nies will utilize this type of outsourcing.

The Computer Economics survey alsofound that outsourcing differs betweensmaller and larger organizations. Forinstance, 66% of large companies (as mea-sured by IT budgets) reported outsourcingapplication development functions, com-pared to only 45% of small and mid-sizedfirms. While the survey examined theextent of outsourcing a number of indi-vidual IT functions, the discussion belowfocuses solely on application develop-ment in order to illustrate the extent ofthe differences that exist between compa-nies of various sizes.

Furthermore, the future of outsourcingapplication development functions differs

according to organization size, with 43%of large firms expecting to increase thelevel of outsourcing, compared to only19% of small and mid-sized firms. A smallpercentage of these entities expects out-sourcing of application development todecrease in the future (12% for small tomid-sized firms; 5% for large firms). Thisexpectation for decreased outsourcing like-ly resulted from dissatisfaction with thequality of current outsourcing arrangementsand the realization that, in some cases, out-sourcing functions is more costly than pro-viding the service internally.

Finance and accounting functions areripe for outsourcing. EquaTerra followedthe development of finance and account-ing outsourcing (often referred to asFAO) and examined 110 FAO contracts,with a total value of over $1 billion, in itssurvey, Global Finance & AccountingOutsourcing Service Provider Performanceand Satisfaction (SPPS): 2010. The surveyfound a high degree of consensus on thefinance and accounting functions that orga-nizations are outsourcing. As Exhibit 3shows, the “procure to pay” cycle is themost frequently outsourced finance andaccounting function. Doing so allows orga-nizations to not only reduce their operat-

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

Where Are Companies Outsourcing To?The entire world is available to a business

looking for a location to outsource its oper-ations. Since 2003, A. T. Kearney has con-ducted an annual study of the most attrac-tive outsourcing destinations and has rankedthe top 50 of these using a weighted scorethat includes financial attractiveness (40%),people skills and availability (30%), and busi-ness environment (30%). The top three mostattractive locations for outsourcing—India,China, and Malaysia—have not changedsince 2007. Rounding out the rest of the2011 top ten are Egypt, Indonesia, Mexico,Thailand, Vietnam, the Philippines, and Chile(http://www.atkearney.com/index.php/Publications/offshoring-opportunities-amid-economic-turbulence-the-at-kearney-global-services-location-index-gsli-2011.html).

While there appears to be relative con-sistency in the top 10 locations overall, thisis not the case when examining the threeindividual components of the overall rank-ing. As Exhibit 4 shows, several countries

EXHIBIT 5Top 10 Global Outsourcing Locations by Outsourced Process Type

High industry activity Low industry activity

Business Process Voice ITCountry Outsourcing Operations Outsourcing

India

China

Malaysia

Egypt

Indonesia

Mexico

Thailand

Vietnam

Philippines

Chile

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

that are not in the top 10 overall global out-sourcing locations still fare well whenlooking at individual characteristics. Forexample, Singapore has the best businessenvironment for outsourcing and theUnited States (in “second-tier” mid-sizedcities such as Madison, Wisconsin;Raleigh/Durham, North Carolina; and NewOrleans, Louisiana) has the greatest advan-tage for people skills and availability, butneither country places in the top 10 overallranking. These differences mean that decision makers will likely need to makesome trade-offs when selecting an out-sourcing location.

Not all countries are created equal whenlooking at the type of activity that is best

outsourced there, as shown in Exhibit 5.For example, the 2011 Kearney reportfound that India has a high level of out-sourced activity in business process out-sourcing, voice operations, and IT out-sourcing. China, on the other hand, hasvery low levels of outsourced voice oper-ations. And while Thailand is viewed asthe seventh most attractive location foroutsourcing, it has actually seen little out-sourcing activity to date. When consid-ering FAO, India is a clear choice, fol-lowed by Central and Eastern Europe, asshown in Exhibit 6. These differencesillustrate that outsourcers must considerthe type of processes being outsourced,and the ability of a particular location to

handle those processes at an acceptablelevel of service, when choosing an out-source location.

Just as different industries outsource dif-ferent business processes, they also chooseto outsource those processes to differentlocations. Based on results reported in BDO2011 Technology Outlook: ExecutiveSummary, it appears that this choice oflocation changes over time. Exhibit 7shows the preferred outsourcing locationsfrom 2008 to 2011 for technology com-panies. The percentage of technology com-panies surveyed that outsource operationsin India has steadily declined during thisperiod, while those using Western Europehas increased.

Looking to the FuturePredicting the future is always a tricky

business, and outsourcing is no different.In a 2004 study of offshoring, ForresterResearch predicted that 3.4 million servicejobs in the United States would be off-shored by 2015—up from 315,000 in 2003(John C. McCarthy, Near-Term Growth ofOffshoring Accelerating, May 14, 2004).Other studies have conjectured that asmuch as 25% of jobs in the United Statesare potential candidates for offshoring(Linda Levine, Offshoring (or OffshoreOutsourcing) and Job Loss Among U.S.Workers, Congressional Research Service,January 21, 2011).

But outsourcing advisors and serviceproviders appear to disagree on where out-sourcing is heading, as reported inEquaTerra’s 4Q10 Advisor and ServiceProvider Pulse Survey Results. Exhibit 8shows that providers and advisors differmost on the future of social media andsocial networks used for business purpos-es, as well as on the poor economic con-ditions driving companies to look for addi-tional outsourcing opportunities.

As companies look to establish new out-sourcing contracts or renegotiate existingones, the contract details will likely lookdifferent from those of the past. Companiesare realizing that outsourcing is more thanjust securing initial operating cost sav-ings. The unexpected costs that arise dur-ing a long-term contract can negate thoseinitial cost savings. Unstable political envi-ronments in some countries that are hometo outsourced operations increase the poten-tial for a deal to go bad. New contracts will


EXHIBIT 7Geographical Concentration of Technology Company Outsourcing

70%

60%

50%

40%

30%

20%

10%

0%

Canada China Eastern India Latin Southeast United Western Europe America Asia States Europe

Source: BDO 2011 Technology Outlook: Executive Summary, 2011

2008

2009

2010

2011

EXHIBIT 6Global Financial and Accounting Outsource Locations

78%

8%14%18%19%

43%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

Perc

enta

ge o

f Org

aniz

atio

ns

India Central andEastern Europe

Central America Caribbean Philippines and China

South America

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

be shorter and will include the ability torenegotiate the contract as circumstanceschange during the life of the contract.These contracts will also focus more onpay-for-performance metrics to ensure thatpromised efficiencies and cost savings areactually realized (Josh Hyatt, “The NewCalculus of Offshoring,” CFO.com,October 1, 2009).

If past events are any indication, out-sourcing might be headed for a resurgence.The recessions of both the early 1980s and2001 saw companies turning to outsourcingas a means of reducing operating costs andfocusing on core business competencies. Thelatter recession saw more companies out-sourcing white-collar jobs, as the supply ofhighly educated, low-cost professional work-ers grew in low-wage countries like India.With the recent economic woes around theworld, increased levels of outsourcing maybe on the horizon.

Because unemployment has risen in theUnited States during the recent economiccrisis, some believe that companies are nowbringing previously offshored jobs back

to the domestic front. As second- and third-tier cities in the United States become moreattractive locations for outsourcing, previ-

ously offshored work might return to theUnited States. For example, Starbucksrecently announced plans to move somemanufacturing of coffee mugs fromChina back to a dormant plant in Ohio.

But even though this movement mightbe occurring to some extent for manufac-turing jobs, businesses are still interestedin the use of nearshore and farshore out-sourcing, as well as captive service centers,for business services, such as IT, financeand accounting, and human resources,according to a KPMG report, SourcingAdvisory 4Q11 Global Pulse Survey. Over50% of outsourcing providers and advisorssurveyed believed that there would beeither some or a significant increase inthe demand for nearshore and farshore out-sourcing in the future. While specific pre-dictions about the future of outsourcing areimpossible to make with exact accuracy,one thing seems certain—outsourcing ishere to stay. ❑

Charles E. Davis, PhD, CPA, is the WalterPlumhoff Professor of Accounting in theHankamer School of Business at BaylorUniversity, Waco, Tex. Elizabeth Davis,PhD, CPA, is an executive vice presidentand provost, also at Baylor University.


EXHIBIT 8Future 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

1.0 = Cold (little market impact); 5.0 = Hot (major market impact)

Advisors

Service Providers

Source: EquaTerra, 4Q10 Advisor and Service Provider Pulse Survey Results

With the recent economic woes

around the world, increased levels of

outsourcing may be on the horizon.


By Heather M. Lively and Nicholas J. Mastracchio, Jr.

With the prospect of a com-pletely converged set ofaccounting standards seem-

ingly no longer imminent, public account-ing firms must face complying with dif-ferent standards for different clients.Moreover, financial accounting instruc-tors face the challenge of teaching mul-tiple accounting standards in one courseand fitting this additional subject matterinto their curriculum. The discussionbelow considers the current state of con-vergence, how it affects the teaching ofaccounting standards, and what can bedone to address this issue.

A Single Set of StandardsCurrently, the sets of accounting stan-

dards that might be taught in college cours-es are U.S. GAAP and InternationalFinancial Reporting Standards (IFRS). In2010, the SEC stated that it “has longpromoted the development of a single setof high-quality, globally accepted account-ing standards,” and, in February of thatyear, the SEC directed its staff to developand execute a work plan detailing the incor-poration of IFRS into the U.S. financialreporting system (http://www.sec.gov/spotlight/globalaccountingstandards.shtml).Although the SEC was expected todecide the fate of IFRS in the United Statesin 2011, it postponed the release of the finalstaff report until July 2012 (http://www.sec.gov/spotlight/globalaccountingstandards/ifrs-work-plan-final-report.pdf), and its releasedoes not include a firm recommendation.

The idea that IFRS should become thesingle set of global financial standardshad been promoted for some time beforethe SEC developed its work plan. In May2005, former FASB Chair Robert Herzstated:

The added costs from having to usethis complex hodgepodge (differentcountry reporting standards) of financialinformation can run in the tens of mil-lions of dollars annually. In the interna-tional arena, they can act as a barrier to

forming and allocating capital efficient-ly. Thus, there are growing demands forthe development of a single set of highquality international accounting stan-dards. (“In Search of a New FinancialWorld Order,” May 2005)Diverse institutions supported this sen-

timent. For example, KPMG stated:The current and growing breadth ofIFRS adoption across the world suggeststhat IFRS has become the most practi-cal approach to achieving the objectiveof having a single set of high-quality,globally-accepted standards for financialreporting. Those who share this beliefare influenced by the fact that theIASB’s structure and due-process pro-cedures are open, accessible, responsive,and marked by extensive consultation.

(Defining Issues, no. 7-34, p. 1,November 2007) And a presidential white paper on reg-

ulatory reform stated:Accounting standard-setters (the IASB[International Accounting Standards

Board] and FASB) need to continue tomake substantial progress toward adop-tion of a single set of high quality stan-dards. Improving and eliminating inter-national differences in fair value account-ing are key ingredients of regulatoryreform of financial markets. (“FinancialRegulatory Reform,” White House WhitePaper, June 2009).

Moving Away From ConvergenceRecently, the prospect of a single set of

accounting standards has dimmed. InDecember 2011, former SEC ChiefAccountant James Kroeker commented onthe progress of FASB and the IASB’s con-vergence efforts:

Based on the deliberations and tenta-tive conclusions reached thus far, it is

Multiple Financial Accounting StandardsIntensify the Dilemma of What to Teach

R E S P O N S I B I L I T I E S & L E A D E R S H I P

e d u c a t i o n

Stalled Convergence Presents Challenges for Educators

unclear whether the Boards will beable to reach convergence on key aspectsof all projects. … Further, the Boards’reprioritization of certain Joint Projects… makes it unclear whether these projects would be completed in the fore-seeable future and, if so, whether sub-stantial progress towards convergencewould be made before any Commissionconsideration of whether to incorporateIFRS into the financial reporting systemfor U.S. issuers (A Comparison of U.S.GAAP and IFRS, SEC staff paper,November 16, 2011). Contrary to Herz’s statement in 2005,

the current members of FASB have aban-doned the idea of a single set of stan-dards. In October 2011, FASB Chair LeslieF. Seidman said that convergence was nolonger the board’s goal, but that a con-dorsement approach—that is, a practicalapproach allowing the standards to con-tinue to be labeled as U.S. GAAP—wouldbe more appropriate. This would entailadopting some IFRS standards but notother, while remaining independent andmaintaining U.S. GAAP.

In a December 2011 speech at the AICPANational Conference on Current SEC andPCAOB [Public Company AccountingOversight Board] Developments, Seidmanstated that the original objective was overlyambitious in scope (http://www.fasb.org/cs/ContentServer?site=FASB&c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176159498181). Thehead of the IASB agreed with her conclusion(“FASB, IASB Chiefs Agree NewConvergence Model Is Needed,” Journal ofAccountancy, December 2011). In an inter-view with CPA Journal Editor-in-ChiefMary-Jo Kranacher, Seidman was askedwhether she agreed with the statement thatpermitting different U.S. standards on someissues (i.e., carve-outs) doesn’t really providea truly global set of standards. She respond-ed that she was not sure that carve-outswere necessarily bad. This answer furtherdemonstrates the board’s reluctance toembrace one single set of standards.

In a September 2011 survey, the AICPAfound that approximately 54% of respon-dents approved of optional adoption ofIFRS. But without a clear regulatorytimetable, there will continue to be a delayin preparing for global standards. OnFebruary 9, 2012, the AICPA reported that

the monitoring board and the trustees ofthe IFRS Foundation—the parent of theIASB—issued recommendations forimproving the governance of the founda-tion and setting its strategy (“OversightGroups Report on Steps to EnhanceIASB Governance, Financing,” by KenTysiac). The AICPA stated that this effortputs additional pressure on the UnitedStates to incorporate IFRS, used by pub-lic companies in more than 100 nations.With the SEC and FASB emphasizingthe concept of condorsement, however, itseems likely that both IFRS and U.S.GAAP are here to stay.

Based upon its survey with practicingCPAs, the AICPA has decided that entry-level CPAs should be familiar with IFRS;thus, questions relating to IFRS havebeen incorporated into the CPA exam. InApril 2011, the New York State Board ofAccountancy voted 12–3 that the inclusionof IFRS on the CPA exam was prema-ture. The Colorado State Board hasexpressed a similar opinion. But despitesome objections, the CPA exam now fea-tures questions addressing IFRS.

Private Company StandardsIn addition to the continued presence of

U.S. GAAP and IFRS, it appears that, insome cases, separate rules will exist for largeand small companies. A Blue RibbonPanel on Private Company FinancialReporting was formed in 2009 by theAICPA, the Financial AccountingFoundation (FAF), and the NationalAssociation of State Boards of Accountancy(NASBA). The members of the panel rep-resented a cross-section of financial report-ing constituencies, including lenders,investors, and owners, as well as preparers,auditors, and regulators. In January 2011, thepanel recommended that a separate board beestablished under the FAF, which also over-sees FASB.

International standards already have pro-visions for small companies. In 2009, theIASB developed and published separateguidance intended to apply to the general-purpose financial statements of small andmedium-sized entities—IFRS for SMEs.IFRS for SMEs is organized by topic, witheach topic presented in a separate num-bered section. Although the blue ribbonpanel considered IFRS for SMEs, it reject-ed this model because “U.S. private com-

panies should not be leading the charge, enmasse, to an IFRS-based set of standardsbefore the SEC makes a decision on U.S.public companies” (“Report to the Boardof Trustees of the Financial AccountingFoundation,” January 2011).

The FAF formed a trustee workinggroup to address the blue ribbon panel’sreport and, in October 2011, it proposedinstead to create a Private CompanyStandards Improvement Council (PCSIC)that ultimately would be subject to FASBratification over the standards-setting pro-cess. Immediately following the announce-

ment of the FAF’s proposal to create thePCSIC, AICPA President and CEO BarryMelancon and AICPA Chair Paul Stahlinshowed their disappointment with theFAF’s proposal through their press release,“Addressing FAF’s Failure to Create anIndependent Standard Setting Board forPrivate Company Financial Reporting.”NASBA, however, endorsed this approach.

The PCSIC would have replaced thecurrent Private Company FinancialReporting Committee (PCFRC), whichwas created in 2006 to advise FASB onaccounting standards for private compa-nies; however, it has been criticized fornot being independent and for having itsproposals rejected by FASB. Even theFAF acknowledged that “the PCFRC hasnot been wholly successful in achievingits mission, in part because in its earlyyears, the FASB did not participate fullyin its processes or pay sufficient attentionto its recommendations” (“Plan toEstablish the 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.

Improvement Council,” FAF Board ofTrustees, October 2011).

In May 2012, the FAF announced theestablishment of a Private CompanyCouncil (PCC), replacing the earlier PCSICproposal. The PCC’s decisions will be sub-ject to endorsement by FASB, rather thanratification, and other provisions have beenmade to ensure that the PCC can exercisesufficient independence from FASB (seeNicholas C. Lynch, “The Controversy overPrivate Company Reporting Standards,”The CPA Journal, July 2012). The finalimplementation differs from the blue rib-bon panel’s initial recommendation, but thePCC ultimately won the support of theAICPA (“Why the AICPA Supports FAF’sCreation of Private Company Council,” byBarry Melancon, http://blog.aicpa.org/2012/06/why-the-aicpa-supports-fafs-cre-ation-of-private-company-council.html).

Teaching Financial Accounting Standards

As recent developments indicate, thereis substantial disagreement as to how dif-ferent standards would be overseen butno fundamental objection to the idea ofseparate standards for small companies.There will be different standards for smallcompanies that will have to be taught andapplied in practice.

Thus, there exists a dilemma about whatacademia should do with respect to teach-ing these standards, given the restraints ofuniversity resources. Some schools havetaken steps to introduce multiple standardsinto accounting courses:■ In 2008, Virginia Polytechnic Institutepublished an 87-page guide on introducingIFRS into intermediate accounting cours-es. It referenced three intermediate account-ing texts: Kieso, Weygandt, and Warfield(Wiley); Spiceland, Sepe, and Tomassini(McGraw-Hill/Irwin); and Stice, Stice, andSkousen (South-Western). It also suggest-ed discussions and questions covered in thetexts’ various topical units.■ In the summer of 2009, KPMG col-laborated with the American AccountingAssociation (AAA) on a survey of educa-tors that focused on the current status ofIFRS education in universities. The AAAsurvey reported the widespread view (39%of professors surveyed) that the class of2014/2015 will be the first graduating classof accounting students with a substantial

knowledge of IFRS (Robert P. Derstineand Wayne G. Bremser, “The JourneyToward IFRS in the United States,” TheCPA Journal, July 2010).■ PricewaterhouseCoopers is providingmaterial for faculty to use in their classes,with the hope that these resources will be use-ful to faculty who wish to introduce IFRSinto the classroom. The Pricewater-houseCoopers Charitable Foundation award-ed grants to 30 schools to develop IFRS in

the curriculum. Even with material like this,however, the teaching of IFRS has been slowto catch on. Of the 30 schools to receivegrants, 17 do not list any separate courses ininternational accounting or IFRS in theironline course descriptions.■ The University of Wisconsin has alsodeveloped a program structured aroundintegrating IFRS into the curriculum. Theschool received a grant from thePricewaterhouseCoopers CharitableFoundation, under which the faculty of thedepartment of accounting and informationsystems developed an integrated set ofIFRS instructional activities in 12 cours-es, with participation by 14 faculty mem-bers. The activities were designed so thatthe materials could be used in multiplecourses or with students at differentstages in the program sequence. The mate-rial includes syllabi for the courses, andboth the courses and the syllabi are on theschool’s website. ■ The University of Delaware statesthat its goal is to develop a graduate coursein IFRS.■ The University of Dayton has anarrangement where students in an interna-

tional accounting course spend 10 days inEngland and receive a certificate in IFRSfrom the Institute of Chartered Accountantsin England and Wales (ICAEW). In addi-tion to the international accounting cours-es, the ICAEW also offers a separate IFRScertificate class.

But these efforts seem to be the excep-tion to the rule. This article’s authors con-ducted a survey of 160 colleges and uni-versities that offer degrees in accountingor related subjects. In a search of cata-logs, course descriptions, and websites,77% do not mention international require-ments or IFRS. Twenty-nine percent hada course listed as international account-ing; however, one-third of those did notindicate that it covered IFRS, but that itcovered such things as foreign currencyexchange, foreign corrupt practices, andother international topics. Over one-quar-ter of the schools listing an internationalaccounting course did not offer the coursewithin the last year. It is possible that someschools might be covering IFRS and notreporting it in their course descriptions.

Recent editions of texts—such asIntermediate Accounting by Kieso,Weygandt, and Warfield—include briefdiscussions of the differences between U.S.GAAP and IFRS at the end of each chap-ter. These authors also have an IFRS edi-tion, which is used primarily outside theUnited States; only 30 schools in theUnited States use the international edi-tion, according to the text’s publisher.These courses are usually IFRS-specificcourses outside of the traditional interme-diate financial accounting sequence.

Part of the reason for the lack of cover-age of IFRS in the curriculum could be thatfaculty members have been waiting forcomplete convergence, after which theycould use texts that focus solely on IFRS.Another reason could be that instructorsare reluctant to add subject matter that theyare not familiar with to their courses. Anadditional reason is that brief comments onthe differences between the two systemsdo not capture the fact that IFRS is prin-ciples-based and U.S. GAAP is rules-based; U.S. GAAP has 17,500 pages, com-pared 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


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.

indications that this status quo willchange soon. It might seem hard to believethat most of the economic world can adoptIFRS while the United States does not, butthis would not be a first for the country;the Metric Conversion Act of 1975 desig-nated the metric system as the preferredsystem of weights and measures for U.S.trade and commerce, and directed federalagencies to convert to the metric system—to the extent that it was feasible—includ-ing the use of metric in construction of fed-eral facilities. It also created the UnitedStates Metric Board to assist in the con-version. This board no longer exists.Most observers would probably agree thatthe conversion to the metric system hasfailed in the United States.

To serve the students and the firms thatwill employ their graduates, schools needto adopt a curriculum that incorporates bothIFRS and U.S. GAAP. The use of end-of-chapter acknowledgment of the differencebetween U.S. GAAP and IFRS on the

topic discussed in the chapter would be asimple way to accomplish some coverage.For example, the University of Detroit Mercyindicates in its description of intermediateaccounting that international differences in afew accounting areas are briefly discussed.The school uses the intermediate book byKieso, Weygandt, and Warfield that has end-of-chapter discussions of IFRS and thecourse description discusses these end-of-chapter presentations.

With respect to the issue of Big GAAP,Little GAAP, the authors are hopeful thatthe differences implemented for small com-panies will be minimal. If so, it will also bepossible to teach this topic through end-of-chapter material in intermediate financialaccounting texts. No doubt it will also appearin future CPA exams.

Logically, there should not be a need formultiple sets of standards for financialreporting, 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 andadjust curricula accordingly. Of course, thedilemma exists not just in academia; pub-lic accounting firms must also comply withthe different standards for different clients.Because today’s students will make uptomorrow’s workforce, it is important forfirms to remain aware of these education-al developments. ❑

Heather M. Lively, MAcc, CPA, is aninstructor at the University of SouthFlorida, Sarasota-Manatee, Fla. NicholasJ. Mastracchio, Jr., PhD, CPA, is anassistant professor, also at the Universityof South Florida. He was formerly theArthur Andersen Alumni Professor ofaccounting at the University at Albany,where he holds emeritus status; was achair of the New York State Board ofAccountancy; and spent three years on theAICPA Board of Examiners that overseesthe CPA exam.



By Nicholas J. Mastracchio, Jr., and Heather M. Lively

While the gap between standardsissued by the InternationalAuditing and Assurance

Standards Board (IAASB)—the auditingstandards-setting committee of theInternational Federation of Accountants(IFAC)—and those issued by the AuditingStandards Board (ASB) has been mini-mized, auditing standards within theUnited States for audits of publicly trad-ed companies and private companies havegrown even further apart—and indicationsare that they will continue to do so. Atpresent, there seems to be little hope forthe convergence of the ASB’s auditingstandards and those of the PublicCompany Accounting Oversight Board(PCAOB), which regulates the activitiesof auditors of public companies in theUnited States. Thus, educators whoteach courses on auditing are faced withthe dilemma of how to present multiplestandards, as well as explain the differ-ences that exist between codified ethicalstandards in the United States and inter-national standards.

Convergence with International Standards

In 2007, the ASB initiated the ClarityProject to address the clarity, length, andcomplexity of its auditing standards. Itdecided to redraft the standards and con-verge the Statements on Auditing Standards(SAS) with International Standards onAuditing (ISA) issued by the IAASB.The ASB established a Clarity TaskForce to clarify and converge the SASs andthe ISAs. The clarified standards wererestructured, and objectives were estab-lished for each clarified SAS, including adefinition section and a separation ofrequirements from application material.

In October 2011, after an extensive four-year project, the ASB issued new standardsin a format that essentially converged withISAs. For example, the new SAS 122,Statements on Auditing Standards:Clarification and Recodification, is an 805-page pronouncement that supersedes AUsection 110, “Responsibilities and Functionsof the Independent Auditor”; AU section120, “Defining Professional Requirementsin Statements on Auditing Standards”; AUsection 150, “Generally Accepted AuditingStandards”; AU section 201, “Nature of theGeneral Standards”; AU section 210,“Training and Proficiency of the IndependentAuditor”; AU section 220, “Independence”;and AU section 230, “Due Professional Carein the Performance of Work.”

On September 1, 2011, the AICPA issueda report, “Substantive Differences Betweenthe International Standards on Auditing andGenerally Accepted Auditing Standards[GAAS],” that analyzed the differences,labeled as “Requirements in the ISAs not inGAAS.” It concluded that almost all of thedifferences are due to laws and regulationsor accounting frameworks that are not appli-cable in the United States. Only two excep-tions were cited: ■ ISA 600, The Work of Related Auditorsand Other Auditors in the Audit of GroupFinancial Statements, does not allow theaudit report on group financial statementsto make reference to a component auditorunless required by law; GAAS does. ■ ISA 810, Engagements to Report onSummary Financial Statements, allows twodifferent phrases in opining on summaryfinancial statements; GAAS only uses one.

The new pronouncements are effectivefor audits of financial statements for peri-ods ending on or after December 15, 2012.Although the CPA Exam ContentSpecification Outline lists internationalauditing standards, the questions on theexam will include the new GAAS stan-

dards and will probably eliminate the inter-national standards because they havealmost all converged into GAAS.

Two Sets of U.S. Auditing Standards In April 2003, the PCAOB adopted cer-

tain preexisting standards as its interimstandards, including GAAS, as describedin 43 sections of the ASB’s SASs.Essentially, because the PCAOB did notadopt the revisions to GAAS, its standardsare based on the superseded SASs andare no longer identical to the ASB’s stan-dards—that is, many of the 49 AU sectionsstill used by the PCAOB have beensuperseded by the ASB, the original author.In the meantime, the PCAOB has issued14 outstanding standards; thus, two setsof substantially different auditing standardsnow exist in the United States—the ASB’sstandards and the PCAOB’s standards,which consist of the ASB’s supersededstandards and some of its own.

Unfortunately, unlike the ASB’s effortsto converge with international standards,the PCAOB has expressed no interest inconverging with the ASB’s standards. Atthe annual NASBA meeting in October2011, PCAOB Chair James Doty wasasked whether there was any effort to con-verge the PCAOB’s and ASB’s stan-dards. He said that the PCAOB talks to theASB but has not established any task forcenor made any formal effort to convergewith ASB standards.

Craig Mills, AICPA vice president ofexaminations, was asked at this same meet-ing which set of standards would be cov-ered on the CPA exam. He replied thatboth would be covered—a logical conclu-sion, because entry-level CPAs should beexpected to know both.

Teaching Auditing StandardsMany colleges do not have the resources

for two auditing courses, and they face a

Multiple Auditing Standards Intensify theDilemma of What to Teach

R E S P O N S I B I L I T I E S & L E A D E R S H I P

e d u c a t i o n

Diverging Guidance Presents Challenges for Educators

choice about what to cover in the coursethat they do have. Thus, auditing instruc-tors are confronted with two sets of stan-dards and the dilemma of deciding what toincorporate into an auditing course.

The authors’ review of university coursedescriptions for auditing courses gave littlehint as to the extent to which each set of stan-dards was taught. There were a few excep-tions, however, such as California StateUniversity, Long Beach, which claimed tocover current pronouncements of thePCAOB. The textbooks used in thesecourses can be a better indicator of what isbeing taught in auditing courses. Of course,that does not mean the text is not supple-mented with additional material.

A study of six leading auditing texts showsa bias between the two sets of standards. Onetext sets the tone in its introduction to theASB: “The AICPA continues as the standardsetter for audits of nonpublic clients. TheAICPA has gained back a good portion ofthe creditability it lost during the late1990s” (Larry E. Rittenberg, Karla Johnstone,and Audrey Gramling, Auditing: A BusinessRisk Approach, 7th ed., Cengage, p. 51). Itthen proceeds to start most chapters with dis-cussions of the PCAOB and the integratedaudit approach. Another text states: “This textinitiates its presentation with an integratedaudit of financial statements and internal con-trol over financial reporting (ICFR). It usesa public company integrated audit as its pri-mary teaching platform” (Karen L. Hooks,Auditing and Assurance Services:Understanding the Integrated Audit, Wiley,p. xxvi).

A third text, although not as obviouslyas the other two, discusses topics—such asthe 10 general auditing standards—with-out any indication that these were elimi-nated from GAAS over a year ago (thecopyright is 2012), and it leads off with thePCAOB standards for reports (Alvin A.Arens, Randal J. Elder, and Mark S.Beasley, Auditing and Assurance Services:An Integrated Approach, 14th ed., PrenticeHall, p. 34). Another text introduces thepronouncements of both the ASB and thePCAOB, listing the relevant sections at thebeginning of each chapter (Iris C. Stuart,Auditing and Assurance Services: AnApplied Approach, McGraw-Hill/Irwin).

The two final texts take the approach ofusing ASB standards, with commentaryregarding PCAOB standards where neces-

sary. One of these texts states, “In themajority of this textbook we will focus ongenerally accepted auditing standards estab-lished by the AICPA. … In areas in whichthere are differences, we will discuss them inaddition (Ray Whittington and Kurt Pany,Principles of Auditing and Other AssuranceServices, 18th ed., McGraw-Hill/Irwin, p.33).” The other states, “In this book we usethe U.S. ASB standards as a foundation andbuild in requirements from PCAOB standardsthat are more stringent than ASB require-ments” (William F. Messier, Steven M.Glover, and Douglas F. Prawitt, Auditing andAssurance Services: A Systematic Approach,8th ed., McGraw-Hill/Irwin, p. 53). Thistext also lists ASB and PCAOB sections atthe beginning of each chapter. All of theseapproaches will be more difficult now thatthere are fewer identical standards betweenthe ASB and PCAOB.

Auditing instructors must find a way toincorporate the two sets of standards intotheir auditing courses. The selection of atext that takes this approach would great-ly assist in the process. The new ASB stan-dards will make the teaching of both setsof standards more difficult, and the differ-ences will likely increase over time. Thatsaid, there might have to be a reductionin subject matter if the curriculum includesonly one three-credit course in auditing.

Teaching EthicsThe teaching of ethics should be uni-

versal, regardless of the codification of eth-ical rules. The sources of ethical stan-dards go back at least as far as Aristotle.The utilitarian approach suggests that eth-ical action is the one that provides the mostgood or does the least harm. The rightsapproach maintains that ethical action isthe one that best protects and respects themoral rights of those affected. The fairnessapproach suggests that all equals should betreated equally. The common-goodapproach maintains that ethical actionsshould contribute to the life of the com-munity. The virtue approach suggests thatethical actions ought to be consistent withcertain virtues.

But auditors do more than just followthese moral approaches; they must complywith rules of ethics that are codifiedeither by the AICPA or IFAC’sInternational Ethics Standards Board forAccountants (IESBA). These two codifi-

cations are structured differently, andboth are included on the CPA exam. TheIESBA standards consist of the followingthree parts: ■ Part A establishes the fundamental prin-ciples and framework, and includes sec-tions on threats and safeguards. ■ Part B applies to accountants in pub-lic practice.■ Part C applies to accountants in industry.

The AICPA’s code of ethics is brokendown into four parts: principles of profes-sional conduct, rules of conduct, interpre-tations of the rules, and rulings by theprofessional ethics executive committee.

What Must Be Done? As with accounting standards, there

should not be a need for two sets ofauditing standards—one set created bythe PCAOB, the other by the ASB. Manyeducational institutions only offer oneauditing course to students, and only a lim-ited amount of time is available. The diver-gence of auditing standards is not likelyto go away, however, and it must be dealtwith by academia.

Some schools are choosing their approachbased on where their graduates are typical-ly employed. Smaller schools might leantoward teaching the ASB standards. Butthe issue is not exclusively a problem foracademia; public accounting firms must alsocomply with different standards, dependingupon whether there will be an SEC filing.Lastly, although there are similaritiesbetween the two applicable codes of ethics,accounting instructors still face the dilem-ma of how to allocate class time to these top-ics and whether to teach both the AICPAcode and the IESBA code. ❑

Nicholas J. Mastracchio, Jr., PhD, CPA,is an assistant professor at the Universityof South Florida, Sarasota-Manatee, Fla.He was formerly the Arthur AndersenAlumni Professor of accounting at theUniversity at Albany, where he holds emer-itus status; was a chair of the New YorkState Board of Accountancy; spent threeyears on the AICPA Board of Examinersthat oversees the CPA exam; recently com-pleted three years on the ASB; andserved on the Clarity Task Force. HeatherM. Lively, MAcc, CPA, is also an instruc-tor at the University of South Florida.



By Jeff Krull and Kevin Rich

Arecent survey of corporate boardmembers by Oliver Wyman’sGlobal Risk Center and the

National Association of Corporate Directors(NACD) found that nearly half of respon-dents (47%) were dissatisfied with theirboards of directors’ ability to provide infor-mation technology (IT) risk oversight, eventhough virtually all respondents believed thatIT would impact their organization withinthe next five years (Jonathan Cohn and MarkRobson, “Taming Information TechnologyRisk: A New Framework for Boards ofDirectors,” Oliver Wyman and the NACD,2011).

This disconnect can have significant impli-cations for an organization’s audit commit-tee, which is typically responsible for oversight of the effectiveness of internal controls that address risk. For example, amajority of audit committee members (58%)surveyed by KPMG and the NACD statedthat they would like to devote more atten-tion to IT risk and emerging technologies(“2011 Public Company Audit CommitteeMember Survey—Highlights,” KPMG andthe NACD 2011).

There are various IT-related questionsthat diligent audit committee membersshould pose to the management of theirorganizations. They should also payattention to certain “red flag” responses thatmight arise and should consider avenuesfor further inquiry, as well as potentialstrategies for working with management toimprove the state of IT controls.

Overseeing IT RiskOne important trait of a good audit

committee member is the ability to askprobing questions of management; how-ever, this can be hard to do in an envi-ronment that requires a significant amountof technical knowledge, such as IT,

because individuals might hesitate to askquestions on a topic that lies outsidetheir expertise. Only 16% of OliverWyman/NACD survey respondentsreported that they have been a chief infor-mation officer (CIO) or senior IT execu-tive during their career; this lack ofexperience might limit the ability of auditcommittees to rigorously monitor the stateof IT risk in their organizations.

Effective IT risk oversight also requiresstrong communication between an auditcommittee and a company’s IT leadership.Despite the importance of IT in theachievement of an organization’s objec-tives, results from the KPMG/NACD sur-vey suggest that audit committee membersoften feel that they have insufficient con-tact time with their organization’s CIO.Therefore, it is critical that audit commit-tees get the most out of the time that theydo spend with IT leadership.

Audit committee members should con-sider the following questions as they assesstheir organization’s IT risks and initiate adialogue with IT leadership. Although ask-ing a set of rigorous initial questions ofIT leadership is critical, effective moni-toring also requires a detailed critique ofmanagement’s responses. The sectionsbelow provide examples of red flagresponses, as well as potential follow-upquestions and activities.

1. How Many Times Has the CompanyBeen “Hacked” This Year?

A recent survey of 583 U.S companiessuggested that over 90% of U.S. compa-nies suffered at least one intrusion into theircomputer network in 2011 (“PerceptionsAbout Network Security: Survey of IT andIT Security Practitioners in the U.S.,”Ponemon Institute, 2011). Foreign anddomestic hackers are attacking U.S. busi-

10 Questions Audit Committees Should Ask

T E C H N O L O G Y

i t m a n a g e m e n t

Managing Information Technology Risks

nesses using increasingly complex tools,some of which are able to infect machines,collect sensitive information, and send theinformation back to a host computer. Suchnetwork intrusions are rarely disclosed tothe public, but when they are, they can gen-erate a significant amount of negative pressabout an organization.

Red flag response. A typical red flagresponse in this situation is “We haven’t beenhacked.” Given the prevalence of attacks, aresponse of “no intrusions” might indicatethat either 1) the organization has not doneenough to determine whether its systemhas been hacked or 2) the person who knowsthe answer is not at the meeting.

Next steps. The audit committee shouldinquire about the methods that IT leadershipuses to identify hacker activity and shouldassess how much confidence managementhas in the metrics. Furthermore, committeemembers should determine whether a robustincident-response plan exists to mitigate anydamage from attacks and notify the appro-priate levels of management.

2. How Many People Can Access Sensitive Data?

Many organizations lack a cohesivemethod of answering this question, especiallywith respect to confidentiality and privacy.It is important to remember that there arevarying levels of access, ranging from theability to change and manipulate data tobeing able to view sensitive informationabout customers, vendors, and employeesstored in files on a computer network.

Red flag response. One red flag mightbe if management answers, “We have con-trols complying with the Sarbanes-OxleyAct of 2002 [SOX].” Such IT controlsfocus exclusively on internal controlsover financial reporting; although thesecontrols can play a role in providing thatfinancial transactions are not manipulated,they do little to ensure that sensitive dataare kept private and confidential. SOX con-trols generally only focus on the core finan-cial systems and do not extend to other sys-tems that might be operationally critical.

Next steps. Audit committee membersshould determine which measures their orga-nization takes in accordance with the TrustServices Framework, which is focused onconfidentiality, privacy, processing integrity,availability, and security. It might also beuseful to identify when the last review of

systems controls took place and whether itextended beyond financial controls.

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

Stakeholders often fail to appropriate-ly define the criteria for a successful pro-ject upfront; even when they do, theyallow it to change when problems arise.Setting goals and evaluating progressagainst them can be especially important,given that implementation consultantsusually get paid more when there are

issues than when everything proceedsaccording to plan.

Red flag response. A vague response,such as “a system that does what it issupposed to do,” should be a red flag foraudit committee members. Audit commit-tee members should ask: Is it within bud-get? Was the system completed on time?Does the system contain all necessaryfeatures? When defining success, the auditcommittee should communicate, to thoseaccountable for the project, what commit-tee members find important and how it willdeal with issues if they arise.

Next steps. The audit committeeshould work with IT leadership to defineconcrete goals for IT projects over aspecified dollar amount and periodicallyreview performance against these goals.

4. Are Laptops and Other PortableDevices Encrypted?

At some point, every organization withdata on portable devices will likely haveto deal with a lost or stolen machine.Encrypting laptops helps show adequatecontrols, which can reassure stakeholdersin the event of a lost machine. In addi-tion, it can help avoid liability if the loss

of hardware leads to a security breachthat is followed by litigation.

Red flag response. One potential red flagresponse in this case is, “It costs too much.”Although it may not be easy to concretelyquantify the cost of data breaches, it is pos-sible to estimate how much it would cost toencrypt all of an organization’s laptops.

Next steps. The audit committeeshould ask the IT organization to compilean estimated cost of encrypting all portabledevices that contain sensitive informationso that committee members can make an

educated decision from a cost-benefit per-spective. Moreover, the cost of encryptingdevices continues to decrease, making it anincreasingly viable option for organizationsof all sizes.

5. Are Strong Password PoliciesEnforced?

Passwords, which play an integral role inproviding a secure computing environment,serve as one of the last lines of defenseagainst attempted intrusions. Hackers oftenhave very sophisticated tools at their disposalfor reverse-engineering passwords, and theirtask is made much easier when an organi-zation fails to require strong passwords.

Red flag response. One red flagresponse might be, “Our users will justwrite them down on a post-it note.” Ifthis is the case, then it could indicate a lackof security awareness training or poor ITgovernance. The organization must rein-force the importance of strong passwordsin keeping data secure, and it mustremind employees to defend them with thesame rigor that they would apply to theirown Social Security numbers.

Next steps. Audit committee membersshould work with management to devel-


Committee members should determine whether a robust

incident-response plan exists to mitigate any damage from attacks

and notify the appropriate levels of management.

op a formal policy related to passwordsecurity (including defined consequencesfor violations) and determine whetheradditional employee training sessions arewarranted.

6. Has a Disaster Recovery Plan BeenTested Recently?

Testing is an integral part of ensuringthat disaster recovery plans will work whenthey are needed. IT environments changefrequently, and it is easy to overlook thelatest changes made to a plan. As such, dis-

aster recovery plans should be completelytested on a regular basis. Furthermore, dis-aster recovery plans often encounter prob-lems during the test run, at which point itis often much easier to rectify issues thanwhen facing an actual crisis.

Red flag responses. If managementresponds, “We haven’t tested it,” or “Itcosts too much to test,” the audit commit-tee should be wary. Asking when theplan will be tested or how much it costscan help set the tone at the top for the orga-nization’s governance structure.

Next step. Similar to encryption, it isimportant to ascertain whether cost concernsfor conducting a test of the disaster recov-ery plan are based upon fact or conjecture.

7. Are Service Providers Keeping DataSafe?

Many organizations outsource largepieces of their operations, ranging from datacenter maintenance to payroll processing. Inaddition, organizations increasingly utilizeconsultants to analyze historical transactiondata in order to make recommendations on


Question Red Flag Responses Next Steps

1. How many times has the company “We haven’t been hacked.” Inquire about the methods used to been successfully hacked this year? evaluate hacker activity.

2. How many people can access “We have SOX controls.” ■ Determine what the organization does customers’ or employees’ sensitive that is related to the Trust Services data? Framework.

■ Identify timing of last full IT controls review.

3. What is the definition of a “A system that does what it is Work with management to develop successful IT project? supposed to do.” concrete IT project goals and periodically

assess performance against these goals.

4. Are laptops and other portable “It costs too much.” Ask for cost estimates to encrypt devices encrypted? portable devices to facilitate a

cost-benefit analysis.

5. Are strong password policies “Our users will just write them down.” Work with management to develop a enforced? formal policy on passwords and determine

if additional training is necessary.

6. Has a disaster recovery plan “We haven’t tested it.” Require that IT leadership quantify the costbeen fully and completely tested “It costs too much.” cost of testing the disaster recovery plan.recently?

7. Are service providers keeping “We get a Statement on Auditing Decide whether to pursue Service data safe? Standards (SAS) 70 report.” Organization Controls (SOC) 2 or SOC 3

“It’s in our contract.” reports from outside service providers.

8. Does the organization have any IT “We don’t know.” Evaluate whether a policy for the use of assets that are not controlled or “Yes.” personal devices is appropriate.administered by the IT department?

9. Has the organization performed “We haven’t.” Work with IT leadership to develop a and documented a formal IT framework for periodic IT risk assessment risk assessment? procedures.

10. Is there adequate IT coverage “We haven’t evaluated it.” Benchmark the IT internal audit function from an internal audit perspective? against peer organizations or industry

best practices.

EXHIBIT 1Summary of Key Questions, Red Flag Responses, and Next Steps

improving profitability. These relationshipscreate opportunities for sensitive data to exitthe organization and are difficult for topmanagement to track because of the ease oftransmitting data.

Red flag responses. The following aretwo potential red flags:■ Management might say, “We get aStatement on Auditing Standard [SAS] 70,Service Organizations, report.” ServiceOrganization Controls (SOC) 1 reports—based on Statement on Standards forAttestation Engagements (SSAE) 16,Reporting on Controls at a ServiceOrganization, and the successor to SAS 70reports—only cover internal controls overfinancial reporting in a user’s financialstatement audit. They have, by definition,a very limited scope and do very little toensure and maintain data privacy. ■ Management might claim, “It’s in ourcontract.” This may be true, but contrac-tual confidentiality guarantees will likelyprovide little protection in the event of asignificant data breach, especially if thethird-party provider is a much smaller orga-nization.

Next steps. The AICPA has set criteria forSOC 2 and SOC 3 reports that serviceproviders can follow to assure clients abouttheir IT control environment, including adher-ence to the Trust Services principles. It mightalso be beneficial for an audit committee topress IT leadership to enquire whetherengaged third-party vendors have faced thesekinds of examinations, the findings ofwhich are often only released upon request.

8. Does the Organization Have AnyAssets Not Controlled by the ITDepartment?

Any device that connects to an organi-zation’s network can expose it to a secu-rity breach, including those that are ownedby individual departments or employees.These devices often contain sensitive infor-

mation, but lack the security features thatassets under the control of the IT depart-ment possess.

Red flag responses. Some red flag respons-es might be “We don’t know,” or even,“Yes.” As smartphones and tablet devicescontinue to increase in popularity, this issuewill likely only increase in importance.

Next steps. The audit committee shouldencourage management to decide whether apolicy is needed to authorize the use of per-sonal devices for company purposes, whichcan include a review by the IT departmentfor minimum security features.

9. Has the Organization Performed andDocumented an IT Risk Assessment?

Risk assessment procedures are an excel-lent time to take an inventory of IT assetsand evaluate how they impact an organi-zation’s operations. Furthermore, recurringIT risk assessment procedures require ITpersonnel to stay current with the latest out-side threats.

Red flag response. If managementresponds, “We haven’t,” then an auditcommittee should be wary of a potentialred flag. Organizations rarely have unlim-ited resources to devote to IT security, andrisk assessment procedures can help ensurethat control procedures are placed wherethey yield the largest benefit.

Next steps. Audit committee membersshould work with IT leadership to devel-op a formal framework for IT risk assess-ment procedures, paying particular atten-tion to details such as scope and frequen-cy. Once implemented, the committeeshould require that IT leadership report theresults to them on a periodic basis.

10. Is there Adequate IT Coverage froman Internal Audit Perspective?

IT is often underrepresented in an orga-nization’s internal audit plan, for reasonsranging from cost to technical expertise.

Red flag response. One answer that shouldraise a red flag is, “We haven’t evaluated it.”Organizations devoting fewer resources to theIT internal audit function might have lessrobust IT risk management practices than oth-erwise comparable organizations.

Next steps. The audit committeeshould suggest that management evaluatehow the amount of IT internal audit cov-erage compares to peer organizations orindustry best practices.

Successful Audit Committee Oversight

These 10 questions represent a startingpoint for audit committee members seek-ing to learn more about the state of ITrisk at their organization. Because all orga-nizations differ, additional questionsdesigned to understand the specifics of howIT impacts operational activities might alsobe required. (See the sidebar, For MoreInformation, for useful links.) In addition,audit committee members might need toconsider whether a combination of minorproblems can lead to major issues whencritiquing responses from IT leadership.

Audit committees can only provide effec-tive oversight of IT risk when they have ade-quate access to an organization’s key ITpersonnel. The authors recommend that auditcommittees periodically invite IT leadershipand IT auditors to both executive sessionsand audit committee meetings in order to gaina better understanding of how they areresponding to the IT risks facing an organi-zation. This can serve to elevate the positionof IT-related issues with top management andensure periodic outside monitoring. ❑

Jeff Krull, CPA, CISA, is a partner atParenteBeard LLC, Philadelphia, Pa.Kevin Rich, PhD, CPA, CFE, is anassistant professor of accounting atMarquette University, Milwaukee, Wis.


FOR MORE INFORMATION

Trust Services Framework www.aicpa.org/interestareas/informationtechnology/resources/trustservices/pages/default.aspx

Service Organization Controls http://www.aicpa.org/interestareas/frc/assuranceadvisoryservices/pages/aicpasoc2report.aspx(SOC) 2 and SOC 3 Reports

ISACA Risk IT Framework http://www.isaca.org/Knowledge-Center/Risk-IT-IT-Risk-Management/Pages/Risk-IT1.aspx


By Susan B. Anders

The Tax Foundation is a nonpartisantax research and education groupthat provides information related to

tax policy and government finance on itswebsite, http://taxfoundation.org. Althoughthis site was previously reviewed in TheCPA Journal in December 2008, theupcoming national election, as well asmajor changes to the site, presents a goodopportunity to revisit its resources. The TaxFoundation offers a vast selection of uniquematerials—such as tax policy calculatorsand tax maps—that can aid tax profes-sionals in understanding current debates ontax policy, as well as in tax planning activ-ities. The publications provided on thewebsite are easy to read, and they containuseful tables, charts, and graphs. In addi-tion, many data files are available as freedownloads.

The website is organized by topical areaand type of resource. The topical coveragespans federal, state, and international taxissues, with information housed under thecategories of tax basics, tax topics, feder-al tax policy, state tax policy, and legal taxreform, as well as other smaller topicalpages. Users can access resources in a vari-ety of formats, including publications, dataand charts, videos, blog posts, maps, pod-casts, and press releases; links to specificresources can be found in the upper right-hand corner of the homepage. The site’spress room section includes contact infor-mation for Tax Foundation staff, pressreleases, and media coverage.

The center of the homepage highlightsfour featured articles in continuous rotation.At the time of this review, they included acomparison of the Obama and Romney taxplans; an interactive tax calculator with taxpolicy customization options; an articlepromoting an end to the estate tax; and ashort video interview with Tax Foundation

President Scott A. Hodge, discussing theneed for corporate tax reform. The remain-der of the homepage highlights selected taxbasics, key tax issues, a tax-by-state inter-active feature, and the most recent posts fromthe Tax Policy blog.

Presidential Candidate Tax ProposalsAn informative, pre–national election fea-

ture is “Romney, Obama, and Simpson-Bowles: How Do the Tax Reform PlansStack Up?” by William McBride, whichcompares the two candidates’ tax plans withthe proposal from the cochairs of theNational Commission on FiscalResponsibility and Reform (i.e., theSimpson-Bowles plan, November 2010). Alink to the Tax Foundation report is avail-able on the homepage; it can also be down-loaded as a PDF. Both versions include foot-noted links to informative underlying docu-ments, such as a draft presentation on theSimpson-Bowles proposal.

The tax reform report includes a tablethat compares Obama’s and Romney’splans to the Simpson-Bowles proposal.Selected issues include top marginal taxrates on personal income, corporateincome, long-term capital gains, and divi-

dends. Tax expenditures and alternativeminimum tax reforms, payroll tax rates,and the estate tax are also covered.

One article found in the website’s fed-eral tax policy section, “The Estate Tax:Even Worse than Republicans Say” byDavid Block and Scott Drenkard, takesadvantage of a Joint Economic Committeereport (issued by the committee’sRepublican staff) to reemphasize the TaxFoundation’s position on the estate taxand briefly summarize recent changes,current conditions, and current adminis-tration proposals. The remainder of thearticle focuses on the perceived failureof the estate tax to meet expectations, as

Website of the Month: Tax Foundation

T E C H N O L O G Y

w h a t t o b o o k m a r k

well as potential damaging effects on theeconomy.

Another example of how the TaxFoundation leverages its tax policy researchin order to participate in the public debateis an article featured on the website’shomepage at the time of this review,“The Fiscal Costs of Nonpayers” by WillFreeland, William McBride, and EdGerrish, released after remarks by presi-dential candidate Mitt Romney directedpress attention to taxpayers who file but donot have any tax liability.

PublicationsThe Tax Foundation issues a variety of

free publications—including Tax Watch,a quarterly policy newsletter, and TaxFeatures, a bimonthly policy review—found in the site’s publications section. Italso features studies, special reports, andbooklets; longer books are available atrelatively low prices.

One example of a featured article is“Taxing the Uninsured: The Latest Estimates”by William McBride, which explores theSupreme Court ruling that the PatientProtection and Affordable Care Act falls underCongress’s power to tax. It summarizes thetax effects for the uninsured and provides atable based on family size. Another article,“State Tax Changes During 2011” byJoseph Henchman, reports on state tax col-lections, individual and corporate income taxrate changes, and adjustments to sales andexcise taxes. A copy of a testimony givenby Hodge to the U.S. Senate Committee onFinance, “Are Tax Credits the Proper Toolfor Making Higher Education Affordable?”details the Tax Foundation’s view of someunintended consequences of introducing cred-its and deductions into the tax code, includ-ing price inflation and high fraud rates.

The Tax Foundation’s convenient 50-page booklet, Facts & Figures Handbook:How Does Your State Compare? by ScottDrenkard, can be downloaded for free, ora hard copy can be purchased for $10. Thebooklet includes individual and corporateincome tax rates, as well as rates for othertaxes, such as sales, excise, property, andexcise and inheritance. A variety of otherdata is also covered, such as lottery rev-enue, state debt, and income and tax bur-dens per capita.

The studies and special reports sectionaddress a wide selection of topics, rang-

ing from state to international tax issuesand from individuals, estates, and corpo-rations to industry-specific taxation. Mostof the reports average 10 pages in lengthand include tables, charts, and graphicalsummaries. Generally, only the report’sintroduction is available on the web; therest must be downloaded in PDF format.

A 28-page special report, “A GlobalPerspective on Territorial Taxation” byPhilip Dittmer (August 10, 2012), providesbackground information on the debate overworldwide versus territorial taxation of cor-poration income. It also presents summa-ry tables that reflect the move by manydeveloped nations to the territorial approachand easy-to-read comparisons of aggregatedata for outbound foreign direct invest-ment, unemployment, and tax revenue.Surveys of five developed nations that haveswitched from worldwide to territorial tax-ation are also discussed.

Calculators and Data ToolsUseful calculators and interactive tools

can be found in the tax basics section ofthe website (http://interactive.taxfoundation.org/About/). For example, thetax burden calculator estimates an indi-vidual’s tax liability under three basicscenarios: full expiration of all the Bush-era tax cuts, the Republican plan toextend the Bush-era tax cuts, and the cur-rent administration’s proposals. Users canchange the tax policy options in any of thebasic scenarios or create custom scenarios.

In addition to the tax burden calculator,the website also offers a healthcare tax cal-culator, a marginal tax rates calculatorand graph, and a value-added tax (VAT)calculator. The healthcare tax calculatorestimates the tax effect of various provi-sions of the Patient Protection andAffordable Care Act, such as the excise taxon high-cost health insurance plans and theincrease in the itemized deduction thresh-old for medical expenses. Users can drilldown to brief descriptions and effectivedates of the provisions.

The marginal tax rates calculatorincludes two example scenarios withgraphs and explanations, as well as videoinstructions for additional help. This cal-culator shows the marginal tax effects ofchanges to income and deductions. Userscan also enter ranges, as opposed to spe-cific amounts, and create tax rate graphs.

Another calculator allows users to estimatea potential U.S. VAT; they can also spec-ify various policy parameters and taxationcategories.

The data tools resource, found on thesame webpages as the calculators discussedabove, includes information on propertytax, migration, and state spending limits.Property tax data by county include nation-al and state median property taxes paid,taxes as a percentage of median homevalue, and taxes as a percentage of medi-an income. State-to-state migration datashow the number of people moving intoand out of a state and their net adjustedgross income. The state spending limit fea-ture allows users to set an imaginary spend-ing cap for a state and compare actual stateexpenditures to that limit.

Selected federal tax rates for 2012, foundin the federal tax policy section, includeindividual and corporate income tax, SocialSecurity and Medicare, and several feder-al excise taxes. Historical federal individ-ual income tax rates, in nominal andinflation-adjusted dollars, are available forevery year from 1913 through 2011. U.S.corporate income tax rates are availablefrom 1909 through 2012, along withcomparisons to Organization for EconomicCooperation and Development data. Stateindividual income tax rates, accessible from2000 through 2012, can be found in thewebsite’s state tax policy section.

The Tax Foundation has provided itsown summary of the latest federalincome tax data, available as a webpage oran 11-page PDF (http://taxfoundation.org/article/summary-latest-federal-individual-income-tax-data-0). The datatables cover the number of federal returnsfiled, total income tax after credits, aver-age tax rates, and several other topics.

The tax-by-state tool, found in a bluebox on most pages, is a useful feature thatsummarizes basic tax information for eachstate and organizes the site’s materials—arti-cles, blog posts, podcasts, and videos—bystate. The individual state pages also provideaccess to several data files on individual andcorporate income taxes, sales taxes, andproperty tax information. ❑

Susan B. Anders, PhD, CPA, is a pro-fessor of accounting at St. BonaventureUniversity, St. Bonaventure, N.Y.



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We represent a number of quality CPA firmswho would like to merge with other CPAfirms or Partners with business. Offices are inthe Metropolitan area. This is an opportunityto insure your future as well as help yourclients by expanding your services to them.Why settle when you can select?

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SERVING THE CPA COMMUNITYSINCE 1939

Goldstein Lieberman & Company LLC

one of the region’s fastest growing CPA

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Successful Midtown NYC Firm (founded

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Contact in confidence. 212-901-6114.

MayerMeinberg, one of the fastest growing CPA firms with offices in New York City and Long Island is lookingto continue expanding its practice throughmerger and/or acquisition opportunities. Weare seeking entrepreneurial practices rangingfrom $500,000 to $3,000,000. Also consid-ering firms with areas of specialization inForensic and Litigation Support and otherindustry specialization. Please contact:[email protected].

Established, Northern New Jersey and

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Westchester Junior Equity Partner (no

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Long established & very successful firm

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Sub-lease office space available. Utilities includ-

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PEER [email protected]

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30 years not for profit accounting

SITUATIONS WANTED

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Small full service LI CPA firm looking toacquire practice with revenue of at least $250k.We are ready to help the right individual(s) in

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statement reporting and will take great care of

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TAX PREPARER - EXPERIENCED(FLUSHING, NEW YORK)FLUSHING EA firm, seeks experienced tax preparer familiar with Lacerte for Tax Season. E-mail: [email protected] or fax to:718-961-4587.

Tax Manager/Reviewer, CPA, skilled preparerand reviewer, seeks 6-8 days/mo. per [email protected].

TAX CONSULTANCY

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SALES TAX, AUDITS, APPEALS, & CONSULTATIONS. Experience: Many years with New York State SalesTax Bureau as auditor and auditor supervisor.Jack Herskovits. 718-436-7900.

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PEER REVIEWSProviding Peer Reviews since 1990

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Peer ReviewIf you need help, the first step is

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Is your website attracting enough business? Get practical tips for making your website partof a profit-building plan. For your free copy, callMostad & Christensen at (800) 654-1654 or goto: www.mostad.com/kc/ss.

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Westchester CPA firm seeks to acquire accounts

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516-454-0800, x204


Ad Index & Website Connections

Ad Index & FAXFORMATION Service. Here’s 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 Page# INTERNET ADDRESS AD INDEX Page# INTERNET ADDRESS Find our advertisers on the Web. Find our advertisers on the Web.

Greatland C2 www.greatland.com

Sterling National Bank 01 www.snb.com

ADP Small Business Services 05 www.accountant.adp.com

Audimation Services, Inc. 23 www.audimation.com

Accounting Practice Sales 29 www.accountingpracticesales.com

PNC Bank 31 www.pnc.com/cfo

Camico 37 www.camico.com

Strategies for Wealth 43

Rosenthal & Rosenthal 45 www.rosenthallinc.com

Nassau/Suffolk Chapter NYSSCPA 47 www.LITPS.org

Transition Advisors LLC 74 www.transitionadvisors.com

Pearl Insurance C3 www.nysscpainsurance.com

Camico C4 www.camico.com

Rates & Word Count:Basic Rate: $4.00 per word; $56 minimum charge—14 words.

Classified Display & Color Rates: 2 1/4 x 1 col. inch = $165.00 net

*Special Option: Logo in color = $45.00 net

Closing Date: All ads must be received no later than the first Monday of

the month preceding the issue date.

Payment: All ads are prepaid.Payment by check or credit card must be received by the

1st of the month preceding the issue date.

All checks should be mailed to:NYSSCPA

P.O. Box 10489Uniondale, NY 11555-0489

Ad copy should be e-mailed as a Word attachment:[email protected]

(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: [email protected]

Classified Rates

Selected Interest Rates 8/31/12 7/31/12Fed Funds Rate 0.15% 0.15%3-Month Libor 0.41% 0.44%Prime Rate 3.25% 3.25%15-Year Mortgage 2.90% 2.97%30-Year Mortgage 3.53% 3.57%1-Year ARM 4.12% 3.54%3-Month Treasury Bill 0.10% 0.09%5-Year Treasury Note 0.60% 0.61%10-Year Treasury Bond 1.57% 1.51%10-Year Inflation Indexed Treas. --0.70% --0.71%

E C O N O M I C & M A R K E T D A T A

m o n t h l y u p d a t e

The information herein was obtained from various sources believed to be accurate; however, Forté Capital does not guarantee its accuracy or completeness. This report was prepared forgeneral information purposes only. Neither the information nor any opinion expressed constitutes an offer to buy or sell any securities, options, or futures contracts. Forté Capital’sProprietary Market Risk Barometer is a summary of 30 indicators and is copyrighted by Forté Capital LLC. For further information, visit www.forte-captial.com, send a message [email protected], or call 866-586-8100.

Forté Capital’s Selected Statistics

U.S. Equity Indexes 8/31/12 YTD Return

S&P 500 1,407 11.80%

Dow Jones Industrials 13,091 7.10%

Nasdaq Composite 3,067 17.70%

NYSE Composite 8,015 7.20%

Dow Jones Total Stock Market 14,636 11.60%

Dow Jones Transports 5,007 --0.20%

Dow Jones Utilities 468 0.80%

Forté Capital's Proprietary Bullish Neutral BearishMarket Risk Barometer 10 9 8 7 6 5 4 3 2 1

Market ValuationMonetary Environment Investor PsychologyInternal Market Technicals

Overall Short-Term Outlook 5.31Overall Long-Term Outlook 6.04

66

55

Equity Market Statistics 8/31/12 7/31/12

Dow Jones IndustrialsDividend Yield 2.72% 2.73%Price-to-Earnings Ratio (12-Mth Trailing) 13.60 16.29Price-to-Book Value 2.69 2.73

S&P 500 IndexEarnings Yield 7.02% 7.16%Dividend Yield 2.02% 2.24%Price/Earnings (12-Mth Trailing as Rpt) 14.25 13.97Price/Earnings (Estimated 2011 EPS) 13.85 13.54

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 wit-nessed this year. Although the top line reported number looks good at first glance, digging deeper reveals issues that raise concerns for a weak-er economic climate down the road. Excluding transportation orders, it actually fell by 0.4%. Core capital goods orders dropped 3.4% during themonth, which is worse than the 2.7% drop seen in June. In addition, inventories increased for the 31st consecutive month, growing 0.7%. Thesedeclines in core capital goods and increased inventories—along with the recession in Europe and the looming threat of the “fiscal cliff” in theUnited States—are all signs that the economy does face headwinds that could temper growth going forward.

Most Prior Key Economic Statistics Recent Month

National

Producer Price Index (monthly chg) 1.70% 0.30%

Consumer Price Index (monthly chg) 0.60% 0.00%

Unemployment Rate 8.10% 8.30%

ISM Manufacturing Index 49.60 49.80

ISM Services Index 53.70 52.60

Change in Non-Farm Payroll Emp. 96,000 163,000

New York State

Consumer Price Index - NY, NJ, CT (monthly) 0.60% --0.20%

Unemployment Rate NA 9.10%

NYS Index of Coincident Indicators (annual) 1.80% 1.70%

As of 8/31/12


Chart of the MonthDurable Goods Orders (Percentage Change)

Source: Federal Reserve

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

Jan

2012

Feb

2012

Mar

201

2

Apr 2

012

May

201

2

Jun

2012

Jul 2

012


What’s Left in the Fed’s Monetary Policy Toolkit?

E D I T O R I A L

a m e s s a g e f r o m t h e e d i t o r - i n - c h i e f

The Federal Reserve System is thecentral bank of the United States,charged with formulating monetary

policy to pursue maximum employmentand price stability in our economy. OnSeptember 13, 2012, Federal ReserveChairman Ben Bernanke announced thatthe Federal Open Market Committee(FOMC), the Fed’s chief policy-makinggroup, was ready to provide a third roundof quantitative easing (QE3)—a plan tobuy $40 billion of mortgage-backed secu-rities every month for an indefinite periodof time, while keeping interest rates nearzero—with the intention of bringing theunemployment rate down to 7.6% by theend of 2013.

The Fed has attempted to stimulate theeconomy twice before, with questionableresults each time—QE1 (the 2008 WallStreet bailout) and QE2 (the 2010 purchaseof Treasury bonds). When asked to explainhow the policy of giving money to finan-cial institutions on Wall Street could beexpected to help Main Street, Bernankedescribed the rationale behind the plan:by making mortgage money readily avail-able and keeping interest rates low, homeprices will begin to rise, which will makehomeowners feel more prosperous andconsumers more willing to spend. Thisadditional spending, in turn, will help busi-nesses grow and hire more workers—insummary, Bernanke’s version of trickle-down economics.

Ben There, Done ThatAlthough QE might seem like a good

idea at first, it isn’t a panacea; after all,wasn’t excessive liquidity (that is, easymoney) a contributing factor to the finan-cial crisis that began in 2008 with thesubprime mortgage scandals? There’s stilltoo much debt in the private sector for QE3to do much good, because most people areunable or unwilling to increase their debt

load, especially in this economic environ-ment. And keeping interest rates low will continue to discourage savings and will disadvantageretirees, many ofwhom depend oninvestment income tocover their livingexpenses.

Although priorstimulus plans liftedstock prices, the mar-ket rush was short-lived, like a tempo-rary sugar high. Atthe same time, gasprices also increased,leading some to won-der if this could bethe beginning of thereturn of inflation.Has the Fed devel-oped a tolerance for inflation, given thecurrent condition of our economy?According to Bernanke, the Fed’s projec-tions don’t involve any inflation becausethe FOMC believes inflation will stay closeto 2% through mid-2015.

Monetary Policy LimitationsIt would be unrealistic to expect that the

Fed could unilaterally solve our economy’sproblems with the limited monetary poli-cy tools it has at its disposal. In theory,QE3 should work; in reality, however, thefunds often seems to get stuck in amoney pipeline bottleneck before they canget into the hands of consumers andinvestors.

Consider some additional economiccomplexities: the wild gyrations of thestock market in response to reports of trou-ble in the European Union, gas priceincreases whenever there is political insta-bility or tension in the Middle East (aregular occurrence), and questions regard-

ing the adequacy of some of our largestfinancial institutions’ capitalization. Add tothis the downgrades of U.S. government

bond ratings by creditresearch firms (the latestwas Egan-Jones’s down-grade of U.S. debt fromAA to AA-), arguablya reflection of a dys-functional federal fiscalprocess. The next crisismay be triggered by theso-called “fiscal cliff”—the potential sequestra-tion (automatic spendingcuts) and the scheduledexpiration of the Bushtax cuts that will occurif our legislators—whoseem to think “compro-mise” is a dirty word—cannot reach an agree-

ment on fiscal matters before the end ofthe year.

It’s no wonder that consumer confidencein the future of our economy has fallen,and with it, consumer spending. A recentstudy by the Fed showed that unemploy-ment would fall to approximately 7% ifconsumers felt less uncertainty about eco-nomic issues. Unfortunately, I don’t thinkthe Fed has anything in its toolkit to fixthat problem.

As always, I welcome your comments. ❑

Mary-Jo Kranacher, MBA, CPA/CFF,CFEEditor-in-ChiefACFE Endowed Professor of FraudExamination, York College, The CityUniversity of New York (CUNY)[email protected]

The opinions expressed here are my ownand do not reflect those of the NYSSCPA,its management, or its staff.

Bernanke Tests Version 3.0

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