2012-08 CPA Journal August

Advisory Services Rise Again at Large Audit Firms
Plus
Tax Consequences of Currency Trading Hybrid Business Entities Non-Compete Agreements
C O N T E N T S august 2012
20 Accounting & Auditing
Auditing
Material Internal Control Weakness Reporting Since the Sarbanes-Oxley Act By Thomas G. Calderon, Li Wang, and Edward J. Conrad
Accounting
The Two-Class Stock Method for Calculating Earnings per Share: Stock Compensation Awards as Participating Securities By Josef Rashty
Auditing
The Transformation of Internal Auditing: Challenges, Responsibilities, and Implementation By Gaurav Kapoor and Michael Brozzetti
20
ESSENTIALS
48 Finance
36 Taxation
Federal Taxation
Not-for-Prot Organizations
Tax Savings from the Sale of Qualified Small Business Stock By Sidney J. Baxendale and Richard E. Coppage
The Need for Hybrid Businesses: Examining Low-profit Limited Liability Companies and Benefit Corporations By Valeriya Avdeev and Elizabeth C. Ekmekjian
International Taxation
Foreign Currency Strategies Can Produce Unforeseen Tax Consequences By Lee G. Knight and Ray A. Knight
54 Management
Practice Management
The Increased Importance of Non-Compete Agreements for Accounting Firms By Michael C. Lasky and David S. Greenberg
vol. LXXXII/no.8
58
ESSENTIALS
PERSPECTIVES
6 Perspectives
2011 Max Block Awards Presented
58 Responsibilities & Leadership

Perceptions of the Profession
Advisory Services Rise Again at Large Audit Firms: Like a Phoenix, Revenues Reborn amid Renewed Concerns By R. Mithu Dey, Ashok Robin, and Daniel Tessoni
IFRS for Privately Owned Businesses Publishers Column: A Pound of Cure: Preparing for the ACAs 2014 Deadline
68 Technology
The Imprecise Nature of Accounting Teaching and Advising a New Generation of Accounting Students: A Glimpse into the NYSSCPAs 2012 Higher Education Conference Quick Response Codes: A Marketing Tool for Accounting Firms Inbox: Letter to the Editor
IT Management
Business E-mails and Potential Liability: Protecting Privilege and Confidentiality Through Disclaimers and Prudent Use Policies By John Ruhnka and Windham E. Loopesko
What to Bookmark
Website of the Month: Accountability Central By Susan B. Anders
74 Classied Ads 79 Economic & Market Data 80 Editorial

The SEC Staff Report on IFRS: Kicking the Decision Down the Road
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FAE 2012 Web Events
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Federal Tax Series and Tax Exempt Organizations Series, with Lynn Nichols, CPA Nichols Notes: Federal Tax Update Friday, September 21, 2012, 9:3011:30 a.m. Nichols Notes: Tax Exempt Organizations Update Friday, September 21, 2012, 1:003:00 p.m. Techology Update Series, with Joel Lanz, CPA, and Yigal Rechtman, CPA Technology Update Tuesday, October 23, 2012, 9:3011:30 a.m.
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P E R S P E C T I V E S standards setting
IFRS for Privately Owned Businesses

By Charles A. Werner
n 1976, the AICPAs Committee on Generally Accepted Accounting Principles [GAAP] for Smaller and/or Closely Held Businesses issued a report and achieved something of a breakthrough: as a result of its work, FASB abolished the requirement for mandatory disclosure of earnings per share data and business segment information for privately held companies. Accordingly, FASB approved the idea that there could be a different set of required disclosures under GAAP for privately held companies. Since that time, the AICPA has addressed the problems caused by one set of U.S. GAAP for both privately and publicly held enterprises on a number of occasions. Since 1976, U.S. GAAP has grown to more than 10,000 pages of rules, not counting the publications of the Emerging Issues Task Force (EITF). In the meantime, the International Accounting Standards Board (IASB) and its predecessor, the International Accounting Standards Committee (IASC), have issued more than 2,500 pages of standards, currently styled as International Financial Reporting Standards (IFRS) and previously known as International Accounting Standards. In July 2003, the IASB commenced deliberations on a project, carried over from the agenda of the IASC, to produce a document on accounting standards for small- and medium-sized entities (SME). The discussion below focuses on accounting standards for SMEs and related problems, such as complexity and accounting standards overload.
IFRS for SMEs

In July 2009, the IASB issued IFRS for SMEs, which created a standalone set of accounting principles and disclosures for SMEs. One of the members of the IASB has reported that 74 jurisdictions have adopted [IFRS for SMEs] or announced plans to do so (International Adoption Issues:
A View from the IASB, The CPA Journal, December 2011, p. 10). Although the term SME is used here because it is widely understood internationally, the IASB definition does not limit the term to small- or medium-sized entities. Instead, the definition merely requires that an entity does not have public accountability and that an entity publishes general-purpose financial statements for external users. Public accountability means that an entity has debt or equity instruments that are publicly traded, or that the entity is contemplating issuing such instruments. The term also refers to entities that hold assets as fiduciaries for a broad group of outsiders, such as banks, credit unions, insurance companies, securities broker/dealers, mutual funds, and investment banks (IFRS for SMEs, p. 226, http://eifrs.iasb.org/ eifrs/sme/en/IFRSforSMEs2009.pdf). IFRS for SMEs boils down the 2,500 pages that make up IFRS to 230 pages. To achieve this result, the IASB did not only propose vastly simplified and reduced disclosures; it also provided for simplifiedand, in some cases, differentmeasurement standards. Thus, a company that adopts IFRS for SMEs will not only have different disclosures in its financial statements, but it will also classify debits and credits in the statements differently. IFRS for SMEs represents an important milestone in the search for a simplified and less costly approach to accounting in general-purpose external financial statements of privately held entitiesa problem on which the accounting profession in the United States had previ(Continues on page 8)
AUGUST 2012 / THE CPA JOURNAL
p u b l i s h e r s c o l u m n
A Pound of Cure: Preparing for the ACAs 2014 Deadline

little over two years ago, I wrote about the important role that CPAs will play in translating the provisions of Obamas healthcare reform law, not only to their clients, but also to the public. Since that time, some of the laws provisions have gone into effect, but the legislations centerpiecethe individual mandate that every American have health insurance or be charged a penalty administered by the IRSwas challenged on the grounds that the mandate is unconstitutional. That left most Americans, including employers and the professionals who advise them, to play a waiting game that ended on June 28, when the United States Supreme Court ruled that the Affordable Care Act (ACA) is constitutionaland it is constitutional because it is a tax. So although nothing has changed, everything has changed. While the law, as it was adopted, was always going to rely on taxing high-wage earners to pay for some of the laws cost2013 comes with a new tax on interest income for individuals who earn more than $200,000 ($250,000 for married couples filing jointly) annuallywhat is different is that the 2014 mandate is actually going to happen (although the presidential election does bring with it some level of continuing uncertainty). The net coststhe combined effects on federal revenues and mandatory spendingreflect gross additional costs of $1.5 trillion for Medicaid, the Childrens Health Insurance Program, tax credits, and other subsidies for the purchase of health insurance through newly established exchanges, as well as tax credits for small employers, according to the Congressional Budget Office (CBO); they are offset, in part, by about $0.4 trillion in receipts from penalty payments, the new excise tax on high-premium insurance plans (set to go into effect in 2018), and other budgetary effects (mostly increases in tax revenues). Shortly after the Supreme Court handed down its decision, the CBO announced that it would assess the effects of the courts
ruling on the ACA (due to be released after this issue went to press).
Get Ready
Those who were preparing for the changes the law requires by 2014 are in a better place than those who waited on the Supreme Courts decision: right now there are plenty of employers scrambling to find out what exactly they have to do to prepare, not only as individuals but as CFOs, CEOs, human resource managers, and compliance officersand most of them will be looking to their most trusted advisor to figure it out, their CPA. With the availability of healthcare exchanges, and certain economic incentives within the law, the ACA has the potential to result in fewer companies offering health insurance packages to their employees, depending on the size of their workforce and their industry, which could lead to a more cost-effective arrangement for the employer and a higer salary for the employee. But such speculation doesnt even scratch the surface of the effect the law might have on American businesses and what CPAs need to know to appropriately advise their clients or their colleagues. To prepare these advisors, the NYSSCPA has multiple opportunities for CPAs and the press to learn about the provisions of the law and how to prepare for it. A free September 5 Breakfast Briefing, SCOTUS Approved: The Affordable Care Act: What It Means for Your Clients and Business, will provide a high-level discussion moderated by Trudy Lieberman, contributing editor of the Columbia Journalism Review, focusing on compliance issues and tax planning for CPAs and their clients. The Foundation for Accounting Educations (FAE) upcoming Healthcare Conference on September 13 is a daylong event in Manhattan, also available as a webcast, that will provide tech-
nical guidance so CPAs and other financial professionals can gain a deeper understanding of the law and its implications for their clients and themselves. Ready or not, change is on its way. CPAs of every professional discipline taxation, audit, industry, nonprofit, and governmentwill be called upon by their employers or clients to help comply with the ACA. Not only will CPAs need to understand the implications of these changes, but theyll also need to translate them for clients and colleagues in their own organizations. Decide now what kind of CPA you want to be: the CPA who is ahead of the curve, or the CPA who spends the majority of 2013 playing catch-up. Whichever camp you are in, the NYSSCPA and FAE will help you get to where you need to be. Joanne S. Barry Publisher, The CPA Journal Executive Director, NYSSCPA jbarry@nysscpa.org
(Continued from page 6) ously expended a good deal of effort (e.g., Invitation to Comment: Financial Reporting by Private and Small Public Companies, FASB, November 1981; Sunset Review of Accounting Principles, Technical Issues Committee of the AICPA Private Companies Practice Section, 1982; Report of the [AICPA] Special Committee on Accounting Standards Overload, February 1983). In 1976, many respected CPAs believed that the profession should not have two or more sets of allowable accounting principles in the United States; today, accounting professionals believe that U.S. GAAP is more complex than ever and that IFRS is complex as well. But many also believe that the SEC will prescribe IFRS for U.S. publicly held companies, possibly as early as 2015; this means that there will be at least two sets of GAAP: IFRS for public companies and some form of U.S. GAAP for privately held companies. This situation has already occurred in Canada, where IFRS was adopted for public companies in 2011; the Canadian Institute of Chartered Accountants devoted section 1500 of its latest accounting manual to rules for privately held companies. One of the major problems smaller privately held entities have had with U.S. GAAP is the voluminous and constantly changing nature of the published standardssometimes referred to as accounting standards overload. The IASB has recognized this problem and has proposed that IFRS for SMEs only be amended once every three years through the use of an omnibus document.
AICPAs Auditing Standards Board (ASB), an auditor reporting on statements prepared in conformity with IFRS would refer only to IFRS conformity rather than U.S. GAAP conformity. Because IFRS for SMEs had not been issued in 2008, the ASB interpretation referenced above did not contemplate it; accordingly, it is unclear how a U.S. auditor should report on financial statements prepared in accordance with IFRS for SMEs. One possibility would be for the auditor to include, in the opinion paragraph of the audit report, that the statement is fairly presented in conformity with IFRS for SMEs. The AICPA has already provided the following encouragement about IFRS for SMEs: The AICPA welcomes the introduction of IFRS for SMEs in the United States. Private companies should be allowed to choose the financial accounting and reporting framework that best suits their objectives and needs of their financial statement users. IFRS for SMEs represents another valuable financial accounting and reporting option for private companies to consider using, depending on their unique circumstances. (http://www.ifrs.com/ overview/IFRS_SMES/IFRS_SMES_ FAQ.html#q10)
for intangibles. A presumption of a 10-year amortization period is specified, unless a reliable estimate can be made of another useful life. Do not require an annual review for residual value and useful lives of property plant and equipment, and prohibit the IFRS revaluation option. For first-time adopters of IFRS for SMEs, allow a pass on the recognition of deferred tax assets and liabilities related to the carrying amounts at the time of transition. In a separate document summarizing the basis for its conclusions, the IASB discussed various simplifications that were considered but rejected. Some of the rejected simplifications were as follows: Do not require cash flow statements. Treat all leases as operating leases (not capitalize any leases). Adopt a taxes-paid approach for income taxes and eliminate deferred tax accounting. Account for all employee benefit plans as defined contribution plans.
The Blue Ribbon Panel

The AICPA, the Financial Accounting Foundation (FAF), and the National Association of State Boards of Accountancy (NASBA) formed the Blue Ribbon Panel on Private Company Financial Reporting in 2009, which was tasked with addressing questions concerning the application of IFRS for SMEs. According to a September 2010 Journal of Accountancy article, at least three models were under consideration by the panel, including the following: U.S. GAAP with exclusions for private companies Baseline U.S. GAAP with add-ons for public companies Separate, stand-alone GAAP for private companies, but based on current U.S. GAAP, similar to the Canadian approach.(http://www.journalofaccountancy .com/Issues/2010/Sep/20103099.htm)
Differences Between IFRS for SMEs and U.S. GAAP

The AICPA is committed to publishing a technical comparison between IFRS for SMEs and U.S. GAAP. The following are some of the major simplified measurements provided for in IFRS for SMEs: Expense all research and development costs. This is the same as U.S. GAAP (except for software costs) but would differ from IFRS, which requires capitalization of certain development costs. Expense all borrowing costs, such as interest. This would differ from both IFRS and U.S. GAAP, which require the capitalization of certain borrowing costs. Simplify the measurement of defined benefit pension obligations. Many SMEs do not have defined benefit plans; instead, they have defined contribution plans. Require the amortization of indefinite life intangible assets, including goodwill, and prohibit the IFRS revaluation option
U.S. Reporting and Ethical Standards

Rule 203 of the AICPA Code of Professional Conduct requires member CPAs to take exception to financial statements purporting to be in accordance with GAAP that use accounting principles that depart from those promulgated by bodies designated by Council. In 1973, the Councilthe legislative body of the AICPAdesignated FASB as the body referenced in this rule. In May 2008, the Council designated the IASB as a Rule 203designated body with respect to establishing international financial accounting and reporting principles. As a result of an interpretation issued by the
AICPA Request for an Independent Board

The AICPA has requested that the FAF (and indirectly FASB, which is overseen by the FAF) set up an independent board to establish accounting principles for privately held businesses. In October 2010,
however, the FAF rejected the AICPAs recommendation for a separate board; instead, it suggested an approach that included ratification by FASB of proposals from a separate board responsible for GAAP for privately held businesses. FASB Chair Leslie F. Seidman stated that such a separate board would have its proposals ratified in accordance with a set of pre-established criteria in a similar fashion to FASBs relationship with the EITF (FASB Looks to the Future: Standards Setting in a PostConvergence World, An Interview with Leslie F. Seidman, FASB Chair, The CPA Journal, December 2011). In the meantime, the AICPA organized a letter-writing campaign to the FAF, arguing for a standalone board whose decisions do not require FASB ratification (http://blog.aicpa.org/ 2011/11/chairs-letter-aicpa-turns-125in-2012.html). In May 2012, the FAF announced the creation of the Private Company Council (PCC), which will be responsible for considering whether exceptions to U.S. GAAP are warranted to meet the needs of privately held companies. In a change from the October 2001 proposal, the PCCs recommendations will be subject to the endorsement of FASB, rather than ratification; in addition, the PCC chair will not be a FASB member. The PCC will also have fewer members and meet more frequently than
initially proposed. These changes were intended to strengthen the PCCs independence and led to the AICPAs eventual support of the council, as voiced by AICPA President Barry Melancon (http://blog.aicpa.org/2012/06/why-(PCC) the-aicpa-supports-fafs-creation-of-privatecompany-council.html).
Recommendations
The problems of accounting standards overload and excessively complex standards have festered long enough. FASB often attempts to resolve accounting issues by seeking the one best answer that represents an accounting truth, but the focus should instead be on finding answers that are practical and cost-effective for privately held entities. In addition to the solutions provided in the IASBs IFRS for SMEs, a number of fundamental measurement standards should be considered for repeal or modification. The following are among the most troublesome standards for privately held entities: Deferred tax accounting. This standard could be replaced with an approach that causes privately held entities to simply report as annual income tax expense the amount payable according to the tax return (a taxes-paid approach). Because the present deferred tax approach causes the reporting of an undiscounted liability that
will never be paid, or might only be paid many years in the future, such a taxes-paid approach would be justified on theoretical, as well as practical, grounds. Lease accounting. It seems probable that FASB and the IASB will soon issue new, and vastly different, guidance on lease accounting. Rather than put privately held entities through another exercise in changing their accounting for leases, the boards should consider a simple approach that would allow all leases to be accounted for as operating leases. Pension accounting. The boards should allow privately held entities to account for defined benefit plans as if they were defined contribution plans. The use of such standards for privately held entities would be accompanied by a simple reference to published simplified standards for those entities. The related auditors reports would state that the financial statements are fairly presented in conformity with accounting standards for privately held entities (published by ). In this authors opinion, these methods represent a simple solution for common issues facing the profession and privately held businesses. Charles A. Werner, CPA, is a professor at Loyola University, Chicago, Ill.
Let Us Hear From You

The CPA Journal welcomes letters from readers in response to articles published in the magazine, as well as those concerning issues of general interest to the accounting profession. Although we receive more letters than we are able to publish, all letters receive consideration. The editors reserve the right to edit letters for clarity and length. Writers should include their contact information, including a daytime telephone number and an e-mail address, if possible. Letters may be addressed to Letters to the Editor, The CPA Journal, 3 Park Avenue, 18th Floor, New York, N.Y., 10016, or to cpaj-editors@nysscpa.org.
announcement
2011 Max Block Awards Presented
he winners of the 2011 Max Block Distinguished Article Awards were honored during The CPA Journal Editorial Board meeting on June 4, 2012. This award recognizes excellence in three categories that reflect the mission of The CPA Journal: Technical Analysis, Informed Comment, and Policy Analysis. CPA Journal Editor-in-Chief Mary-Jo Kranacher presented the awards. One author, Sandra B. Richtermeyer, was in attendance at the meeting to accept the award in person; FASB Chair Leslie F. Seidman participated via conference call. The 2011 winners are as follows: Technical Analysis. Estimating the Fair Value of Investments in Entities That Calculate Net Value per Share, by Matthew Crane and Robert A. Dyson, March 2011, won in the Technical Analysis category. This article analyzed Statement of Financial Accounting Standards (SFAS) 157, Fair Value Measurements (now Accounting Standards Codification [ASC] Topic 82010). The authors focused on the difficulty that can occur when applying the guidance to investments in certain nonpublic entities. In addition, they discussed diverging views on fair value and the difficulty in obtaining information on alternative investments. Matthew Crane, CPA, ABV, is a valuation specialist at McGladrey & Pullen LLP. Robert A. Dyson, CPA, is a director at McGladrey & Pullen LLP, as well as a member of the CPA Journal Editorial Board. Informed Comment. Better Analytical Reviews of Charitable Organizations: Using Financial Ratios and Benchmarks, by Janet S. Greenlee, David W. Randolph, and Sandra B. Richtermeyer, July 2011, placed first in the Informed Comment category. The article examined Form 990 tax information submitted to the IRS in order to develop meaningful financial ratios and suitable benchmarks for evaluating the performance of charitable organizations. Janet S. Greenlee, PhD, CPA, is an associate professor of accounting in the school of business administration at the University of Dayton, Dayton, Ohio. David W. Randolph, PhD, CPA, is an assistant
professor of accountancy in the Williams College of Business at Xavier University, Cincinnati, Ohio. Sandra B. Richtermeyer, PhD, CPA, CMA, is a professor of accountancy, also in the Williams College of Business at Xavier University. Policy Analysis. FASB Looks to the Future: Standards Setting in the PostConvergence World: An Interview with Leslie F. Seidman, FASB Chair, pub-
The CPA Journal Editorial Board and Editorial Review Board, who rank a selection of articles from a list of nominees determined by the editorial staff. The editors thank all of the board members who judged the nominated articles.
About Max Block

Max Block (19021988) was a founding partner of Anchin, Block & Anchin
Max Block Award winner Sandra B. Richtermeyer with CPA Journal Editor-in-Chief Mary-Jo Kranacher. lished in the December 2011 issue, won the Max Block Award for Policy Analysis. In the article, Seidman discussed her perspective on standards setting and a global set of standards. In addition, she shared her thoughts on the challenges and opportunities currently facing the CPA profession, as well as on FASBs role in the future. Seidman assumed the position of FASB chair in 2010; she had first been appointed to FASB in 2003 and then reappointed to a second term in 2006. As chair, she leads the organization in providing guidance on both global and domestic concerns. LLP, and he served as managing editor of the NYSSCPAs Journal (now The CPA Journal) from 1958 to 1972. Many individuals who knew him have described him as a visionary whose ideas helped form the basis for many reporting and practice-management concepts used today. Since 1975, The CPA Journal has recognized his contributions and achievements by bestowing the Max Block Distinguished Article Award on the most outstanding articles published in the past year. Although the judging and selection procedures continue to evolve, the criterion remains the same: An innovative and stimulating article which is of current significance and which is likely to be of lasting value.
Determining the Winners

The Max Block Distinguished Article Awards are determined by the members of
10
viewpoint
The Imprecise Nature of Accounting

Questions on Measurement, Standards Setting, and the IASBs Course for the Future
By Hans Hoogervorst
The following is an edited transcript of Hans Hoogervorsts speech at an International Association for Accounting Education and Research conference in Amsterdam on June 20, 2012.
has the same problem as its sibling, economics: you need math to exercise it, but you should not count on outcomes with mathematical precision. In short, I did not have nave expectations of accountingor so I thought. One year later, now that I am well ahead on a steep learning curve, I must admit that I may have been a bit nave after all. Let me give you a couple of examples that served to open my eyes.
Measurement Techniques and Outcomes

First of all, I was struck by the multitude of measurement techniques that both IFRS [International Financial Reporting Standards] and U.S. GAAP [Generally Accepted Accounting Principles] prescribe, from historic cost, through value-in-use, to fair value and many shades in between. In all, our standards employ about 20 variants based on historic cost or current value. Because the differences between these techniques are often
ccounting should be the most straightforward of topics for policymakers to deal with. Accounting is mainly about describing the past in order to faithfully reflect what has already happened. This should be dull business, better left to bean counters. Surely, counting beans cannot cause too many problems; yet, over the years, many securities regulators have told me of their surprise upon finding out that accounting policy is one of the most difficult and controversial topics to deal with. It is the same around the worldjust ask the Japanese FSA [Financial Services Agency], the U.S. SEC, or the European Commission. Why is accounting the source of such heated debates? There are many reasons why this is the case. Sir David Tweedie, my predecessor as chairman of the IASB [International Accounting Standards Board], used to say that it was the job of accounting to keep capitalism honest. It is no wonder that accounting standard setters come under so much pressure. Some business models can thrive off of a lack of transparencyjust think of the pre-crisis Special Purpose Vehicles in the banking industry. There is another reason why accounting can be so controversial: the inescapable judgment and subjectivity of accounting methods. Put simply, there is a lot to disagree about. When I became chairman of the IASB in July last year, I knew enough about accounting to know that I was not entering a world that was governed by the iron rules of science. I knew that accounting
answer. Still, some may find it counterintuitive that a government bond that is held to maturity would be valued at a higher price than the same bond held in a trading portfolio, where it may be subject to a discount. In the exact sciences, such a dual outcome would certainly not be acceptable. One of the biggest measurement dilemmas relates to intangible assets. We know that they are there. While the value of Facebooks tangible assets is relatively limited, its business concept is immensely valuable (although 25% less immense than a month ago). Likewise, the money-making potential of pharmaceutical patents is often quite substantial; however, both types of intangible assets go unrecorded (or underrecorded) on the balance sheet. Under strict conditions, IAS [International Accounting Standard] 38, Intangible Assets, allows for limited capitalization of development expenditures, but we know
It is also remarkable that our standards can cause one and the same asset to have two different measurement outcomes, depending on the business model according to which it is held.
small, the significance of this apparently large number should not be over-dramatized. Still, the multitude of measurement techniques indicates that accounting standards setters often struggle to find a clear answer to the question of how an asset or liability should be valued. It is also remarkable that our standards can cause one and the same asset to have two different measurement outcomes, depending on the business model according to which it is held. For example, a debt security has to be measured at market value when it is held for trading purposes, but it is reported at historic cost if it is held to maturity; in this case, the business model approach certainly provides a plausible the standard is rudimentary because it is based on historical cost, which may not reflect the true value of the intangible asset. The fact is that it is simply very difficult to identify or measure intangible assets. High market-to-book ratios may provide indications of their existence and value. After the excesses of the dot.com bubble, however, there is understandable reluctance to record them on the balance sheet. Although our accounting standards do not permit the recognition of internally generated goodwill, our standards do require companies to record the premium they pay in a business acquisition as goodwill. This goodwill is a mix of many things, including the internally generated goodwill
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of the acquired company and the synergy that is expected from the business combination. Most elements of goodwill are highly uncertain and subjective, and they often turn out to be illusory. The acquired goodwill is subsequently subject to an annual impairment test. In practice, these impairment tests do not always seem to be done with sufficient rigor. Often, share prices reflect the impairment before the company records it on the balance sheet; in other words, the impairment test comes too late. All in all, it might be a good idea if we took another look at goodwill in the context of the post-implementation review of IFRS 3, Business Combinations.
In the future, OCI will certainly be an important source of information about insurance contracts. Several weeks ago, both FASB and the IASB proposed that changes in the insurance liability due to fluctuations in the discount rate would be reported in OCI. Many of our constituents requested us to do so; both preparers and users wanted to prevent underwriting results being snowed under by balance sheet fluctuations. As a result, OCI will become bigger and will contain meaningful information, such as indications of duration mismatches between assets and liabilities.
theoretical underpinning for the meaning of OCI, and we will endeavor to do so. For now, while we may not always know how important OCI exactly is, we can be sure that net income is not a very precise performance indicator either. Both need to be used with judgment, especially in the financial industry.
Standards Setting
What is the reason for all this ambiguity and lack of precision in accounting? Well, to a great extent it is simply the nature of the beast. Valuation is as much of an art as a science, and we are fully aware of that. Our Conceptual Framework says: General purpose financial reports are not designed to show the value of a reporting entity; but they provide information to help users to estimate the value of the reporting entity. Value is ultimately in the eye of the beholder. There is often not a clear-cut answer to the question of which measurement technique is most appropriate to capture it. These comments about the imperfections of accounting should not be interpreted as a sign of wary relativism about the significance of our standards. Quite the opposite: I am deeply convinced that our accounting standards are an essential ingredient of trust in our market economy. In an economic system in which so many parties are working with other peoples money, high-quality accounting standards that provide transparency to the market are of paramount importance.
Defining Income
It is not only the balance sheet that is fraught with imprecision and uncertainty; we also have a problem defining what income is and how to measure it. We report three main components of income: the traditional profit or loss or net income, other comprehensive income [OCI], and total comprehensive income. Total comprehensive income is the easy part; it is simply the sum of net income and other comprehensive income. Not too many people seem to be paying attention to it, even if they should. The distinction between net income and OCI lacks a well-defined foundation, however. While the P&L [profit and loss statement] is the traditional performance indicator on which many remuneration and dividend schemes are based, the meaning of OCI is unclear. It started as a vehicle to keep certain effects of foreign currency translation outside net income and gradually developed into a parking space for unwanted fluctuations in the balance sheet. There is a vague notion that OCI serves for recording unrealized gains or losses, but a clear definition of its purpose and meaning is lacking. But that does not make OCI meaningless. Especially for financial institutions with large balance sheets, OCI can contain very important information; it can give indications of the quality of the balance sheet. It is very important for investors to know what gains or losses are sitting in the balance sheet, even if they have not been realized.
For now, while we may not always know how important OCI exactly is, we can be sure that net income is not a very precise performance indicator either.
This decision for the use of OCI was not easy to make. Our fellow board member Stephen Cooper showed us in a razor-sharp analysis that, in this presentation, both net income and OCIif seen in isolation might give confusing information. We will try to tackle some of these problems with presentational improvements. But it is also clear that a full picture of an insurers performance can only be gained by considering all components of total comprehensive income. We will point this out explicitly in the basis for conclusions of the new standard. More fundamentally, we will look at the distinction between net income and OCI during the upcoming revision of the Conceptual Framework. All of our constituents have asked us to provide a firm
High-Quality Standards
IFRS, as a global standard, has had a tremendously beneficial impact for global investors, who lacked all comparability in the pre-IFRS days. Several academic studies have shown that the introduction of IFRS has contributed to lowering the cost of capital. Moreover, financial reporting does not need to be mathematically exact to be useful; it is a tool to help investors on their way. Warren Buffett is known to use financial reports as a rough-and-ready checklist: more than five or six question marks are enough for him to decide against making an investment. One has only to look at the insurance industry to see how essential proper
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accounting standards are. Currently, IFRS does not have a full-blown standard for insurance. As a result, financial reporting by the industry is riddled with nonGAAP measures, and there is a serious lack of comparability. Because the industrys reporting lacks the underlying rigor of uniform accounting, investors demand a higher price for capital to make up for the lack of transparency. Public sector accounting also demonstrates the primitive anarchy that results without the discipline and transparency that good financial reporting provides. While the IPSASB [International Public Sector Accounting Standards Board] has created good standards for the public sector, based on IFRS, they are used only haphazardly. Around the world, governments give very incomplete information about the huge, unfunded social security liabilities they have incurred. Many executives in the private sector would end up in jail if they reported like ministers of finance, and rightly so. There can be no question about the relevance and importance of our standards. As the convergence program comes to a close, and the IASB is ready to take on a new agenda, we should concentrate on further improving the quality of our standards. Although we know that some of the imprecision and ambiguity I mentioned before is inevitable, it is our job to push back the grey areas in accounting as far as possible. So how should we go about it? I believe we should be guided by the following three terms: principles, pragmatism, and persistence. For the very reason that accounting is not an exact science, principles-based standards setting remains the right way forward. If the use of judgment is inescapable, it should be guided by clear principles and not by detailed, pseudo-exact rules. We will strengthen our basic principles by finishing the review of the Conceptual Framework and by tackling thorny issues such as measurement, performance indicators, OCI, and recycling. While I am not so nave to think that a new Conceptual Framework will solve all our problems, I think it can serve to give us firmer ground under our feet. Even if precise answers are not always available, a completed Conceptual Framework should give us more guidance on the recognition
of assets and liabilities, measurement techniques, and performance indicators. If we know that there is not always a precise answer to every question, our work needs to be grounded in pragmatism and common sense. As [economist John Maynard] Keynes said, it is better to be roughly right than to be precisely wrong. We should avoid trying to get companies to achieve precision without accuracy. Pragmatism also means we need to look very carefully at any possible undesirable
That is why we need persistence, too. In the face of the pressures we are continually facing, persistence is an important quality for standard setters. Accounting standards setting should be sensitive to legitimate business concerns, but should also be firm and independent in the face of special interests. Many times, doomsayers have predicted their business would come to an end as a result of our standards. Just as often, the industry in question miraculously seemed able to survive our rules very well indeed. We always need to listen, but we have to take decisions, too.
Looking to the Future
While investors are our prime audience, their voice is too often drowned out by vociferous business interests.
use of our standards. Whenever we are confronted with a high degree of uncertainty, we should act with great caution. I just gave the example of intangible assets. We know they are there, but measurement is a big problem. If our standards were to provide too much room for recognition of intangible assets, the potential for mistakes or abuse would be immense. In such circumstances, it is better for our standards to require more qualitative reporting than pseudo-exact quantitative reporting. People always tell us we should not set our standards from an anti-abuse perspective; I think that is nonsense. If we see ample scope for abuse in a standard, we had better do something about it. There are sufficient temptations and incentives for creative accounting as it is. Pragmatism is important, but it should not be confused with opportunism.
For the IASB to persist on a steady course, it would be hugely beneficial if investors views were heard more loudly and clearly than currently is the case. While investors are our prime audience, their voice is too often drowned out by vociferous business interests. In the coming years, we are determined to further invest our relationship with investors in order to ensure that we get more balanced feedback on our proposals than currently is the case. We are especially interested in strengthening our relations with what I would like to call our end-users. With this term, I refer to true investors, in the sense that they actually own assets, such as institutional investors. The support of the investor community will make it easier for us to stay our course. So it is with principles, pragmatism, and persistence that the IASB will take on its new agenda. We should use the coming years to strengthen the underlying principles of our work. We should improve the significance of the quantitative outcome of our standards where possible. Where this is impossible, we should make this clear and put more emphasis on qualitative information. This is all much easier said than done, but my board looks forward to taking on this challenge with our highly motivated staff. Whatever the coming years may bring, it is clear that they will not be a peri od of calm. Hans Hoogervorst is the chairman of the IASB.
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education
Teaching and Advising a New Generation of Accounting Students

A Glimpse into the NYSSCPAs 2012 Higher Education Conference
By Stephen Scarpati and Patricia Johnson
ollege students considering a major in accounting and a career as a CPA quickly learn that there is nothing easy about the process: they discover that the undergraduate accounting curriculum is more rigorous than that of other business majors and they are told that this must be followed by demanding graduate studies. Students then hear of the infamously difficult CPA exam, as well as stories of long hours once they start work. To an 18- or 19-year-old student, the entire prospect can seem frightening. Consequently, individuals pursuing careers as a CPA frequently look to professionals they know for guidance and advice. CPAs who are in a position to offer such counsel usually welcome the opportunity; often, they find it rewarding to share their experiences and instill an understanding of the profession in students. Mentors also learn something in the process: this generation of young people differs from the generations that preceded it. Furthermore, the work environment that these young people are entering offers new sets of challenges. College accounting professors, by necessity, are at the forefront of advising students about CPA careers. This advice usually takes multiple forms. First are the factsexplaining the requirements for licensure in the particular state in which a student wants to work. Second is reassurance to an often-overwhelmed freshman or sophomore that this formidable career path is a road worth taking. While some students back away, others step up. Many CPAs often recall that the encouragement
of an accounting professor pointed them toward a rewarding career. With full recognition of their need to remain current with this mission, a large group of educators met at KPMG headquarters in New York City for the NYSSCPAs 2012 Higher Education Conference. To assist accounting professors in their dual role of advisor and teacher, the Higher Education Conference covered the following topics: The Millennial generation Careers in accounting CPA licensure Program assessments Technology A professional update.
The Millennial Generation

During the conference, a fascinating wealth of information came from Richard Sweeney, university librarian at the New Jersey Institute of Technology, Newark. He presented his research on the Millennial generation, which comprises individuals who were born between 1980 and 1994. Because this includes current undergraduate students, college professors attending the event were extremely interested in the topic. According to Sweeneys research, this generation definitely has different behaviors from the generations that preceded it. (Exhibit 1 presents an excerpt from Sweeneys research.) An intercollegiate focus group of accounting majors from Fordham University and Manhattan College in the Bronx, N.Y., and Sacred Heart University, in Fairfield, Conn., augmented the presentation. The ensuing dialogue with the students reinforced many of the research points and acted as a learning experience for attendees. The following lessons can be incorporated into accounting classes: More hands-on learning Further engagement of students, when possible Creating a sense of personal involvement and interaction in the classroom.
Careers in Accounting
The conference featured four sessions that covered the following topics related to careers in accounting: Government accounting
Internal auditing Management accounting Accounting recruiting. Government accounting. Because government accounting is not usually included in core accounting curriculums, careers in this field can often be overlooked. Michele Mark Levine, director of accounting services for the New York City Office of Management and Budget, increased accounting educators awareness of the nature, variety, and quantity of career opportunities in government. She provided information and resources that were useful for interested educators and students. Levine also identified and discussed issues related to government accounting and auditing that are currently facing the accounting profession. The first issue she discussed was governmental GAAP, which is promulgated by the Governmental Accounting Standards Board (GASB) for U.S. state and local governments, the Federal Accounting Standards Advisory Board (FASAB) for the U.S. federal government, and the International Public Sector Accounting Standards Board (IPSASB) for many non-U.S. government entities. (While there are some project collaborations between GASB and IPSASB, there is no planned convergence between the sets of standards.) A second issue that Levine addressed was the question of what CPAs in government actually do. The answer, in short, was: almost everything that CPAs in any organization do. Most private sector accounting and auditing work has a governmental counterpart; however, some governmental work, such as law enforcement, is only performed in or under the auspices of government. Levine also mentioned some of the attractions of careers in government, including favorable work/life balance, attractive employee benefits such as health insurance and defined benefit plans, and a spirit of public service. A vigorous discussion with conference participants followed, focusing on the role of politics in government accounting. Some attendees believed that this might be a drawback to careers in the field; Levine acknowledged a need to tolerate some polAUGUST 2012 / THE CPA JOURNAL
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itics but thought that, in the end, talented people will rise through the government ranks. Internal audit. Another career field that can be overlooked is internal auditing. Charles Windeknecht, vice president of the internal audit function of Atlas Air Worldwide, updated attendees on why internal auditing represents an important cornerstone in corporate governance. Windeknecht indicated that an internal audit is an objective assurance and consulting activity designed to add value and improve an organizations operations; it helps an organization accomplish its objectives by using a systematic, disciplined approach in order to evaluate and improve the effectiveness of risk management, control, and governance processes. Windeknecht said he believes that its a great time to be an internal auditor because, not only is the profession growing, it offers accountants the opportunity to understand a business, its risks, and its controls. He also briefed educators on the Institute of Internal Auditors (IIA), the international professional association established in 1941 that has more than 150,000 members and operates in 165 countries and territories. The IIAs vision is to be the global voice of the internal audit professionadvocating its value, promoting best practices, and serving its members. Management accounting. Jeffrey Thomson, president and CEO of the Institute of Management Accountants (IMA), shared his perspective on this field. According to Thomson, too much time is spent recording rather than driving businesses. He discussed the importance of preparing students for careers in accounting and not just their first job. In addition, he stated that about 80% of students will eventually work in the field of management accounting and that the global market for accountancy remains healthy and resilient. The IMA and the management accounting division of the American Accounting Association are currently developing a model curriculum for management accounting. Student chapters and academic partnerships play an important role in this curriculum. Resources for faculty include case studies for use in the classroom, as well as research opportunities.
Accounting recruiting. A panel of college recruiters from KPMG, PricewaterhouseCoopers, McGladrey, Protiviti, and OConnor Davies spoke about the current status of recruiting young accountants, as well as their expectations for new graduates. Representatives from both big and small firms debated the relative benefits of each entity. Recruiters from smaller firms emphasized the opportunities for young accountants to experience a greater variety of industries and more fully develop their skill sets.
the partners and recruiters of the firms visiting their campuses.
CPA Licensure: New York State Update

Mary Beth Nelligan-Goodman, acting executive secretary of the New York State Board of Accountancy, provided timely information about the education requirements for 1) sitting for the CPA exam and 2) becoming licensed as a CPA. For the former, applicants need to have completed 120 credit hours and must have taken one course in each of the following areas: Financial accounting and reporting Cost or managerial accounting Taxation Auditing and assurance services. In order to become licensed, applicants must show that they have completed 150 credit hours, including 33 hours in accounting and 36 hours in business, as well as one year of experience. They must demonstrate that they have covered ethics and professional responsibilities, business and accounting communications, and accounting research; however, these areas can be embedded in a variety of courses. Applicants can count internships in accounting as belonging to either the accounting or business content areas. The 2009 accountancy reform law expanded the scope of practice in New York; now a broad range of experience, under the direction of a CPA, will qualify an individual for licensure. The passing rate on the CPA exam has remained relatively consistent over the past several years. In 2011, coverage of International Financial Reporting Standards (IFRS) was added to the exam, along with changes in the simulations, a new research task format, new authoritative literature (FASB codification), and the inclusion of the written communication component in the business environment concepts (BEC) section of the exam. Candidate satisfaction with the exam remained high. Starting in August 2011, the CPA exam was offered in selected Prometric testing centers overseas; the exam is given in English, and candidates abroad must meet the same requirements as U.S. candidates. One noteworthy change in the continuing education requirements relates to the
Many CPAs often recall that the encouragement of an accounting professor pointed them toward a rewarding career.
Recruiters from large firms noted the trend toward increased specialization earlier in the careers of young accountants who joined their firms, as well as more exposure to both international and larger clients. Additional comments from the panel included the following: The expansion of the definition of public accountancy in New York State has not had an impact. Increasingly, an internship is the optimal first step on the path to a full-time position. All firms place a high priority on students plans to attain their 150 hours of education prior to beginning employment. The lack of business writing skills among college graduates continues to be a problem. The current generation of young adults is more laid-back, with a more casual communication style that is often not appropriate in business circumstances. Educators were urged to get to know
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professional ethics requirement: effective for registrations taking place on or after January 1, 2012, the required four credits of ethics must be completed within the three prior calendar years.
Program Assessment
The issue of program assessment is one that all educators have been dealing with, in one form or another. Eileen Beiter, an assistant professor at Nazareth College, Rochester, N.Y., and Maxine MorganThomas, an assistant professor at Long
Island University, Brooklyn, N.Y., shared their experience developing and refining program-assessment strategies. They emphasized the importance of identifying what is being assessed, how it is being assessed, and where it is being assessed (what course or series of courses), as well as keeping the process simple. Takeaways for conference attendees included curriculum-mapping examples and sample rubrics. To stay competitive, programs must let the results, both favorable and unfavorable, inform future changes in the curriculum.
Technology
It is important for both educators and students to understand the role of accounting information systems, as well as the available technology tools, in making the practice of accounting more efficient. Accounting information systems. The importance of understanding how to effectively provide information in order to support decision making and business processes has grown as the role of accounting in an organization has evolved. One related topic, requested by conference attendees in
EXHIBIT 1
Research Excerpt: How Millennial Behavior Differs from Previous Generations at the Same Age
Millennials More Consumer Choices; Selectivity Born from 1980 to 1994; ages 32 to 18 in 2012; largest generation since Baby Boomers; most racially and ethnically diverse U.S. generation ever; more than 40% are children of divorce. One of the most important Millennial behaviors is their expectation for more selectivity and options. They have grown up with a huge array of choices and they believe that it is their birthright. They feel less need to conform in their consumer choices to everyone else in their generation or other generations. The converse is also true: they are most unhappy with limited choices. Once Millennials do make their choices in products and services, they expect many personalization and customization features that meet their changing needs, interests, and tastes. Millennials, by their own admission, have no tolerance for delays. They require almost constant feedback to know how they are progressing. They hate it when they are delayed, required to wait in line, or have to deal with some lengthy unproductive process. The need for speed and efficiencyor, as some believe, instant gratificationpermeates virtually all of their service expectations. Millennials strongly prefer learning by doing. They almost never read the directions; they love to learn by interacting. Multiplayer gaming, computer simulations, and social networks are some of their favorite environments and provide little penalty for their trial-and-error learning. By and large, Millennials have said that they find their average lectures boring. With such experiential learning, Millennials get much more interactivity and feedback about what works and what does not. They expect to spend no more than 18 months to two years in their first job, expect constant practical training and useful skills, want office hours with flexible schedules, and are more likely to be recruited online. Sixty-one percent of CEOs say they have difficulty attracting and integrating younger workers. They dont want to work 80 hours per week and sacrifice their health and their leisure time, even for considerably higher salaries; free time is more important than compensation. Yet, they typically expect incomes exceeding their parents. Millennials prefer to keep their time and commitments flexible longer in order to take advantage of better options; they also expect employers, other people, and institutions to give them more flexibility. They want to time and placeshift their services, where and when they are ready. They want more granularity in the services, so they can be interrupted and finish when they are ready without loss of productivity.
Personalization and Customization Impatient
Experiential Learners
As Employees
Balanced Lives
Flexibility/Convenience
Source: Richard Sweeney, New Jersey Institute of Technology, 2012, used with permission under a Creative Commons attribution, share-alike, noncommercial license.
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previous years, focused on how to develop and implement a course in accounting information systems. James Goldstein, an assistant professor at Canisius College, Buffalo, N.Y., shared tips on establishing a course, topics to cover, and software and textbooks that educators can utilize. The following were the objectives for a course in accounting information systems: Identifying and modeling business processes Designing and implementing systems to carry out routine tasks Designing and implementing internal controls in information systems. Tools for improving efficiency and effectiveness. CPAs Stephen Valenti and Peter Frank shared how they utilized a variety of technology tools, both at work and at home. Whether organizing a music collection or accessing client tax returns remotely, users should select the right device for the task at hand, considering both costs and benefits. Whether individuals are students, educators, or practitioners, the key is to identify the features of new tools that are most important to those individuals. Functionality is crucial. For educators interested in augmenting the classroom experience, it can be timeconsuming to try to understand the limitations of technology, such as device specifications or wireless data plan contracts, but it is definitely time well spent. The ability to access files anywhere at any time has become a reality; the choice of what device to use in doing so is an individual decision. Valenti and Franks presentation concluded with a look into the near future, and highlighted the following near-term developments: New operating systems Cross-platform compatibility Enhanced processor, graphics, and battery life Lighter devices Hybrids Improved cloud options.
accounting professionals. Teresa E. Iannaconi, a partner at KPMG, presented an update on issues currently under discussion within the profession. Her remarks focused on what constitutes risk accountants and auditors need to consider risk not only with regard to what should be quantified on the financial statements, but at a broader level. Exposure to reputational risk in the Internet age is an area of increasing concern for corporations. The SEC has recently issued guidance on assessing the need for disclosures about cyber security, as well as European debt exposure. Disclosure overload continues to be discussed, and the question of enhancing understandingutilityshould be the main concern in determining the right level of disclosure. Foreign operations are also high on the SECs agenda as legal and cultural differences continue to complicate international transactions. In addition, Iannaconi encouraged educators to familiarize students with uncertainty in financial statements; everything on the statements, with the possible exception of cash, involves uncertainty to some degree. Fair value, the use of non-GAAP measures, and loss contingency disclosures have also received recent attention from the SEC. Two current FASB-IASB joint projects focus on revenue recognition and accounting for leases. The final revenue recognition standard is expected later this year. The scope of the proposal is limited to revenue arising from contracts with customers. One of the key impacts of the new standard for lease accounting is the inclusion of virtually all leases on the balance sheet, effecting key ratios and covenants. The boards received more than 800 com-
ment letters in response to the original exposure draft, which led to the reexposure of the proposed leasing standard. The final leasing standard is expected in 2013, with a likely effective date of 2016 or later. Modifications to the auditors report, auditor independence, and auditor rotation have all been under discussion by the PCAOB. The final standard on communications with audit committees is expected later this year.
Collaborative Benefits
Collaboration among practitioners and educators provides students with a bridge to the profession, and taking the opportunity to learn from each other helps ensure that students receive a relevant education that meets the needs of their future employers. For those in attendance, the NYSSCPAs 2012 Higher Education Conference provided information that can be applied in the classroom to improve accounting education. In addition, professors gained updated insight and knowledge that will help them better advise a new generation of accounting students as they embark on the path to becoming a CPA. Stephen Scarpati, CPA, CLU, ChFC, is an accounting professor at the John F. Welch College of Business at Sacred Heart University, Fairfield, Conn., and a member of The CPA Journal Editorial Board. Patricia Johnson, MBA, CPA, CFE, is an accounting professor at Canisius College, Buffalo, N.Y.; past chair of the NYSSCPAs Higher Education Committee; and a board member of the Foundation for Accounting Education.
Correction
In The Best Firms to Work For: Popularity, Prestige, and Quality of Life Rankings Explored, published in the July 2012 CPA Journal, Ernest Patrick Smith was incorrectly identified as a professor of fraud and forensic accounting at Hofstra University; he is an adjunct instructor of fraud and forensic accounting. In addition, one statement attributed to SmithAnd in at least one graduating accounting class at Hofstra, not one person has plans to work at a large accounting firm, according to Smithwas meant to refer to one accounting class that he taught that included six students, rather than the entire graduating class of the university. The editors apologize for any confusion.
Professional Update
Keeping current on what is happening with the SEC, FASB, the International Accounting Standards Board (IASB), and the Public Company Accounting Oversight Board (PCAOB) is important to all
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technology
Quick Response Codes: A Marketing Tool for Accounting Firms

By James Alexander
n todays technological world, it is critical for businesses to have an online mobile presence that contacts can easily access. More than 50% of online searches now begin on a mobile phone. Approximately 500 million Facebook users have used mobile devices to access their pages. Professional networking site LinkedIn has reported that nearly one quarter of its unique visitors in a recent three-month period accessed the site from a mobile device. Yet most accounting firms dont have mobileoptimized websites, even though a weak or nonexistent mobile presence can cost an accounting firm business. Quick response (QR) codes are a marketing tool widely used by top consumer brands to bolster their mobile marketing efforts. QR code use is also making serious inroads into the marketing strategies of professional services firms, and for good reason: according to a recent comScore study, more than 20 million Americans scanned a QR code with a smartphone in just one three-month period last fall (http://www.comscoredatamine.com/2011/ 12/20-million-americans-scanned-aqr-code-in-october/). These two-dimensional codes can be printed on business cards, brochures, proposals, and other material in order to direct users to a website for further information. Professional services organizations, such as accounting firms, are increasingly using the codes to provide potential clients and business contacts with additional information online. QR codes can be an excellent marketing tool, but professionals who use them should follow best practices in their QR code campaign to ensure that visitors learn something new and retain the contact information for later reference.
addition of QR codes to their overall marketing strategy is the information that they will convey with the code. Its not enough just to integrate QR codes into a firms overall marketing campaign. If the code merely leads visitors to the standard firm website, it can even be counterproductive if the site isnt optimized for mobile viewing. Ideally, the QR code should lead users to a site containing unique information. The site should showcase items like the firms contact information, credentials, and value proposition. For example, the site linked to the QR code could serve as a mobile business card that allows new acquaintances who scan it to retain the accounting professionals contact informa-
A QR code strategy can be an exceptional marketing tool, but it pays for professionals to think through the approach.
tion on their smartphone for future reference. It could also deliver one-click access to hand-picked Google search results to connect users to relevant links that make a positive first impression, videos of the professional discussing an area of expertise, access to online bios, and other relevant information. Firms should keep in mind that the website linked to the QR code will almost always be viewed on a mobile device. For that reason, its important to direct contacts who scan the code to a mobile-optimized site; visitors are unlikely to scroll from side-to-side to view a standard website on a small smartphone screen.
nielsenwire/online_mobile/smartphonesaccount-for-half-of-all-mobile-phones-dominate-new-phone-purchases-in-the-us). Thus, accounting firms that do not have a mobile web presence could be at a competitive disadvantage. QR codes are an inherently mobile tool because people scan them with smartphones and other mobile devices, such as tablets. Accounting firms that use QR codes can stay ahead of the curve when it comes to mobile marketing if they choose a QR code service partner that offers mobile site options, such as a microsite, that can bridge the gap between the firms printed material and mobile information. For example, Melissa Burnside, marketing coordinator at REDW LLC, a New Mexico CPA and business consulting firm, recently began using QR codes on accounting professionals business cards. She observed: QR codes are still somewhat novel on business cards. In fact, I believe we are one of the first CPA firms to implement QR codes. They make a great conversation starter with clients and business contacts, but more importantly, they fit nicely with our social media strategy because they give our accountants another way to connect with new contacts and share information on a mobile device. Its an instant mobile presence that also conveys the fact that our firm is forward-thinking.
Adding It All Up
Mobile marketing is an increasingly important component of a total marketing strategy for individual professionals and firms. A QR code strategy can be an exceptional marketing tool, but it pays for professionals to think through the approach and make sure that using QR codes will the codes deliver their information in the appropriate form. With the right QR code approach, as well as QR code service partner that delivers more than just a code and a link to a main website, accounting firms can effec tively showcase their qualifications. James Alexander is founder and CEO of Vizibility Inc., New York, N.Y., an online identity management platform.
Bridging the Digital Gap with QR Codes

According to a 2012 Nielsen study, about half of all mobile phone users in the United States use smartphones, which represents a nearly 40% increase over the previous year (http://blog.nielsen.com/
Delivering Value and Optimizing Mobile Viewing

The most important consideration for accounting professionals contemplating the
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inbox: letter to the editor
Rethinking the Audit

he NYSSCPA, the editors of The CPA Journal, and those who write for the Journal each month should all be commended for the quality of their work and their commitment to the accounting profession. The recent articles, Enron Ten Years Later: Lessons to Remember (Anthony H. Catanach, Jr., and J. Edward Ketz, May 2012) and, earlier, Mark-toMarket's Real Role in the Crisis: How Accounting Standards Helped Build the Super Bubble (Gina McMahon, February 2011), are outstanding examples of what should be found in journals written for practitioners and financial accounting statement users. I doubt that any other publication would have the courage or the insight to make available the results of similar research, carried out on critical issues of professional import. The assessment of the AICPA by Catanach and Ketz is well received. The AICPA is a reflection of a problem identified in a monograph by John Buckley (University of California, Los Angeles) for the California Society of CPAs, published in 1969. In it, Buckley asserted that CPAs had lost their identity. Robert K. Mautz, in a monograph for the American Accounting Association, drew an important distinction between accounting as a practice and auditing as a profession. Professions hold a socially granted franchise, mandate, or monopoly to provide an essential service, which is acknowledged through licensing and government oversight. My own dissertation research from 1987 to 1988 documented the validity of Buckley's concern. When a large number of CPAs in practice and in industry were asked one questionWhat is the unique role (function) of the CPA?more than two-thirds did not answer with auditing/attestation. In my opinion, the AICPA fell into the trap of the times in the 1980s: head count and membership revenue. Almost any warm body could join. The AICPA sold out the audit side of the profession when it agreed to the Justice Departments demand for a change in the Code of Professional Ethics, which had long protected the profession from commercialization. Subsequently, the management of the
thenBig Eight decided to compete not on quality but on price, thus destroying the traditional economics of the firms and forcing the pursuit of non-audit revenues. Ultimately, the non-audit revenue producersthe consultantstook over the management of the firms, and marketing pressure, rather than accounting and auditing expertise, came to dominate. Arthur Andersens consulting partners, fed up with subsidizing auditing, split from Andersen Consulting to become Accenture. The same forces were at work in the other firms, leading to the mergers that have since resulted in the creation of the Big Four. If one looks carefully at the economic model of an audit-based firm, the future is
Perhaps it is time to rethink the relationship between the requirement for the statutory audit and the ability of the private sector to perform it.
bleak. Using the basic accounting equation, the situation becomes clear. A firm can monetize its assets, but most of its real value resides in its professional staff. The equity can be monetized by measuring the partnership/LLC capital. The problem lies with liabilities. The reality is that the number is immeasurable, potentially infinite; there is a structural reason for this. The statutory audit is a socially demanded product. The production has been outsourced to CPAs, but the auditor has no statutory power or protection to do the work. The private sector has not been given the investigative power, authority, and protection it needs. If financial statement auditors had the same legal status as IRS
auditors, they would have governmentgranted power and protection. The consequences for lying to an IRS auditor are severe and well known. The consequences for lying to a private sector auditor carrying out a government service obligation are also severeespecially for the auditor. A client will often take an auditor to court, as will stockholders, creditors, and other stakeholders. At best, it becomes a he said, she said confrontation; at worst, it becomes an autopsy or malpractice case, where the client-patient is dead or injured and the blame or fault is attributed to the auditorafter the lawyers have directed attention away from management. In some cases, a true professional failure has occurred; however, in many other situations, the auditor did not know and could not have knownbut in hindsight should have or could have known. Client management has every reason not to cooperate with an auditor because failure and liability will inevitably accrue to the auditor. One of the rubrics of auditing is to follow the money. Who pays for the audit? Company management. What do they expect for their money? Certainly not a negative report. IRS auditors, who also provide an attest service to society, do not face this same pressure. They are protected from both financial pressure and the legal consequences of failure or disagreement. Perhaps it is time to rethink the relationship between the requirement for the statutory audit and the ability of the private sector to perform it. Perhaps it is time to acknowledge that public accounting firms can be providers of financial and accounting services on many dimensions. But on the other hand, perhaps the attest function must be shifted to government, where the likelihood of expected performance can be monitored and enhanced, and where attestors can receive adequate and appropriate power and protection to do the work, ask the questions, and write the assessments expected from them. William Bruce Schneider, PhD, CPA (retired) California State University and the Maastricht School of Management Los Angeles, Calif.
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C C O U N T I N G
& A auditing
U D I T I N G
Material Internal Control Weakness Reporting Since the Sarbanes-Oxley Act

By Thomas G. Calderon, Li Wang, and Edward J. Conrad
ection 404(a) of the Sarbanes-Oxley Act of 2002 (SOX) requires the senior management of U.S. public companies to issue a report assessing the effectiveness of the companys internal control over financial reporting (ICFR). In addition, SOX section 404(b) requires the independent auditors of U.S. public companies to attest to the effectiveness of ICFR, although smaller public companies have been permanently exempted from this provision. Through these reporting requirements, regulators have sought to improve the quality of financial reporting and bolster investor confidence. An entitys ICFR is considered ineffective if a material weakness is identified. The Public Company Accounting Oversight Board (PCAOB) defines a material weakness as a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the companys annual or interim financial statements will not be prevented or detected on a timely basis (Auditing Standard [AS] 5, An Audit of Internal Control over Financial Reporting That Is Integrated with an Audit of Financial Statements, Appendix A, A7, PCAOB, 2007). Numerous studies have examined various issues related to material weakness reporting, such as the following: Characteristics of companies reporting material weaknesses (e.g., Weili Ge and Sarah E. McVay, The Disclosure of Material Weaknesses in Internal Control After the Sarbanes-Oxley Act, Accounting Horizons, vol. 19, no. 3, pp. 137158, 2005; Jeffrey T. Doyle, Weili Ge, and Sarah E. McVay, Determinants of Weaknesses in Internal Control over Financial Reporting, Journal of Accounting and Economics, vol. 44, no. 1/2,
pp. 193223, 2007; Hollis Ashbaugh-Skaife, Daniel W. Collins, William R. Kinney, Jr., and Ryan LaFond, The Effect of SOX Internal Control Deficiencies on Firm Risk and Cost of Equity, Journal of Accounting Research, vol. 41, no. 1, pp.143, 2009) Changes in corporate governance after reporting material weaknesses (e.g., Karla M. Johnstone, Chan Li, and Kathleen Hertz Rupley, Changes in Corporate Governance Associated with the Revelation of Internal Control Material Weaknesses and Their Subsequent Remediation, Contemporary Accounting Research, vol. 28, no. 1, pp. 331383, 2011) Capital market reactions to material weaknesses (e.g., Ashbaugh-Skaife 2009; Messod D. Beneish, Mary B. Billings, and
Leslie D. Hodder, Internal Control Weaknesses and Information Uncertainty, Accounting Review, vol. 83, no. 3, pp. 665703, 2008; Jacqueline S. Hammersley, Linda A. Myers, and Catherine Shakespeare, Market Reactions to the Disclosure of Internal Control Weaknesses and to the Characteristics of Those Weaknesses Under Section 302 of the Sarbanes-Oxley Act of 2002, Review of Accounting Studies, vol. 13, no. 1, pp. 141165, 2008) The relationship between material weaknesses and earnings quality (e.g., Jeffrey T. Doyle, Weili Ge, and Sarah E. McVay, Accruals Quality and Internal Control over Financial Reporting, Accounting Review, vol. 82, no. 5, pp. 11411170, 2007; Kam C. Chan, Barbara R. Farrell, and Picheng Lee,
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Earnings Management of Firms Reporting Material Internal Control Weaknesses Under Section 404 of the Sarbanes-Oxley Act, Auditing: A Journal of Practice and Theory, vol. 27, no. 2, pp. 161179, 2009; Ruth W. Epps and Cynthia P. Guthrie, Sarbanes-Oxley 404 Material Weaknesses and Discretionary Accruals, Accounting Forum, vol. 34, pp. 6775, 2010) The effects of material weaknesses on the cost of debt or equity (e.g., Maria Ogneva, Kannan Raghunandan, and K.R.
Subramanyam, Internal Control Weakness and Cost of Equity: Evidence from SOX 404 Disclosures, Accounting Review, vol. 82, no. 5, pp. 12551297, 2007; Dan S. Dhaliwal, Chris E. Hogan, Robert Trezevant, and Michael S. Wilkins, Internal Control Disclosures, Monitoring, and the Cost of Debt, Accounting Review, vol. 84, no. 4, pp. 11311156, 2011). In contrast to prior studies, the analysis below reviews the trend and frequency of reported material weaknesses from 2004 to
2010, examines how company size correlates with material weaknesses, discusses how significant regulatory events altered ICFR reporting, describes the specific types of material weaknesses that were most prevalent during the 20042010 reporting period, and reports on the extent to which different types of material weaknesses persisted among companies. The conclusion discusses the implications of these material weaknesses for auditors, management, and boards of directors.
EXHIBIT 1 Timeline of Significant Events Related to Internal Control Reporting

Organization Public Company Accounting Oversight Board (PCAOB) SEC Event Auditing Standard (AS) 2, An Audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of Financial Statements Requirement (Press Release, February 24, 2004) Effective Date for Compliance with SOX Section 404 Reporting Requirements Fiscal years ending after November 15, 2004
Accelerated filers: fiscal year ending after November 15, 2004 Nonaccelerated filers and foreign private issuers: fiscal year ending after July 15, 2005
SEC SEC SEC
Extension (Press Release, March 2, 2005) Extension (Press Release, September 22, 2005) Extension (Press Release, August 9, 2006)
Nonaccelerated filers and foreign private issuers: fiscal year ending after July 15, 2006 Nonaccelerated filers: fiscal year ending after July 15, 2007
Nonaccelerated filers: SOX section 404(a), fiscal year ending after December 15, 2007; SOX section 404(b), fiscal year ending after December 15, 2008 Accelerated foreign private issuers: SOX section 404(b), fiscal year ending after July 15, 2007 Fiscal year ending after November 15, 2007
PCAOB
AS 5, An Audit of Internal Control over Financial Reporting That Is Integrated with an Audit of Financial Statements, superseded AS 2 (June 12, 2007) Management Guidance (Press Releases, June 27, 2007) Extension (Press Release, February 1, 2008) Extension (Press Release, October 2, 2009) Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
SEC SEC SEC Congress
Management guidance for evaluating and assessing internal control over financial reporting (ICFR) Nonaccelerated filers: SOX section 404(b), fiscal years ending after December 15, 2009 Nonaccelerated filers: SOX section 404(b), fiscal years ending after June 15, 2010 Permanently exempted nonaccelerated filers from SOX section 404(b) requirements
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Background
Originally, the SEC required larger public companies (i.e., accelerated filers) to comply with SOX section 404 starting in 2004. To aid auditors in addressing the new requirements, the PCAOB issued AS 2, An Audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of Financial Statements, in 2004. The first two
years of implementation came with significant costs and challenges; in light of the time and resources needed, the PCAOB released AS 5 in 2007, superseding AS 2, with the goal of improving audit efficiency in this area through a top-down approach focusing on significant financial statement accounts. In addition, the SEC extended the compliance dates several times for nonaccelerated filers
(see Exhibit 1). Lastly, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 permanently exempted nonaccelerated filers from the SOX section 404(b) reporting requirements.
Data
This articles analysis is based on data obtained from Audit Analytics for 2004 to 2010. Because nonaccelerated filers (i.e., companies with a market capitalization less than $75 million) were eventually exempted from SOX section 404(b) reporting requirements, the analysis focuses on accelerated (i.e., companies with a market capitalization between $75 million and $700 million) and large accelerated (i.e., companies with a market capitalization of at least $700 million) filers. In addition, because external auditors are independent and their reports on ICFR effectiveness are probably more objective than those provided by management, the analysis focuses on external auditors reports (SOX section 404[b]).
EXHIBIT 2 Accelerated Filers with Material Weaknesses, by Year and Filing Category
Number of Filers with Material Weaknesses 246 281 234 205 123 80 76 161 179 146 105 45 32 28 Percentage of All Filers in the Filing Category 20% 15% 13% 11% 7% 5% 5% 12% 9% 6% 5% 3% 2% 1%
Year 2004 2005 2006 2007 2008 2009 2010 2004 2005 2006 2007 2008 2009 2010
Panel A: Accelerated Filers
Analysis
Accelerated filers with material weakness by year and filing category. Exhibit 2 presents an analysis of both large accelerated and accelerated filers with material weaknesses by year and filing category. The result in Exhibit 2 indicates that there is an overall downward trend in the number of companies with material weaknesses over the 20042010 period. Public companies were first required to file SOX section 404(b) reports as of November 15, 2004. Approximately 20% of accelerated filers reported material weak-
Panel B: Large Accelerated Filers
EXHIBIT 3 Top 10 Types of Material Weakness

MW1: Accounting documentation, policy, or procedures MW11: Material or numerous auditor/year-end adjustments MW2: Accounting personnel resources and competency/training MW20: Restatement of or nonreliance on company filings MW19: Untimely or inadequate account reconciliations MW7: Information technology, software, and security and access MW12: Nonroutine transaction control issues MW14: Restatement of previous SOX section 404 disclosures MW17: Segregation of duties and design of controls MW9: Journal entry control issues 97.4% 60.9% 51.4% 42.1% 24.8% 20.2% 19.4% 15.0% 14.2% 10.7%
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nesses in 2004, as opposed to only 12% of large accelerated filers. Although the number of companies with material weaknesses increased in 2005 for both types of accelerated filers, the corresponding percentages decreased for both types of filers. This is due largely to the fact that, in 2004, only accelerated registrants with fiscal years ending after November 15 were subject to the SOX section 404(b) requirement; on the other hand, all accelerated registrants, regardless of fiscal year-end, were subject to the requirement in 2005. Interestingly, both categories of filers experienced a sharp decline in reported material weaknesses in 2008. This sharp drop may have resulted from the improved guid-
ings for accelerated and large accelerated filers were combined because only negligible differences between the two were observed. The predominant material weakness issue is accounting documentation and policy, followed by material or numerous auditor/yearend adjustments, and then by accounting personnel resources and competency. On average, 97.4% of all accelerated filers with material weaknesses had issues related to accounting documentation and policy. Because this is a critical part of the internal control structure, the consistency and quality of financial statements are likely to be significantly affected by a lack of controls in this area. Many
other controls rely on the existence of proper documentation and policy. Exhibit 4 shows the trend of the top five material weakness issues from 2004 to 2010, broken down by year. The exhibit reveals several salient patterns. The top two issues from 2004 to 2010 have consistently been the following: Accounting documentation, policy, or procedures (MW1) Material or numerous auditor/yearend adjustments (MW11). Accounting personnel resources and competency/training (MW2) and restatement of or nonreliance on company filings
EXHIBIT 4 Rank of Material Weakness Issues by Year
Material weaknesses seem to have been significantly remediated from 2004 to 2010.
ance of AS 5, which became effective in 2007. It is possible that public companies experienced the intended effect of AS 5 more fully in 2008 than in 2007. In addition, it is very likely that corporations became more adept at designing effective internal control structures and complying with sound internal control practices (i.e., problems were fixed over time). By 2010, only 1% of large accelerated filers and 5% of accelerated filers had material weaknesses, and material weaknesses seem to have been significantly remediated from 2004 to 2010. The result reported in Exhibit 2 suggests that mandatory reporting on ICFR led to improvements in the quality of internal control over financial reporting, particularly among large public companies. Specific material weakness issues. Several internal control issues can give rise to a material weakness. Audit Analytics uses a 21-item taxonomy to identify these issues. Exhibit 3 shows a ranking of the top 10 issues (collectively, over the 20042010 period). The rankAUGUST 2012 / THE CPA JOURNAL
Rank 1 2 3 4 5
2004 MW1 MW11 MW20 MW2 MW19
2005 MW1 MW11 MW20 MW2 MW19
2006 MW1 MW11 MW2 MW20 MW19
2007 MW1 MW11 MW2 MW20 MW7
2008 MW1 MW11 MW2 MW7 MW19
2009 MW1 MW11 MW2 MW20 MW7
2010 MW1 MW11 MW2 MW20 MW4
Note: MW1: Accounting documentation, policy, or procedures MW11: Material or numerous auditor/year-end adjustments MW2: Accounting personnel resources and competency/training MW20: Restatement of or nonreliance on company filings MW19: Untimely or inadequate account reconciliations MW7: Information technology, software, and security and access MW4: Inadequate disclosure controls
EXHIBIT 5 Persistent Material Weakness

Persistence 1 Persistence 2 Persistence 3 Persistence 4 Persistence 5 or more
50% 31% Accelerated Filers 5% 2% 54% 27% Large Accelerated Filers 5% 2% 12% 12%
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(MW20) have consistently appeared to be either the third or fourth most prevalent issues from 2004 to 2010. MW2 ranked fourth in 2004 and 2005, but moved up to third place after 2005; in contrast, MW20 was third on the list until 2005, but dropped to fourth place from 2006 to 2010 (except for 2008). The increasing pressure on accounting personnel resources is evident in these results, which seems consistent with the emphasis in organizations on lean personnel resources and deferred training due to diminishing personnel budgets. Inadequate disclosure controls (MW4) rose into the top five for the first time in 2010, possibly reflecting the greater monitoring of this area by the SEC. Consecutive years of material weakness. Exhibit 5 identifies the percentage of companies that experienced consecutive years of material weaknesses (although not necessarily the same issues). If a company had mate-
rial weaknesses in only one year, it is counted as Persistence 1; if a company had material weaknesses in two consecutive years, it is counted as Persistence 2; and so on. A surprisingly large number of companies had multiple years of ineffective internal controls and thus persistent material weaknesses. Exhibit 5 shows that 50% of accelerated filers and 46% of large accelerated filers with material weaknesses reported them for two or more years. Less than 20% of companies had material weaknesses for three or more years, and at least half of the large accelerated and accelerated filers had them for only one year. Thus, it seems that the majority of the companies were able to remediate identified material weaknesses within one or two years. The top three material weaknesses that persisted for three or more consecutive years are MW1, MW11, and MW2. These are the same three material weaknesses that occurred most frequently among all accelerated fil-
EXHIBIT 6 Average Number of Material Weaknesses

3.0 2.5 2.0 1.5 1.0 0.5 0 2.4 2.3 2.5 2 2.2 2.1 2.3 2.1 2.3 2
ers and in each year examined from 2004 to 2010. Average number of material weaknesses. Exhibit 6 reveals that the average number of material weaknesses for accelerated filers has been declining; this number decreased from 2.5 in 2005 to 1.6 in 2010 for accelerated filers. In contrast, the average number of material weaknesses for large accelerated filers started at 2.4 in 2004, dropped to 2 in 2005, remained relatively constant through 2008, increased to 2.8 in 2009, and eventually decreased again to 2.4 in 2010. A closer look at material weaknesses reported in 2009 by large accelerated filers (Exhibit 7) reveals that the frequency of the presence of MW1, MW11, and MW7 (information technology, software, and security and access) increased in 2009. In addition, MW4 (inadequate disclosure controls) emerged among the top four issues in 2009 for large accelerated filers. This is consistent with the SECs increasing emphasis on disclosure in recent years.
Implications
2.8 2.2 2.4 1.6
2004
2005
2006
2007
2008
2009
2010
Large Accelerated Filers
Accelerated Filers
The number of companies with reported material weaknesses declined significantly from 2004 to 2010. Companies are strengthening their internal controls, and existing professional guidance has become more effective. One practice that became fairly common over the 20042010 period was strengthening the internal audit team; internal auditors are now routinely reporting to the audit committee of the board (Raymond Elson and Michael Lynn, The Impact and Effect of the Sarbanes-Oxley Act on the Internal Audit Profession: Chief Audit Executives Perspectives, Academy of
EXHIBIT 7 Top Five Types of Material Weakness for Large Accelerated Filers (2009)
MW1: Accounting documentation, policy, or procedures MW11: Material or numerous auditor/year-end adjustments MW2: Accounting personnel resources and competency/training MW4: Inadequate disclosure controls MW7: Information technology, software, and security and access 34% 31% 53% 81%
100%
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Accounting and Financial Studies Journal, vol. 12, no. 1, pp. 5965, 2008; Lawrence J. Abbott, Susan Parker, and Gary F. Peters, Serving Two Masters: The Association Between Audit Committee Internal Audit Oversight and Internal Audit Activities, Accounting Horizons, vol. 24, no. 1, pp. 124, 2010). Company size, as reflected by market capitalization, has a bearing on the number of material weaknesses discovered. Large accelerated filers appear to have stronger internal control systems and, thus, fewer incidents of ineffective internal controls than accelerated filers. It seems that the level of resources that a company can commit to internal controls has an important effect on whether it will experience a material weakness. Audit committees should remain aware of the apparent relationship between the resources committed to internal controls and the effectiveness of those controls. As noted above, MW1, MW11, and MW2 in particular persist across years and across accelerated and large accelerated companies. Audit committees and internal auditors should be aware that several issues are the prime culprits in the assessment of internal control effectiveness. Internal audit personnel and management should stay vigilant in monitoring and evaluating these areas. It is not certain that internal controls attestation will produce incremental cash flow benefits as a result of process improvements that are normally associated with enhanced internal controls. Yet, a large body of literature suggests a direct correlation between the effectiveness of internal controls and audit fees (Arnold Schneider, Audrey Gramling, Dana Hermanson, and Zhongxia Ye, A Review of Academic Literature on Internal Control Reporting Under SOX, Journal of Accounting Literature, vol. 28, pp. 146, 2009; Thomas G. Calderon, Li Wang, and Tom Klenotic, Past Control Risk and Current Audit Fees, Managerial Auditing Journal, forthcoming). Thus, it seems plausible that audit committees and internal auditors could help reduce their companies audit and related professional fees by continuing to nurture their internal control systems. Material weaknesses persist longer for smaller accelerated filers; this is not surprising, given the comparably limited resources available to such entities. Larger corporations exhibit less persistent material weaknesses;
this is consistent with access to greater resources. It is incumbent upon current and prospective boards of directors to be aware of likely areas of material weaknesses and
It seems that the level of resources that a company can commit to internal controls has an important effect on whether it will experience a material weakness.
their overall implications for corporate governance. Board members and audit committees should review all material weakness findings, but they should pay particular attention to the three predominant internal control issues that commonly challenge corporations of all sizes. In doing so, board
members should work closely with internal audit units; a direct relationship between the internal audit function and the audit committee of the board enhances a corporations control structure and can minimize internal control problems (Schneider 2009). Internal auditors and a companys audit committee must stay abreast of requirements in the continuously evolving reporting environment. The PCAOBs AS 5, the SECs guidance regarding managements report on ICFR, and the requirements of the Dodd-Frank Act illustrate the changing nature of this dynamic area. Thomas G. Calderon, PhD, is a professor of accountancy, Li Wang, PhD, CPA, CMA, is an assistant professor, and Edward J. Conrad, PhD, is an associate professor, all at the George W. Daverio School of Accountancy, the University of Akron, Akron, Ohio. The authors wish to thank Diane Jules for her feedback on this article.
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C C O U N T I N G
& A accounting
U D I T I N G
The Two-Class Stock Method for Calculating Earnings per Share

Stock Compensation Awards as Participating Securities
By Josef Rashty
arnings per share (EPS) is one of the most common and complex performance measurements that a publicly held company presents in its quarterly and annual reports. (See Josef Rashty and John OShaughnessy, Restricted Stock Unites and the Calculation of Basic and Diluted Earnings per Share, The CPA Journal, June 2011, pp. 4045.) Accounting Standards Codification (ASC) Topic 260, Earnings per Share, covers guidance for the calculation and presentation of basic and diluted EPS, and ASC Topic 718, CompensationStock Compensation, provides guidance for certain unique characteristics of stock compensation awards that impact the EPS calculation. In their July 2005 CPA Journal article, The Two-Class Method for EPS: Theory, Rule, and Implementation, Nathan Slavin and Steven Petra discussed the calculation of basic EPS under the two-class stock method for certain participating securities, based on Emerging Issues Task Force (EITF) Issue 03-6, Participating Securities and the Two-Class Method Under FASB Statement No. 128. The discussion below is based on FASB Staff Position (FSP) EITF 03-6-1, Determining Whether Instruments Granted in Share-based Payment Transactions Are Participating Securities, subsequent guidance effective for fiscal years beginning after December 15, 2008. This FSP was subsequently codified under ASC 26010-45-61-A and 68-B, and ASC 260-1055-76-A through D. The discussion below explains and illustrates the application of the two-class method in the calculation of basic and diluted EPS for stock compensation awards that are considered participating securities under ASC 260, and it highlights the complexities surrounding such calculations and related disclosures.
The Two-Class Method

The two-class method is an earnings allocation formula that treats participating securities as having rights to earnings that otherwise would have been available only to common shareholders. Complications arise during the application of the two-class method in the calculation of basic and diluted EPS, primarily because of the com-
plexity of the calculation and the limited application guidance under ASC 260 and in related accounting literature. Certain companies issue stock compensation awards that contain rights to receive nonforfeitable dividends prior to the awards being vested. Under ASC 260, such unvested stock compensation awards are considered participating securities and, as such,
26
must be included in the two-class method calculation of basic and diluted EPS, regardless of a companys intention to declare or commit to pay any dividends. These awards are considered participating securities because the holders of the awards participate in the distributions of earnings with common shareholders from the date that the awards are granted. By contrast, unvested stock compensation awards that contain rights to receive dividends only if the awards are fully vested do not represent a participation right. These awards are not considered participating securities because the holders of the awards do not have the right to retain dividends unless the employees have rendered the requisite service and the awards are fully vested. In practice, however, most companies design their employee compensation plans in such a way that stock compensation awards will not be considered participating securities. In other cases, the impact
of stock compensation awards as participating securities have not been material (e.g., Hewlett-Packard Company, Form 10Q for the period ended January 31, 2012, http://www.sec.gov/Archives/edgar/data/ 47217/000104746912002476/a2207600z 10-q.htm). Nevertheless, there are many other publicly held companies that have classified their stock compensation awards as participating securities and have reported their EPS under the two-class method (e.g., Helmerich & Payne Inc., Form 10Q for the period ended March 31, 2012, http://www.sec.gov/Archives/edgar/data/46 765/000110465912032962/a12-5931_ 110q.htm).
Participating Securities
A company should determine if it has any participating securities and whether it should allocate earnings to those securities. A participating security is a security other than common stock that may participate in the distribution of earnings, together with
common stock, in its current form. This participation may even be conditioned upon the occurrence of a specified event. One example of a participating security is a companys preferred stock with dividend participation rights, whereby the holder would receive a cash dividend when dividends are declared on common stock. Participation does not have to be in the form of dividends, however; any form of participation in undistributed earnings constitutes participation. For example, participating securities may participate in the undistributed earnings of a company through a formula tied to the dividends paid on common stock, such as a warrant entitling the holder to a yield right equal to a certain percentage of the dividends paid on common stock, even though this yield right is not labeled as a dividend. Applicability of losses. Generally, losses are not applicable to participating securities. A publicly held company allocates losses to a participating security in the peri-
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EXHIBIT 1 An Illustration of the Two-Class Method

The following example reflects the computation of basic and diluted EPS when an entity has issued nonqualified stock options (NQSO). It reflects the calculation of basic and diluted EPS both for NQSOs as nonparticipating securities and NQSOs as participating securities. Assumptions Net income (NI) Weighted average of common shares outstanding (WAS) Number of common shares outstanding at the end of the period (CSO) NQSOs granted at the beginning of the period 1 Grant price (exercise price) at the beginning of the period (EXP) Average stock price during the period (AVG) Black-Scholes-Merton valuation of NQSOs (FMV) Unrecognized stock compensation at the beginning of the period 2 Stock compensation for the period Unrecognized stock compensation at the end of the period Average unrecognized stock compensation 3 Dividend declared and payable per common share Estimated forfeiture rate Effective tax rate (ETR)
$500,000 1,000,000 1,000,000 100,000 $ 10 $ 15 $ 4 $400,000 $ 80,000 $320,000 $360,000 $ 0.10 20% 40%
1 NQSOs will be fully vested at the completion of four years; therefore, no options have been vested or exercised during the first year that EPS is calculated. 2 Number of NQSOs grants (100,000) multiplied by the Black-Scholes-Merton valuation of $4 3 The simple average of unrecognized stock compensation at the beginning of the period for $400,000 and at the end of the period for $320,000 Calculation of basic and diluted EPS if NQSOs were not participating securities. In this scenario, the option holders do not have rights to participate in dividends with the common shareholders. Basic EPS 1 Diluted EPS: Assumed proceeds from the exercise of options 2 Average unrecognized compensation Excess tax benefits 3 Total assumed benefits Incremental diluting shares (IDS) 4 Diluted shares outstanding (DSO) 5 Diluted EPS 6
1 2 3
$0.5000 $1,000,000 360,000 40,000 $1,400,000 6,667 1,006,667 $0.4967
$500,000 (NI) 1,000,000 (WAS) = $0.5000 100,000 (NQSOs) $10 (EXP) = $1,000,000 ($15 [AVG] $10 [EXP] $4 [FMV] = $1 40% [ETR]) 100,000 (NQSOs) = $40,000 4 100,000 (NQSOs) ($1,400,000 $15 [AVG]) = 6,667 5 1,000,000 (WAS) + 6,667 (IDS) = 1,006,667 (DSO) 6 $500,000 (NI) 1,006,667 (DSO) = $0.4967 Calculation of basic and diluted EPS if NQSOs were participating securities. In this scenario, the option holders have a nonforfeitable right to participate in dividends with the common shareholders on a dollar-for-dollar basis. Net income (NI) Less distributed income (DI)1 Undistributed income (UI) Average diluted shares outstanding (ADS) Average diluted expected-to-vest shares outstanding (AES)
1
$500,000 (108,000) $392,000 1,100,000 1,080,000
1,000,000 (CSO) + (100,000 [NQSOs] [80% or excluding the estimated forfeited awards]) = 1,080,000 $0.10 (dividend) = $108,000 Basic EPS $0.1000 1 0.3564 2 $0.4564 Basic EPS $0.08003 0.3564 2 $0.4364 Diluted EPS $0.0993 4 0.3542 5 $0.4535 Diluted EPS $0.0800 6 0.3542 5 $0.4342
Common shares Distributed earnings Undistributed earnings Common shares EPS Unvested shares Distributed earnings Undistributed earnings Unvested shares EPS
1 2
$0.10 dividend declared and paid to each common shareholder $392,000 (UI) 1,100,000 (ADS) = $0.3564 3 $80,000 of earnings distributed to 100,000 unvested NQSOs 4 (1,000,000 CSO $0.10 dividend declared) 1,006,667 (DSO) = $0.0993 5 $392,000 (UI) 1,106,667 (ADS plus IDS) = $0.3542 6 $80,000 dividend applicable to 80,000 NQSOs expected to vest 100,000 average unvested options outstanding
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ods of net loss if, based upon the contractual terms of the participating security, the security had not only the right to participate in the earnings of the issuer, but also a contractual obligation to share in the losses of the issuing entity on a basis that was objectively determinable. The company should determine whether the holder of a participating security has an obligation to share in the losses of the issuing entity for the calculation of EPS in a given period, on a period-by-period basis.
Computing EPS Using the Two-Class Method

All securities, including stock compensation awards, that meet the definition of a participating securityirrespective of whether the securities are convertible, nonconvertible, or potential common stock securities should be included in the computation of basic and diluted EPS, using the two-class method. Under this method, a company assumes that it distributes all of its earnings
to the holders of all outstanding participating awards (not just those awards that are expected to vest), which would ultimately reduce the earnings available for distribution to common shareholders. In other words, the two-class method is an earnings allocation formula that treats all participating securities as having rights to earnings that otherwise would have been available only to common shareholders. The two-class method calculation, comprising the sum total of EPS applicable to distributed and undistributed earnings, is calculated as follows: Distributed earningsFirst, the company determines the amount of the dividends that it has declared in the current period (dividends declared in the current period should not include dividends declared with respect to prior-year unpaid cumulative dividends) and is applicable to its common stockholders and its participating securities. Second, the company allocates the distributed earnings to an aver-
age number of common stock and an average number of participating securities that are expected to vest. Undistributed earningsThird, the company reduces its income from continuing operations (or net income) by the amount of distributed earnings (calculated above). Fourth, the company allocates the undistributed earnings to an average number of common stock and an average number of participating securities. It should be noted, however, that the amount of distributed earnings allocated to the unvested stock compensation awards equals the total dividends distributed to all stock compensation awards, minus the dividends applicable to awards that are expected to be forfeited. By contrast, the amount of undistributed earnings must be allocated to all outstanding awards, including awards that are expected to be forfeited. This approach is based on the assumption that, under the two-class method, an entity distributes its earnings to
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all outstanding awards (not just the awards expected to vest). Generally, the application of the two-class method reduces the earnings available to distribute to common shareholders. Exhibit 1 illustrates this concept.
Stock Compensation Awards

ASC 260 requires that all awards be included in the computation of diluted EPS as long as the effect is dilutive. Dilutive stock compensation awards (e.g., stock
options and restricted stock units) will be included in the diluted EPS computation even if employees are not able to exercise the awards until some future date. Companies determine the dilutive effect of
EXHIBIT 2 Computation of Basic and Diluted EPS by Helmerich & Payne Inc.
Three Months Ended March 31, 2012 2011 Numerator: Income from continuing operations Loss from discontinued operations Net income Adjustment for basic EPS: Earnings allocated to unvested shareholders Numerator for basic earnings per share: From continuing operations From discontinued operations Adjustment for diluted EPS: Effect of reallocating undistributed earnings of unvested shareholders Numerator for diluted EPS: From continuing operations From discontinued operations Denominator: Denominator for basic EPSweighted-average shares Effect of dilutive shares from stock options and restricted stock Denominator for diluted EPSadjusted weightedaverage shares Basic earnings per common share: Income from continuing operations Loss from discontinued operations Net income Diluted earnings per common share: Income from continuing operations Loss from discontinued operations Net income $129,763 (44) 129,719 (530) 129,233 (44) 129,189 $98,961 (171) 98,790 (300) 98,661 (171) 98,490
Six Months Ended March 31, 2012 2011 $274,060 (55) 274,005 (1,009) 273,051 (55) 272,996 $203,326 (386) 202,940 (599) 202,727 (386) 202,341
7 129,240 (44) $129,196 107,385 1,657 109,042 $1.20 $1.20 $1.18 $1.18
6 98,667 (171) $98,496 106,515 2,080 108,595 $0.92 $0.92 $0.91 $0.91
14 273,065 (55) $273,010 107,285 1,640 108,925 $2.54 $2.54 $2.51 $2.51
11 202,738 (386) $202,352 106,270 2,105 108,375 $1.90 $1.90 $1.87 $1.87
Figures in thousands, except per-share amounts Source: Helmerich & Payne Inc. Form 10-Q filed for the period ended March 31, 2012, http://www.sec.gov/Archives/edgar/data/46765/000110465912032962/a12-5931_110q.htm
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the stock compensation arrangements using the treasury stock method (TSM). The use of forfeiture rates in the calculation of basic and diluted EPS is consistent with the provisions of ASC Topic 780, Stock Compensation. Therefore, any changes in the estimated number of forfeited share awards must be reflected in the EPS calculation in the period that a change in estimate occurs.
Treasury Stock Method

The TSM assumes that a company uses the proceeds from the hypothetical exercise of the stock compensation awards to repurchase common stock at the average market price during the period (Rashty and OShaughnessy 2011). Therefore, higher assumed proceeds (the numerator) and a lower average market price during the reporting period (the denominator) increases the number of shares that a company can hypothetically repurchase. An increase in the number of shares that a company can hypothetically repurchase lowers the denominator and raises the amount of diluted EPS. The assumed proceeds under the TSM include the following: The purchase price of the award that the grantee pays in the future (usually the exercise price of the stock compensation awards) The average compensation costs for future services that have not been recognized Any windfall tax profits (or shortfalls) due to the exercise of awards. Unvested stock compensation awards that contain nonforfeitable rights to dividends (or dividend equivalents) are participating securities, and should be included in the calculation of basic and diluted EPS under the two-class method.
Dividends or dividend equivalents may also be transferred to the holders of stock compensation awards, in the form of a reduction in the exercise price of the awards. This feature is not a participatory right because the award does not represent a nonforfeitable right to participate in earnings absent the exercise of the award that is, a right to dividends or dividend equivalents in the form of a reduction in the exercise price is a contingent transfer of value. Similarly, if payment of dividends or dividend equivalents is contingent upon vesting in the stock compensation award, the awards are not considered participating securities.
The inclusion of any provision that contains rights to receive nonforfeitable dividends prior to awards being vested might have a negative impact on a companys calculation of its basic and diluted EPS.
Disclosures
FSP EITF 03-6-1 requires the presentation of basic and diluted EPS only for each class of common stock and not for participating securities; however, the guidance does not preclude the presentation of basic and diluted EPS for participating securities (e.g., stock compensation awards) as a note to the financial statements. For example, Helmerich & Payne Inc., in its Form 10Q filed for the period ended March 31, 2012, made the following disclosure regarding the calculation of EPS under the two-class method: Accounting Standards Codification (ASC) 260, Earnings per Share, requires companies to treat unvested share-based payment awards that have non-forfeitable rights to dividend or dividend equivalents as a separate class of securities in calculating earnings per share. We have granted and expect to continue to grant restricted stock grants
to employees that contain non-forfeitable rights to dividends. Such grants are considered participating securities under ASC 260. As such, we are required to include these grants in the calculation of our basic earnings per share and calculate basic earnings per share using the two-class method. The two-class method of computing earnings per share is an earnings allocation formula that determines earnings per share for each class of common stock and participating security according to dividends declared (or accumulated) and participation rights in undistributed earnings. Basic earnings per share is computed utilizing the two-class method and is calculated based on weighted-average number of common shares outstanding during the periods presented. Diluted earnings per share is computed using the weighted-average number of common and common equivalent shares outstanding during the periods utilizing the two-class method for stock options and nonvested restricted stock (http:// www.sec.gov/Archives/edgar/data/ 4676/000110465912032962/a125931_ 110q.htm). Exhibit 2 replicates Helmerich & Paynes computation of basic and diluted EPS.
Practical Impact
EPS is one of the most common and complex performance measurements calculated by publicly held companies. Certain companies issue stock compensation awards that contain rights to receive nonforfeitable dividends prior to those awards being vested. These stock compensation awards could be considered participating securities and thus could be included in a companys calculation of basic and diluted EPSyet the inclusion of any provision that contains rights to receive nonforfeitable dividends prior to awards being vested might have a negative impact on a companys calculation of its basic and diluted EPS. The framework for calculating EPS using the two-class method described above can be helpful to CPAs facing such a scenario. Josef Rashty, CPA, has held several managerial positions with publicly held technology companies in the Silicon Valley region of California. He can be reached at jrashty@sfsu.edu.
Participating and Nonparticipating Securities

ASC 260 considers unvested stock compensation awards as participating securities, as long as they participate in distributions of earnings with common shareholders from the grant date, and the grantee is not required to render any service to earn such dividends. The unvested stock compensation awards that contain rights to receive dividends only upon full vesting are not participating securities, because the holders of the awards do not have the right to retain the dividend unless they complete the requisite service period.
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C C O U N T I N G
& A auditing
U D I T I N G
The Transformation of Internal Auditing

Challenges, Responsibilities, and Implementation
By Gaurav Kapoor and Michael Brozzetti
selves several related questions: Is our internal audit department designed to add value? Are our internal audit processes systematic and disciplined enough to sustain that value? Are we willing to change areas that need change? To truly add value to an organizations operations, internal auditing has to remain relevant to stakeholders, such as managetors, they are generally accountable first to their companys audit committee. The following sections present some of the key concerns of audit committees that internal auditors should keep in mind. Risk assurance and governance. Although the focus on risk management has, for some time, been a key trend in the field of internal auditing, audit committees con-
he field of internal auditing has transformed significantly over the past decade. Several factors have contributed to this change, including the increased complexity of a globalized marketplace, high-profile fraud and corruption scandals, new laws and regulations, and increased demand from stakeholders for greater assurance. (See Exhibit 1 for some specific shifts that have occurred with respect to internal auditing.) Within the profession, internal auditing serves as a corporate conscience and guiding force that helps to ensure that business decisions and management operations remain consistent with an organizations mission, strategies, and goals. Given the continually changing climate, auditors must take on additional responsibility to aid organizations in managing risk. Exhibit 2 highlights key qualities that internal auditors should possess. Although internal auditing presents certain challenges, businesses should strive to implement an enterprise-wide internal audit system that takes advantage of the advice provided below.
Adding Value
The Institute of Internal Auditors (IIA) defines internal auditing as an independent, objective assurance and consulting activity designed to add value and improve an organizations operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control and governance processes (http://www.theiia.org/ theiia/about-the-profession/internal-auditfaqs/?i=1077). Internal auditors would do well to frequently revisit this definition and ask themment and the board of directors. Internal auditors are the eyes and ears of the organization, and they can constructively improve the entitys risk management and internal control processes, while also providing assurances as to the effectiveness and efficiency of these processes and management operations. When properly designed, internal audit activities can significantly improve the business as a whole. tinue to consider it a major area of concern. The IIA has issued guidance on how to provide internal audit opinions regarding the risk management, internal control, and governance activities of an organization by updating standards within its International Professional Practices Framework. Enterprise risk management. With enterprise risk management (ERM) becoming a top organizational priority, organizations internal audit plans are being aligned with key enterprise risk areas to provide assurance that these risks are being managed effectively and kept in check by management.
Emerging Concerns
Although internal auditors often report to management and the board of direc-
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Fraud. Fraud has become a major area of concern for organizations worldwide. Internal auditors are being asked to assess and monitor fraud risks and controls, detect and investigate vulnerabilities, and provide advice on how to remedy these weaknesses. Governmental regulation and reform. The increasing complexity of compliance laws and regulations has prompted internal auditors to help track regulatory changes and compliance issues. Aligning an organizations internal audit plan to its strategic plan. Internal auditors can play a significant role in assessing strategic risks and guiding the expansion of business plans. They can also aid in the acquisition of a new company, the launch of new products and services, or the modification of a business organizational structure to achieve operational excellence. International Financial Reporting Standards. Although U.S. Generally Accepted Accounting Principles (GAAP) remains the standard for U.S. businesses, there is a good chance that International Financial Reporting Standards (IFRS) might become the standard in the near future. In general, IFRS requires increase transparency and greater disclosure around the methods and reasons for the accounting treatment of certain transactions. Ethics. Internal auditors are being called upon to help maintain a high standard of ethical behavior in their organizations by assessing the design and operation of thirdparty services; whistleblower policies; and ethics and compliance programs, including the handling of reported violations and subsequent disciplinary actions, when warranted. IT security. The move toward cloud computing, mobile computing, and virtualization have raised serious concerns about the security, integrity, and privacy of information. Internal auditors are being asked to audit these risks and the controls used to manage them, while also getting involved in other IT areas, such as data analytics, disaster and data recovery, system access management, change management, and software development life cycles. Doing more with less. Risks might be infinite, but resources arent. Thus, the task of improving risk and control management while also minimizing costs continues to be at the forefront of every internal auditors mind.
Knowledge, skills, and abilities. Given the growing importance of internal audits to the organization, much emphasis is being placed on the skills and qualifications required by auditors, as well as on their development, training, and retention. Many organizations are seeking a certified internal auditor (CIA) at the same time that many professional practitioners are pursuing the CIA designation as a means of demonstrating their internal auditing knowledge, skills, and competence.
Challenges of Internal Auditing

The changing environment has created numerous challenges that internal auditors must face while performing their duties. The following sections highlight three of these issues. Coping with expanding responsibilities. Today, internal auditors are not only asked to assess financial controls, but also to enhance governance, risk management, and control processes within an organization. Their responsibilities have expanded significantly to include strategy audits, ERM audits, ethics audits, operational audits, quality audits, IT audits, supplier audits, and due diligence in mergers and acquisitions. Internal auditors also have an obligation to understand how and why certain assumptions have or have not been made with respect to organizational strategy audits. For example, if an entitys management wants to launch a new product and assumes that it will get 20% of the market share within the first year, internal auditors need to question how such an assumption has been validated and how the
organization might be impacted if those targets are not met. Managing information. In order to add value to an organization, internal auditors need to efficiently integrate and disseminate information in various ways vertically, with management and the board of directors, and horizontally, with other functions related to governance, risk, and compliance. Sharing information and intelligence with the right people at the right time is absolutely critical in decision making. In other words, information is only as good as the hands it gets into and the timeliness with which it gets there. Keeping pace with changing business risks. The traditional model of creating an annual audit plan cannot be sustained any longer; in light of ever-changing business risks, internal audit plans need to be flexible. More importantly, internal auditors must prioritize preimplementation activities over postimplementation activities when an organization undergoes transformational changes, such as establishing new goals, restructuring the enterprise, implementing management and personnel changes, engaging in mergers and acquisitions, and implementing new IT innovations.
Implementing an Enterprise-wide Internal Audit Program

For an internal audit activity to be supported across an enterprise in an effective and sustainable manner, it must meet the objectives described below. Act as a resource for risk information. Internal auditors should present information and discoveries in a way that allows
EXHIBIT 1 A Comparison of Internal Audits, Then and Now

Then
Provided assurance over threats (i.e., the downside of risk) Performed discrete audits on compliance with internal controls
Now
Provides assurance over threats and opportunities (i.e., the downside and upside of risk) Performs integrated audits on governance, risk management, and controls Acts as a front-office function Provides leading indicators about risk Is the expert that management seeks
Acted as a back-office function Provided lagging indicators about risk Was the cop that management avoided
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decision makers to make good choices. Auditors cant control the future, but they can help control the likelihood of future success by advocating sound risk management and internal control practices. Balance a risk-based approach with an objective-driven approach. The traditional approach to risk managementlisting out and managing hundreds of risksis no longer an efficient one. With the growing need for better risk management policies and lower costs, there needs to be a stronger focus on key business objectives that set bound-
EXHIBIT 2 10 Essential Qualities Sought in Internal Auditors

1. Integrity and character 2. Communication skills 3. Technical skills and expertise 4. Intelligence 5. Business acumen 6. Professional skepticism 7. Inquisitiveness 8. Self-starter skills 9. IT knowledge 10. Personality
aries for risk assessment. This helps related activities remain relevant and manageable. Get involved at the top. Internal auditors must collaborate with management and the board of directors to ensure that an organizations mission, strategy, and goals align with its purpose and values. They should ask relevant questions: Are the right people setting and approving strategy? Is the board providing risk oversight in the strategy planning process? Do the proposed strategies support the core values? Maintain excellent talent. An internal audit department requires a balanced mix of internal recruits, external recruits, and third-party consultants. There should be an emphasis on training, including functional and industry certifications. In addition, the internal auditors Code of Ethics includes the principles of integrity, competence, objectivity, and confidentiality, which must be followed by internal auditors and supported by management and the board of directors with unwavering conviction. Prioritize people. Many internal auditors believe that people represent the most important area of an internal control environment. But when it comes to auditing, more time is usually spent on processes and technology than on people. If internal auditors want to save costs and manage risks more effectively, they must leverage
an organizations people in the process and ensure that the right people have been placed in the right positions to do the right thing. (Exhibit 3 provides an example of an internal control system.)
Utilizing Technology
Faced with multiple types of audits and increasing responsibilities, internal auditors can quickly find themselves overwhelmed. Fortunately, technology offers an advanced solutionit helps streamline and simplify audit processes, organize data, and automate time-consuming and resource-intensive workflows. The following sections address several ways that technology can enhance internal audits. Integration. In a shift to simplify and improve the efficiency of internal audits, many companies opt for a single, integrated audit management platform. Such platforms extend across the enterprise, transcending business and functional silos, facilitating collaboration, and minimizing redundant processes and effort. Audit workflows. An integrated audit management system helps streamline the complete internal audit life cycle and establishes the systematic and disciplined approach recommended by the IIA that closely maps each business objective to various compliance areas, business and functional areas, processes, risks, and controls. The end result is a structured, organized, and value-driven approach to internal auditing, which is an essential part of the broader risk management concerns of an enterprise. Risk assessments. Advanced audit management systems are usually equipped with a centralized repository or library of all the risks and controls that might affect an organization. This enables internal auditors to facilitate a targeted, risk-based internal audit that better supports business activities and key business objectives. Automated systems can help internal auditors save substantial time and effort in their risk assessment and tracking process. Risk prioritization. Internal audit systems can support the quantification of relevant inherent risks and residual risks. They provide an aggregate view of an organizations risk profile, enabling internal auditors to prioritize and plan their activities more effectively.
EXHIBIT 3 The Internal Control System
People
Ethics and Governance
Process
Internal
Technology
Systems / Devices Information / Data
Internal Adjudication External
Source: Boundless LLC
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Resource management. An integrated internal audit system allows internal auditors to efficiently plan and schedule audits for an entire enterprise and to deploy resources so that the most relevant and significant risks are addressed first. The system also helps standardize audit processes and methodologies for consistency in work quality; this, in turn, supports the quality assurance and improvement program required by the IIA. Reporting. Using a robust audit management system, internal auditors can efficiently organize audit data to support their recommendations and can gain management support for taking action. Some systems are equipped with powerful dashboards that provide real-time visibility into all the audit activities across the enterprise. This improves audit tracking and enables audit progress to be measured against key milestones for timely execution. Continual monitoring. Internal audit systems help automate the monitoring of
There is no doubt that audit competencies and skills will continue to be in high demand.
risks and controls, provide alerts and warnings for risks that require attention, and track corrective actions recommended by internal auditors and implemented by management. Information from multiple audits can be aggregated and easily plotted on maps or graphs to track audit trends.
organizations board of directors, as savvy as an organizations management, as diligent as its accountants, as intelligent as statisticians, and as persuasive as attorneys. In other words, they must play a multifaceted role, while maintaining the highest levels of professional integrity in order to help their organizations avoid harmful risks and seize beneficial opportunities. It is not only a tall order but also a great responsibility. There is no doubt that audit competencies and skills will continue to be in high demand, especially as the IIA endeavors to turn internal auditing into a universally recognized and accepted profession around the world. Gaurav Kapoor is the chief operating officer of MetricStream, Inc., Palo Alto, Calif. Michael Brozzetti, CIA, CISA, CGEIT, is the president of Boundless LLC, Philadelphia, Pa.
A Multifaceted Role
The current generation of internal auditors must strive to become as wise as an
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T A X A T I O N federal taxation
Tax Savings from the Sale of Qualified Small Business Stock

By Sidney J. Baxendale and Richard E. Coppage
M
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ost tax professionals are familiar with the complex nature of the federal taxation of capital gains from the sale of common stock, but there are also tax savings opportunities for shareholders of qualified small business stock: the Internal Revenue Code (IRC) section 1045 capital gain rollover provision and the IRC section 1202 provision for the exclusion of capital gain. Moreover, the tax savings associated with these IRC sections will increase in 2013 when the capital gains rate rises to 20% and the 3.8% Medicare tax on investments com-
mences. Shareholders who have held shares for more than five years can soon benefit from tax savings associated with the 75% and 100% exclusion under IRC section 1202. The following discussion examines the expected future increases in tax savings and provides examples designed to quantify the tax savings as a percentage of the capital gain. This information can help individuals maximize their tax savings by deciding whether to utilize IRC section 1045, IRC section 1202, or a combination of both, by first applying the capital gain rollover
provisions of IRC section 1045 and then excluding a percentage of the capital gain not rolled over using IRC section 1202.
Rollover of Capital Gain

If the sale of qualified small business stock results in a capital gain, the seller can avoid taxation of the gain by meeting the conditions under IRC section 1045. Qualified small business stock refers to stock in a C corporation that was issued after August 10, 1993, and acquired by the shareholder at its original issue in exchange for money or other property (not including stock), or as compensation for services provided (IRC section 1045[b][1]). Stock in a corporation will not be regarded as qualified small business stock unless at least 80% of the assets of the corporation are used in an active qualified trade or businessthat is, any trade or business other than one involving the performance of services in the fields of accounting, actuarial science, architecture, athletics, brokerage services, consulting, engineering, health, law, performing arts, or any other trade or business
where the principal asset is the reputation or skill of one or more employees. Other trade or business exclusions include banking, farming, financing, insurance, investing, leasing, mining, and restaurant or hotel management (IRC section 1202[e]). The stock acquired by the shareholder will not be considered qualified small business stock if, at any time during a fouryear period beginning two years before the issuance of such stock, the corporation purchased any of its stock from the shareholder or from a person related to the shareholder (IRC section 1202[c][3]). In addition to meeting the requirements for qualified small business stock, the stock must have been held by a noncorporate shareholder for more than six months (IRC section 1045[a]), and the qualified small business stock of another corporation must be purchased during a 60-day period beginning on the date of the sale. If the necessary conditions are met, all or a portion of the capital gain may be rolled over; thus, the tax on the gain rolled over may be postponed.
If the sale and purchase is accomplished to permit a rollover, the taxpayer must recognize the capital gain only up to the proceeds from the sale of the stock, minus the cost of any qualified small business stock purchased during the 60-day period (IRC section 1045[a]). IRS Publication 550, Investment Income and Expenses, clarifies the above rule by stating, If this amount is less than the amount of your capital gain, you can postpone the rest of that gain. If this amount equals or is more than the amount of your capital gain, you must recognize the full amount of your gain (p. 67, 2011). The amount refers to the proceeds from the sale of the stock, minus the cost of the newly purchased stock, as stated under IRC section 1045(a). Any portion of the capital gain that is not recognized is regarded as a rollover capital gain. The basis of the newly purchased stock is the purchase price less the rollover capital gain (IRS Publication 550, 2011). Any recognized gain would be taxed at the capital gains tax rate, which is currently
EXHIBIT 1 Federal Income Tax Advantages of Rollover of Entire Capital Gain

Tax Rates Starting in 2013 Capital Gain of $200,000 Rollover of No Rollover of Tax Advantage Capital Gain Capital Gain of Rollover $ 600,000 $ 600,000 400,000 400,000 $ 200,000 $ 200,000 $ 600,000 $ 0
Proceeds from sale of 40,000 shares at $15 per share Original cost of 40,000 shares at $10 per share Amount of capital gain on sale of stock Amount reinvested in qualified small business stock within 60 days
Taxable capital gain in year of stock sale Capital gains tax rate1 Capital gains taxes in year of stock sale Adjusted cost basis of newly purchased stock: Purchase price of new stock Less capital gain not taxed (rolled over) Adjusted cost basis of newly purchased stock
1
$ $
0 23.8% 0
$ 200,000 23.8% $ 47,600
$ 47,600
$ 600,000 (200,000) $ 400,000
Capital gain rate of 20% plus Medicare tax rate of 3.8%
37
15%. Without congressional action extending that rate, it is scheduled to increase to 20% in 2013. In addition, recognized capital gains will be subject to a 3.8% unearned income Medicare contribution tax in 2013 for high-income taxpayers. The investment income subject to the 3.8% tax is the lesser of 1) the net investment income or 2) the excess of modified adjusted gross income over a threshold amount ($250,000 for taxpayers filing jointly and $125,000 for taxpayers filing separately, per IRC section 1411). Example: full rollover of capital gain. This example, which shows the federal income tax advantages of the rollover of capital gain, relies on the following assumptions: A taxpayer joins with another entrepreneur to start a company that manufactures accessories for golf carts. The taxpayer (married or single) is highly paid, with a marginal capital gains tax rate of 20% in 2013. He is also subject to the 3.8% Medicare tax on investment income starting in 2013.
The company was organized as a C corporation in the United States after August 10, 1993, and each of the two entrepreneurs was issued 40,000 shares in exchange for a cash investment of $400,000. During all years of the corporations existence, the assets of the corporation were devoted solely to the manufacture of golf cart accessories, and the company was very successful. The corporation has not redeemed any of the shares that were issued to the two entrepreneurs. After owning the stock for several years, the shareholder sold his 40,000 shares for $15 per share in 2013 ($5 per share more than the original cost of the shares). Thus, the selling shareholder has a capital gain of $200,000 ([$15 $10] 40,000) on the sale of the stock. The shareholder who sold the 40,000 shares for $15 per share ($600,000) purchased $600,000 worth of shares of qualified small business stock in another C corporation within 60 days after selling the 40,000 shares.
Exhibit 1 shows that the capital gain on the sale of the 40,000 shares was $200,000 ($600,000 [40,000 shares $10]), and the entire $600,000 in proceeds from the sale are reinvested within 60 days after the sale. Because the proceeds from the sale minus the cost of the purchased shares is zero ($600,000 $600,000), and zero is less than the $200,000 capital gain, the entire $200,000 may be rolled over; as a result, the entire $200,000 capital gain avoids taxation in the year of the sale. Using the tax rates effective for 2013, $47,600 ($200,000 [20% + 3.8%]) of capital gain tax would be avoided. Of course, when the newly acquired stock is sold at some future date, the $200,000 gain may be taxed at that time. If this sale of the shares had occurred in 2012, the tax savings would be only $30,000 ($200,000 15%). In addition, Exhibit 1 shows that because the $200,000 capital gain was not taxed, the cost basis of the newly purchased stock is reduced by the amount of the capital gain. The cost basis of the newly purchased shares is $600,000, but the adjusted cost
EXHIBIT 2 Federal Income Tax Advantages of Rollover of Portion of Capital Gain

Tax Rates Starting in 2013 Capital Gain of $200,000 No Rollover of Tax Advantage Capital Gain of Rollover $ 600,000 400,000 $ 200,000 $ 0
Proceeds from sale of 40,000 shares at $15 per share Original cost of 40,000 shares at $10 per share Amount of capital gain on sale of stock Amount reinvested in qualified small business stock within 60 days
Rollover of Capital Gain $ 600,000 400,000 $ 200,000 $ 575,000
Taxable capital gain in year of stock sale Capital gains tax rate1 Capital gains taxes in year of stock sale Adjusted cost basis of newly purchased stock: Purchase price of new stock Less capital gain not taxed (rolled over) Adjusted cost basis of newly purchased stock
1
$ 25,000 23.8% $ 5,950
$ 200,000 23.8% $ 47,600
$ 41,650
$ 575,000 (175,000) $ 400,000
Capital gain rate of 20% plus Medicare tax rate of 3.8%
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basis of the newly purchased stock is $400,000 ($600,000 $200,000). The adjusted cost basis of $400,000 in this example is important because if the newly purchased stock is ever sold, the $400,000 adjusted cost basis will be used to determine the capital gain or loss on the sale. For example, if the newly purchased shares were sold for $500,000 in some future year, the capital gain on that sale would be $100,000 ($500,000 selling price, minus $400,000 adjusted cost basis). There is a means by which the $200,000 rollover capital gain and any future capital gain rollovers can escape taxation entirely: the rollover process could continue until the death of the owner of the shares. Upon the owners death, the stock could be inherited by the shareholders beneficiary, who will receive a cost basis in the shares equal to the market price on the date of the shareholders death. Thus, in the case of the death of a shareholder who properly rolled over capital gains, these capital gains from qualifying small business stock sales and purchases over a period of years would completely avoid capital gains taxation and the beneficiary would inherit the stock at the stepped-up basis (IRC section 1014[a]). Example: partial rollover of capital gain. Exhibit 2 shows a partial rollover of capital gains using the same basic assumptions as those in Exhibit 1; the only changed assumption is the purchase price on the newly acquired shares ($575,000 rather than $600,000). If the sales proceeds from the stock sale minus the purchase amount for the newly purchased shares were less than the $200,000 capital gain, then a portion of the gain must be recognized. For example, if the purchase price of the newly purchased shares was $575,000, then the $600,000 sales price minus the $575,000 purchase price would yield $25,000. Thus, a capital gain would have to be recognized up to the $25,000 amount; the rolled-over capital gain would be $175,000 ($200,000 $25,000). In this case, the adjusted cost basis of the newly purchased shares would be $400,000 ($575,000 purchase price, minus $175,000 capital gain rolled over). Comparing Exhibit 1 with Exhibit 2 reveals that the tax savings associated with the $175,000 rollover is only $41,650, rather than the $47,600 savings that results
from rolling over the entire $200,000 capital gain. If the sale of the shares had occurred in 2012, the tax savings associated with the $175,000 rolled-over capital gain would have been only $26,250 (15% $175,000), rather than the $41,650 shown in Exhibit 2. The complex rule used in determining the amount of the capital gain that may be rolled over requires careful consideration. If the sales price of shares sold minus the purchase price of the newly purchased shares yields an amount that is equal to or greater than the capital gain on the sale, then the entire capital gain will be taxable. Therefore, once the taxpayer knows the proceeds from the sale and the capital gain on the sale, she must carefully choose the amount of stock that must be purchased within 60 days to maximize the tax savings associated with the rollover of capital gain.
held for more than five years (IRC section 1202[a]). The percentage of the exclusion is determined by the time period during which the shares were acquired, in accordance with the following schedule: Shares acquired after August 10, 1993, but before February 18, 2009, have a 50% exclusion percentage. Shares acquired after February 17, 2009, but before September 28, 2010, have a 75% exclusion percentage. Shares acquired after September 27, 2010, but before January 1, 2012, have a 100% exclusion percentage. (If the 100%
To qualify under IRC section 1202, however, a corporation that issued qualified small business stock must be a qualified small business.
Exclusion of Capital Gain

IRC section 1202 contains another potential tax-saving opportunity when the shareholder of qualified small business stock realizes a capital gain upon the sale of the shares. This tax-saving provision is available for noncorporate shareholders who have a capital gain from the sale or exchange of qualified small business stock owned for more than five years (IRC section 1202[a][1]). Qualified small business stock is defined the same way as in the IRC section 1045 capital gain rollover provision. To qualify under IRC section 1202, however, a corporation that issued qualified small business stock must be a qualified small businessthat is, a domestic C corporation that, at all times on or after August 10, 1993, and before the issuance of the qualified small business shares, had aggregate gross assets equal to or less than $50 million. In addition, the aggregate gross assets immediately after the issuance of the qualified small business shares must not exceed $50 million. All corporations that are members of the same parent-subsidiary controlled group are treated as one corporation with respect to the aggregate gross asset provision (IRC section 1202[d][1]). If the common stock sold is qualified small business stock issued by a qualified small business, then the capital gain from the sale of the stock can be reduced by a specified percentage if the stock has been
exclusion is not extended or modified beyond December 31, 2011, it will automatically revert back to the 50% exclusion.) Although capital gains on the sale of stock are typically taxed at a maximum tax rate of 15% in 2012 (and at 20% starting in 2013), the portion of the gains not excluded in the case of an IRC section 1202 capital gain is taxed at a higher 28% tax rate under IRC section 1(h)(4)(A)(ii). In addition, 7% of the excluded gain is considered a preference item for alternative minimum tax (AMT) purposes when the exclusion percentage is 50% or 75%. The AMT on 7% of the capital gain was eliminated for the 100% exclusion (IRC section 57[a][7] and IRC section 1202[a][4][C]). Depending upon the taxpayers particular circumstances, preference items have the potential of being taxed at a 26% or 28% rate for AMT purposes (IRC 55[b][1][A]). If a shareholder has an eligible gain for the taxable year from sales of stock
39
issued by any qualified small business, the aggregate amount of such gain for which the exclusion is applicable may not exceed the greater of 1) $10 million, reduced by the aggregate amount of eligible gain taken into account in prior years; or 2) 10 times the aggregate adjusted basis of qualified small business stock issued by the qualified small business and sold by the shareholder during the taxable year (IRC section 1202[b]). Example: advantages of the capital gain exclusion. This example makes the same assumptions as the example above, with one modification and one addition. In order to examine the impact of the 50%, 75%, and 100% exclusions on tax savings, this example makes three alternative assumptions about when the shareholder purchased the 40,000 shares that were sold. The one additional assumption is that the shareholder has owned the shares for more than five years before the sale of the stock.
The 50% exclusion is applicable for qualified small business shares purchased from August 11, 1993, through February 17, 2009, and held for more than five years. If the shareholder purchased the 40,000 shares on February 17, 2009, he would have to wait until February 18, 2014one day more than five years laterto sell the shares in order to qualify for the 50% capital gains exclusion. The 75% exclusion is only applicable to situations where the shareholder purchased the shares from February 18, 2009, through September 27, 2010, and will have owned the shares for more than five years (that is, at least until February 19, 2014). The 100% exclusion is applicable for shares purchased from September 28, 2010, through December 31, 2011 (unless further extended), and owned by the same shareholder for more than five years (that is, at least until September 29, 2015). As discussed above, the highest tax savings from
IRC section 1202 are the 75% and 100% exclusions that are not attainable until a future date. Exhibit 3 examines the situation in which the stock was sold at a gain of $200,000 (40,000 shares [$15 $10]), and the tax savings associated with the IRC section 1202 capital gain exclusion are calculated for each of the 50%, 75%, and 100% exclusion alternatives. The tax savings and the tax savings as a percentage of capital gain for each of the three alternatives are shown in Exhibit 3. Exhibit 3 reveals that the tax savings associated with the 50% exclusion, using the tax rates starting in 2013, are minimal. Without considering the AMT, the tax savings is 7.9% of the capital gain. Although not shown in Exhibit 3, the 50% exclusion tax savings are even less when the AMT is considered (6.99% at the lower 26% AMT rate; 6.92% at the higher 28% AMT rate). The tax savings is only 1% of the capital
EXHIBIT 3 Federal Income Tax Advantages of IRC Section 1202 Capital Gain Exclusion
Tax Rates Starting in 2013 Capital Gain of $200,000 50% Exclusion 75% Exclusion $ 200,000 $ 200,000 (100,000) (150,000) $ 100,000 $ 50,000
Amount of capital gain on sale of qualified small business stock Less gain excluded from gross income Amount of capital gain included in gross income Tax effect of capital gain exclusion: Amount of capital gain excluded Normal capital gains tax rate Taxes saved as a result of exclusion Amount of capital gain not excluded Excess tax rate for IRC section 1202 capital gain not excluded (31.8%23.8%)1 Extra tax on section 1202 capital gain not excluded Net capital gains tax savings from exclusion Net tax savings as a percentage of total capital gain
1
100% Exclusion $ 200,000 (200,000) $ 0
$ 100,000 23.8% $ 23,800 $ (100,000) 8% $ $ (8,000) 15,800 7.9%
$ 150,000 23.8% $ 35,700 $ (50,000) 8% $ (4,000) $ 31,700 15.85%
$ 200,000 23.8% $ 47,600 $ 0 8% 0
$ 47,600 23.8%
31.8% equals the 3.8% Medicare tax plus the 28% capital gains tax on gain not excluded. 23.8% equals the 3.8% Medicare tax plus the 20% capital gains tax on gain not subject to IRC section 1202.
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gain when the AMT is ignored and the 2012 tax rates are used to calculate the tax savings; when the AMT is considered, the tax savings percentage drops to .09% for the lower 26% AMT tax rate and to .02% for the higher 28% AMT tax rate. The tax savings percentages are much more attractive for the 75% and 100% exclusions, which will become available in the next few years. In the case of the 75% exclusion (using the tax rates starting in 2013), the tax savings percentage is 15.85% of the capital
These two rather obscure provisions of the IRC are often overlooked when applying the rules for capital gains taxation.
qualified small business and if the other conditions required by both IRC sections 1045 and 1202 are met. In such a joint application of IRC sections 1045 and 1202, the portion of the gain rolled over under IRC section 1045 would be deducted from the purchase price of the newly purchased stock to arrive at the adjusted cost basis of the stock. Next, the portion of the capital gain that was not deferred would be eligible for exclusion from capital gains tax under IRC section 1202. The amount of the gain excluded from taxation under IRC section 1202 would only be related to the stock that was sold and would have no effect on the adjusted basis of the newly acquired stock. Of course, those shareholders fortunate enough to qualify for the 100% capital gain exclusion should not even consider using the rollover capital gain provisions of IRC section 1045.
significantly in the next few years as well; stockholders who will have held the qualified small business shares for more than five years will be able to realize the tax savings associated with the 75% and 100% capital gains exclusion. Taxpayers can also jointly use both IRC provisions to maximize the capital gains tax savings. Any remaining taxable capital gains after applying the rollover provisions of IRC section 1045 may be partially reduced by using the capital gain exclusion provisions of IRC section 1202. A taxpayers overall objective is to minimize the capital gain tax, and CPAs can advise an indi vidual of the right steps to take. Sidney J. Baxendale, PhD, CPA, CMA, CGMA, and Richard E. Coppage, PhD, CPA, CMA, are professors of accountancy in the college of business at the University of Louisville, Louisville, Ky.
An Obscure Opportunity
It is essential to mention several caveats related to the tax provisions and examples described above. The tax rates used here are based on the tax rates that are expected to be in effect starting in 2013 and those that are currently in effect in 2012. If the stockholder is in a lower federal income tax bracket and subject to the lower capital gains rate, however, the tax savings could be less. The focus here is on the salient tax provisions related to IRC sections 1045 and 1202. As is true with all generalized tax advice, however, taxpayers should consult with their advisors before taking action. Only a tax professional who understands a taxpayers precise situation and has a comprehensive understanding of the relevant tax provisions is in a position to make the correct decision concerning the issues discussed above. These two rather obscure provisions of the IRC are often overlooked when applying the rules for capital gains taxation. Both of these provisions represent opportunities to reduce the capital gain tax due on the sale of qualified small business stock. These savings will increase significantly in 2013 because of the scheduled increase in the capital gains tax rate and the new Medicare tax on investment income. The tax savings associated with IRC section 1202 are scheduled to increase
gain (Exhibit 3). Although not shown in Exhibit 3, the tax savings for the 75% exclusion, as a percentage of the capital gain, is 14.49% at the lower 26% AMT rate and 14.38% at the higher 28% AMT rate. In the case of the 100% exclusion (using the tax rates starting in 2013), the tax savings is 23.8% of the capital gain (Exhibit 3). There is no tax preference amount associated with the 100% exclusion; thus, there is no AMT for the 100% exclusion. A sensitivity analysis revealed that, for each of the exclusion percentages, the tax savings as a percentage of the capital gain remained unchanged as the capital gain amount changed.
Joint Application
There is nothing in the IRC that prevents a taxpayer from rolling over the capital gain using IRC section 1045 and then, if there is a taxable portion that was not rolled over, applying IRC section 1202 to that portion. Of course, this joint application is only possible if the capital gain involved qualified small business stock issued by a
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T A X A T I O N international taxation
Foreign Currency Strategies Can Produce Unforeseen Tax Consequences

By Lee G. Knight and Ray A. Knight
ultinational corporations use foreign currency strategies to reduce the impact of foreign currency volatility in the countries in which they have business operations. Such strategies often produce unforeseen tax consequences, however; many tax issues arise when foreign currency options, contracts, hedges, or straddles are accounted for before or at settlement. This article analyzes and discusses these issues and their potential resolution under the Internal Revenue Code (IRC) for CPAs who advise on structuring foreign currency positions.
The Nature of Trading

A corporation (investor) may engage in foreign currency trading using a wide variety of derivative and cash instruments, including options, forwards, swaps, and leveraged spot positions. In addition to trading in outright (also called naked) positions in foreign currencies, a corporation may engage in arbitrage trading. Arbitrage trading strategies typically call for the purchase and sale of very large notional amount derivative contracts, where the risk of loss is reducedbut not eliminated by entering into positions in a manner that substantially reduces outright foreign exchange risks. Such positions are referred to in financial markets as straddles. A corporation may execute its foreign currency arbitrage trading strategy in several major currencies, including the currencies of the G-8 industrialized nations, for which there are regulated futures contracts, as well as currencies of smaller nations. Currencies for which regulated futures contracts are availablesuch as the euro, British pound, and Swiss francare
referred to as major currencies; any currencies for which there are no regulated futures contracts traded on an exchange are referred to as minor currencies. Seeking to profit and protect international business operations from changes in relative currency exchange rates and international interest rate movements, a corporation develops its trading strategy. Prices for less widely traded currencies can be more volatile than those of major currencies, and
this relative volatility presents trading opportunities. Example. A corporation engages in a trade comprising two forward contracts: one long forward contract to purchase a specified amount of Indian rupees (INR) for a specific amount of U.S. dollars (USD), and one short forward contract, of shorter maturity and a different strike price, to sell a specified amount of INR for a fixed amount of USD. The short forward contract has a smallAUGUST 2012 / THE CPA JOURNAL
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er notional amount than the long forward contract. Each pairing of short and long forward contracts is referred to as a combined transaction. This may require a relatively small capital commitment that will profit handsomely if 1) INR increases in value compared to the USD, 2) INR interest rates drop, or 3) the INR yield curve flattens relative to the USD yield curve. Conversely, if exchange rates or interest rates move in the opposite direction, the combined transaction will drop in value. The corporation intends to trade its positions rapidly to take advantage of small price and interest rate movements. All the currencies in which the corporation will trade are actively traded in the interbank currency markets. The corporation enters into forward contracts in the over-the-counter market to execute the arbitrage strategy because that market is more liquid and provides tighter bid-asked spreads compared to the foreign currency transactions on regulated futures exchanges.
IRC Section 988

IRC section 988(a)(1)(A) provides that any foreign currency gain or loss will be treated as ordinary income or loss. To qualify as an IRC section 988 transaction, two conditions must be met. First, the amounts that the taxpayer receives or pays in the transaction must either be denominated in terms of a nonfunctional currency or be determined by reference to the value of one or more nonfunctional currencies (IRC section 988[c][1][A]). Second, the transaction must be one of several specified types of transactions. One category, foreign currency derivatives, includes forward contracts, futures contracts, options, or other similar financial instruments (IRC section 988[c][1][B][iii]). Any gain or loss attributable to a foreign currency derivative (as described in IRC section 988[c][1][B][ii], such as a forward contract) is considered a foreign currency gain or loss and, as such, is treated as ordinary income or loss, unless an exception applies (IRC section 988[b][3]). IRC section 988(c)(1)(D)(i) excludes regulated futures contracts that are marked-tomarket under IRC section 1256 from the definition of a section 988 transaction. A regulated futures contract is any contract traded on or subject to the rules of a qualified board or exchange, with respect to which the amount required to be deposited and the
amount that may be withdrawn depend on a system of marking-to-market. Qualified boards or exchanges include national securities exchanges registered with the SEC, a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission (CFTC), and any other market determined by the Treasury Department to have adequate rules (IRC sections 1256[g][1],[7]). Under Treasury Regulations section 1.988-1(a)(2)(iii)(A), section 988 treatment is limited, with respect to foreign currency derivatives, to those instruments where the underlying property itself is a nonfunctional currency. The exceptions to ordinary income treatment are very narrow and primarily elective. A taxpayer may elect to treat any gain or loss attributable to any foreign currency derivative that is not part of a straddle (defined in IRC section 1092[c]) as capital gain or loss if the foreign currency derivative is a capital asset in the hands of the taxpayer (IRC section 988[a][1][B]). A similar elective rule is available to certain partnerships that are qualified funds that trade foreign currency derivatives (IRC section 988[c][1][E]). A qualified fund must be a partnership with at least 20 unrelated partners during the entire taxable year. In addition, the partnerships principal activity must be the buying and selling of options, futures, or forward contracts with respect to commodities (de minimis amount), and at least 90% of its gross income must come from interest, dividends, gains from the sale or disposition of capital assets held for the production of interest or dividends and income, and gains from commodities, futures, forwards, and options, with respect to commodities (IRC section 988[c][1][E][iii]). A final, broader exception provides capital treatment for foreign currency derivatives that are part of certain hedging transactions (Treasury Regulations section 1.988-5[a]). Under this exception, the disposition of a foreign currency derivative that is treated as a hedging transaction may result in a capital gain or loss under certain circumstances, generally when the hedge relates to a capital asset. Section 988 hedges are limited, however, to hedges of qualifying debt instruments, certain executory contracts, and certain stock or securities purchases (Treasury Regulations sections 1.988-5[a],[b],[c]). For these purpos-
es, an executory contract is an agreement to pay nonfunctional currency for property used in the ordinary course of the taxpayers business or for services, or to receive nonfunctional currency for such property or service. A section 988 transaction, such as forward contract for a nonfunctional currency, is not an executory contract (Treasury Regulations section 1.988-5[b][2][ii][A],[B]).
Forward Contracts in Major Currencies and Minor Currencies

An IRC section 1256 contract is markedto-market at the end of each tax year; that is, each contract must be treated as if sold at the end of the year for its fair market value, and any gain or loss must be accounted for in that year. In addition, when a taxpayer terminates a section 1256 contract position during the year, the contract is marked-tomarket. This treatment is required if a taxpayer 1) offsets a section 1256 position, 2) makes or takes delivery under a section 1256 contract, 3) exercises or is exercised on a section 1256 option position, 4) makes or is the recipient of an assignment under a section 1256 option, or 5) closes a position by lapse or otherwise (IRC section 1256[a] [1],[c][1]). IRC section 1256(b) encompasses any of the following types of contracts: 1) regulated futures contracts, 2) foreign currency contracts, 3) nonequity options, 4) dealer equity options, or 5) dealer securities futures contracts. For this purpose, a foreign currency contract, by definition, is a contract (i) which requires delivery of, or the settlement of which depends on the value of, a foreign currency in which positions are also traded through regulated futures contracts, (ii) which is traded in the interbank market, and (iii) which is entered into arms length at a price determined by reference to the price in the interbank market. (IRC section 1256[g][2]). A forward contract based on any major currency will meet these three criteria, and thus will constitute a section 1256 contract. A forward contract in any minor currency will not be a section 1256 contract because no regulated futures contracts in any minor currency trade on any exchange; thus, it will not be subject to any mark-to-market requirement. Instead, the gain or loss will be recognized only upon the sale, exchange, or ter-
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mination of these forward contracts (IRC sections 1001, 1234A).
Straddles Under IRC Section 1092

A straddle is defined as two or more offsetting positions with respect to personal property, where one position provides a substantial diminution of the risk of loss from holding the other position (IRC section 1092[c][2][A]). For the purposes of this definition, personal property
the margin requirements for each such position (if held separately), or (vi) there are such other factors (or satisfaction of subjective or objective tests) as the Secretary may by regulations prescribe as indicating that such positions are offsetting (IRC section 1092[c][3]). The prescribed regulations have not yet been issued. For the purposes of these rules, two or more positions are treated as described in subsections (i), (ii), (iii), or
there is an active interbank market are presumed to be actively traded (IRC section 1092[d][7][B]).
Forward Contracts and the Timing Rules

The Treasury Regulations implementing IRC section 988 provide specific timing rules for section 988 transactions, such as forward contracts, that confirm the application of the IRCs general timing rules. Treasury Regulations section 1.9882(d)(2)(i) states that, unless a forward contract subject to IRC section 988 is a hedge for its purposes, the general realization rules of the IRC govern the timing of the recognition of gain or loss on the contract. Special provisions in the IRC and Treasury Regulations override the general rule of realization-based timing. Forward contracts are also specifically excluded from the accounting method rules applicable to notional principal contracts (Treasury Regulations section 1.4463[c][1][ii]). Finally, if forward contracts are investments, rather than hedges entered into to manage the risks arising from a trade or business, they are not subject to the timing rules of Treasury Regulations section 1.446-4 (IRC section 1221[b][2]; Treasury Regulations section 1.1221-2[b], 2[c][3], 1.446-4[a]). Terminating one financial position ordinarily has no impact for tax purposes on any other position held by an investor. If the termination of one position had any impact on any offsetting position, the numerous cases discussing tax-motivated straddles would never have arisen; in addition, IRC section 1092 would not be necessary. The IRC, however, establishes one special circumstance where terminating one financial instrument will cause a deemed termination of another financial instrument. IRC section 1256(c)(2) provides that where two or more section 1256 contracts are part of a straddle and the taxpayer takes delivery under or exercises any of such contracts each of the other such contracts shall be treated as terminated on the day on which the taxpayer took delivery. The special termination rule applies only where a taxpayer takes delivery of the underlying asset of a section 1256 contract. The legislative history concerning section 1256(c)(2) states: The bill also requires, if a straddle includes two or more regulated futures contracts, that all the contracts will be treated as
If two or more positions qualify as a straddle, a loss realized by disposing of one of the positions cannot be deducted by the taxpayer, to the extent that there is unrecognized gain in the position still owned by the taxpayer.
is limited to property of a type that is actively traded, and position means an interest (including a futures or forward contract or option) in personal property (IRC sections 1092(d][1], 1092[d][2]). The straddle rules describe six circumstances under which two or more positions will be presumed to be offsetting: (i) the positions are in the same personal property (whether established in such property or a contract for such property), (ii) the positions are in the same personal property, even though such property may be in a substantially altered form, (iii) the positions are in debt instruments of a similar maturity or other debt instruments described in regulations prescribed by the Secretary, (iv) the positions are sold or marketed as offsetting positions (whether or not such positions are called a straddle, spread, butterfly, or other similar name), (v) the aggregate margin requirement for such positions is lower than the sum of
(vi), only if the value of one or more such positions ordinarily varies inversely with the value of one or more other such positions. If two or more positions qualify as a straddle, a loss realized by disposing of one of the positions cannot be deducted by the taxpayer, to the extent that there is unrecognized gain in the position still owned by the taxpayer (IRC section 1092[a][1]). Moreover, if a taxpayer has not held property that is part of a straddle for at least one year before establishing the straddle, the holding period for such property will be reset to zero and will not start until the property is no longer part of a straddle (e.g., when the offsetting position is terminated). Finally, any costs, such as interest, incurred to purchase or maintain the positions constituting the straddle cannot be deducted. Instead, such costs are capitalized and may only be used to reduce the gain recognized when the profitable side of the straddle is sold (IRC section 263[g]). As noted above, forward contracts are positions in personal property; furthermore, foreign currencies for which
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terminated on the date the taxpayer takes delivery under any of such contracts. Thus, section 1256(a) will apply to all regulated futures contracts constituting part or all of a straddle when the taxpayer takes delivery under any of such contracts. (S.Rep. No. 97-592, at 27, 1982). Under IRC section 1256(c)(2), where the taxpayer receives the commodity pursuant to one of the contracts making up a straddle, the remaining contracts in the straddle are treated as terminated and immediately reestablished. This termination allows investors to make a mixed-straddle election under IRC section 1256(d) for the new straddle, which would consist of the commodity and any related short section 1256 contracts remaining in the investors hands. The legislative history of this provision states: The bill amends section 1256(d)(4) defining mixed straddles to require identification of all positions constituting such straddle not later than the close of the day on which the first regulated futures contract forming part of the straddle is acquired. This amendment clarifies that an election as to whether section 1256 will apply to a regulated futures contract included in a mixed straddle may not be deferred beyond the date the contract is acquired. For this purpose, when a short regulated futures contract is treated as terminated on the date the taxpayer takes delivery under a long regulated futures contract (under the straddle amendment to section 1256[c], the short position will be treated as a new regulated futures contract acquired on that date.) (S.Rep. No. 97592, at 27, 1982; Andrea Kramer, Financial Products: Taxation, Regulation and Design, 63.07(c), 3d ed., 2001 Supp.). A mixed straddle consists of at least one IRC section 1256 contract and one position that is not a section 1256 contract. If a taxpayer makes the IRC section 1256(d) mixed-straddle election, the section 1256 contract in the straddle will not be subject to the mark-to-market and character rules under section 1256. The special rule of IRC section 1256(c)(2) does not apply to other terminations of section 1256 contracts that are part of a straddle because other forms of termination do not leave the investors with the underlying commodity that automatically creates a new mixed
straddle (compare IRC section 1256[c][1] with IRC section 1256[c][2]). The gain or loss attributable to a forward contract in a minor currency should be realized in accordance with the applicable section of the tax code (Treasury Regulations section 1.988-2[d][2]). For example, a gain or loss should be realized when the contract is transferred, assigned, or terminated (Kevin M. Keyes, Federal Taxation of Financial Instruments and Transactions, section 15.03[4][a], 1997). The termination of a forward contract in a minor currency does not trigger tax consequences with respect to the remaining forward contract forming part of a combined transaction. The tax treatment of the termination of a forward contract was discussed in Vickers v. Commissioner (80 T.C. 394, 1983).
Neutralizing Further Risk of Loss or Opportunity for Gain

Typically, one forward contract in a combined transaction will increase in value while the second one will not. The combined transactions are designed so that if an investor is correct in its assessment of future currency and interest rate movements, the increase in value of one contract will substantially exceed the loss on the second contract. The investor may terminate the profitable contract in exchange for a termination payment from the counterparty; the investor would then hedge its remaining exposure by entering into a new forward contract that perfectly hedges its risks. The two forward contracts will form a new straddle. To the extent that gains on one forward contract exceed losses on the remaining forward contract in a combined transaction, terminating the profitable contract will yield funds beyond those needed for collateral. The excess funds are available for additional trading activities. The new hedging forward contract does not terminate the initial forward contract; instead, it creates a new obligation between the parties, reflecting current market conditions. Under general tax principles, merely eliminating the risk of loss and the opportunity of gain from one financial position by entering into a new position does not trigger recognition of gain or loss with respect to the first position. IRC section 1259 provides an exception to this realization-based timing rule. IRC section 1259(a) requires tax-
payers to recognize gain on the constructive sale of an appreciated financial position. An appreciated financial position means an interest, including a futures or forward contract, with respect to any stock, debt instrument, or partnership interest (IRC section 1259[b]). Because a forward foreign currency contract is not an interest in any stock, debt instrument, or partnership interest, forward contracts do not constitute appreciated financial positions within the meaning of IRC section 1259. Generally, a taxpayer recognizes gain or loss only when a position is sold, otherwise disposed of, or terminated (IRC sections 1001, 1234A). The Treasury Regulations implementing IRC section 988 provide specific timing rules for section 988 transactions, such as forward contracts, that conform to the general timing rules. Treasury Regulations section 1.988-2(d)(2)(i) states that, unless a forward contract subject to section 988 is a hedge for purposes of section 988, the general realization rules govern the timing of the realization of gain or loss on the contract. Treasury Regulations section 1.988-2(d)(2)(ii)(A) further states that exchange gain or loss shall not be realized solely because such transaction is offset by another transaction (or transactions). The regulations do provide one circumstance where entering into an offsetting position will cause the recognition of gain (but not loss). If a taxpayer offsets a position, exchange gain is recognized to the extent that the taxpayer derives an economic benefit from the gain, such as a pledge of the position (Treasury Regulations section 1.988-2[d][2][ii][b]). Aside from terminating a profitable forward contract and receiving its cash value, the only means of accessing the contracts value is through its use as collateralwhich, under these rules, would cause a deemed recognition event and result in phantom income. Additional special timing rules apply to section 1256 contracts, such as forward contracts in major currencies. IRC section 1256(c)(1) provides that the mark-to-market and character rules of IRC section 1256 apply to any termination (or transfer) during the taxable year of the taxpayers obligation (or rights) with respect to a section 1256 contract by offsetting, by taking or making delivery, by exercise or being exercised, by assignment or being
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assigned, by lapse or otherwise. IRC section 1256(c)(1) thus applies the markto-market regime to all terminations and transfers of futures contracts (Greene v. U.S., 79 F.3d 1348, 1354, 2d Cir., 1996). IRC section 1256 uses several terms of art from the commodity futures market, including offsetting. In the regulated futures marketplace, offsetting is a means of legally terminating an investors rights or obligations under a futures contract (Vickers v. Commr, 80 T.C. 394, 405, 1983). To terminate a futures contract via offsetting, the holder of a futures contract purchases the opposite type of contract on the same exchange for the same delivery month as the existing contract. For example, under the rules of the commodity exchanges, the holder of a long contract can terminate the contract by acquiring a short contract on the same exchange for the same delivery month (see Mertens Law of Federal Income Taxation, para. 21A.05, no.85, 1997). In contrast, entering into a new forward contract to eliminate the risk of loss on one of the original forward contracts will not terminate any rights or obligations under the original forward contract. As used in IRC section 1256(c)(1), offsetting therefore refers to a specific means of terminating a futures contract. Merely entering into a forward contract that is not traded on any exchange and that neutralizes further gain or loss from another forward contract will not cause the latter contract to be terminated (see PLR 88-18-010, February 4, 1988). Because entering into the new contract does not terminate the preexisting contract, IRC section 1256(c)(1) does not cause a preexisting forward contract to be treated as terminated (Treasury Regulations section 1.988-2[d][2][ii][C]).
payer owned stock identical to stock that was sold short. IRC section 1259, added by the Taxpayer Relief Act of 1997, now provides that under some circumstances such short sales will be treated as a constructive sale of the stock held by the taxpayer. The IRS has occasionally attempted to require taxpayers to integrate financial instruments. Prior to the enactment of IRC section 1092 in 1981, the IRS took the position that taxpayers could not recognize the tax consequences of closing one leg of a straddle if an offsetting leg remained open. In Revenue Ruling 77-185, the taxpayer purchased and sold silver futures contracts on margin to generate losses that could be used to minimize the tax consequences of a short-term capital gain realized from the sale of real estate. The transactions involved were as follows: On August 1, 1975, the taxpayer sold silver futures contracts for July 1976 delivery and simultaneously purchased the same number of silver futures contracts for March 1976 delivery.
In analyzing the treatment of financial transactions, there has been a strong bias against integrating separate financial contracts.
On August 4, 1975, the taxpayer sold the March 1976 futures contracts at a short-term capital loss. On the same day, the taxpayer purchased the same number of silver futures contracts for May 1976 delivery. On February 18, 1976, the taxpayer sold the May 1976 futures contracts at a longterm capital gain and covered the short position established on August 1, 1975, by purchasing futures contracts for July 1976 delivery, which resulted in a shortterm loss. The commission on the closing of each transaction was minimal and because the
Independent Economic Significance

The IRS could argue that the forward contracts in a combined transaction should be integrated, thereby deferring the tax consequences of closing out one contract of the straddle until gains or losses are recognized on the remaining contract. In analyzing the treatment of financial transactions, however, there has been a strong bias against integrating separate financial contracts. In Bingham v. Commr (27 B.T.A. 186, 190, 1932), the court held that the tax consequences of a short sale should be deferred until they are covered, even though the tax-
taxpayer consistently maintained a spread, the margin requirement to finance these was minimal. In 1975, the taxpayer reported a shortterm capital loss on the sale of the March 1976 futures that offset short-term gains from real estate. In 1976, the taxpayer had a net long-term capital gain on the May 1976 futures and a short-term capital loss on the sale of the July 1976 futures; the taxpayer realized a small economic loss. The IRS concluded that the taxpayer was not entitled to deduct his short-term capital loss on the closing of one position when, at the same time, a new position was acquired. Moreover, the taxpayer was not entitled to deduct, in a later year when the entire transaction was closed out, the economic loss on the transactions. In disallowing the short-term capital loss in 1975, the IRS relied on Treasury Regulations section 1.165-1(b), which states that a loss is deductible only when a transaction is closed. According to the IRS, the taxpayer established a balanced position with his initial long and short contract purchases. After the sale and purchase of the silver futures contracts in 1975, the taxpayer was in exactly the same balanced position as before these transactions; the only difference was the month of delivery of the replacement contracts. Because the taxpayer continued to hold this balanced position, the IRS concluded that the transaction resulted in no real change in a true economic sense and was, therefore, not a completed transaction. Because the transaction was incomplete, any deduction of losses in 1975 was premature. The IRS also disallowed the loss when all of the positions were closed in 1976, based on IRC section 165, which states that only losses incurred in a transaction entered into for profit may be claimed to offset tax liability. It asserted that taxpayers involved in offsetting position transactions had, as their dominant purpose, the creation of an artificial short-term capital loss, while ensuring that no real economic effect resulted from such transactions. Thus, the taxpayers lack of a profit motive in trading its offsetting positions resulted in the disallowance of any deductions. In Smith v. Commissioner (78 T.C. 350, 1982), the position set forth in Revenue Ruling 77-185 was challenged. While the IRS won the case, the court disagreed with
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many of the IRSs arguments. Like the taxpayer described in Revenue Ruling 77-185, Smith had purchased and sold silver futures contracts, which resulted in a short-term capital loss in 1973, and a short-term capital loss and a long-term capital gain in 1974. The economic loss of the taxpayer with respect to these transactions was approximately $5,082 (which included $4,000 of commissions). The IRS argued that the short-term capital losses recognized in the first year should be fully disallowed because 1) there were no genuine losses realized; 2) the losses were one step in a series of transactions, which had to be integrated and recognized only in the year when all of the positions were closed out; 3) the transactions lacked economic substance; and 4) the losses, if real, were not deductible because they were not incurred in a transaction for profit. The Tax Court first determined that the short and long positions entered into by the taxpayer were separate properties possessing independent significance for tax purposes. Furthermore, it determined that the close of one leg of a straddle was a closed and completed transaction, and that a gain or loss was sustained at that point in time. (See also Valley Waste Mills v. Page, 115 F.2d 466, 468, 5th Cir., 1940). In analyzing whether the futures transactions should be integrated, the Tax Court examined the following three theories: A common law wash sale doctrine A nonstatutory straddle integration rule The step transaction doctrine. In each case, the court determined that such theories did not require integration of the transactions. The Tax Court held, however, that the real loss sustained in the first year was substantially less than what was reported by the taxpayer. After reviewing the nature of the taxpayers trading activity, the Tax Court held that the taxpayer had exchanged existing contracts for new contracts rather than for sold and purchased contracts. Gain or loss on such an exchange of property is determined by comparing the taxpayers basis in the old property to the cash plus fair market value of property received. The court determined that the fair market value of the new contracts received was nearly equal to that of the old contracts surrendered. Therefore, only a small loss was realized (Smith, 78 T.C. 38184).
Based on prior case law, the Tax Court found clear authority that there was no common law wash sale doctrine with respect to a continuous position in a commodity future; the question was whether a common law doctrine existed with respect to straddles. The court noted that prior case law supported a non-statutory wash sale doctrine where a party had not completely relinquished an economic investment in the same, or substantially identical, investment. Because each of the positions was neither the same asset nor substantially similar under any wash sale doctrine, statutory or otherwise, the court held that such a doctrine could not force the integration of the losses. The Tax Court also refused to create a new, nonstatutory straddle integration rule. The court cited the complexity of articulating a theory where investments in different assets were to be integrated because their prices move on tracks that are close to parallel. The complexity of such a theory was evidenced by the enactment of IRC section 1092 and its myriad rebuttable presumptions. The court left open the possibility of ruling differently if the taxpayer had been guaranteed an exact offsetting unrealized gain. Still, it noted that contracts with different delivery months showed varying relative prices, and while the price variations were small, they were not de minimis. In response to the argument that the step transaction doctrine would be an appropriate ground for disallowing the claimed losses, the Tax Court stated that the general purpose of the step transaction doctrine was to disregard unnecessary steps undertaken to achieve a tax consequence different from what would have occurred if a transaction were done directly. The Tax Court stated that there was no authority for the proposition that the step transaction doctrine requires the integration of gains and losses realized in different years, and acceptance of such a concept would undermine the system of annual tax accounting. In addition, because of the risk that future offsetting gains might not materializeeven though this result was not probablethe court distinguished the previous case from situations where the step transaction was applied, especially in the taxation of transactions between corporations and stockholders.
In evaluating the argument that the taxpayers real losses should not be allowed because the transaction was not entered into for profit, the Tax Court stated that, if the taxpayer had nontax profit motives for entering into a transaction involving offsetting positions, losses from the transaction would not be disallowed merely because the taxpayer also had strong tax avoidance reasons for entering into the transaction. Likewise, the taxpayers hope of profit did not necessarily have to be reasonable, just bona fide. In Smith, however, the evidence presented indicated no apparent nontax profit motive for entering into the offsetting positions. Thus, the Tax Court reasoned that the losses were not incurred in any transaction entered into for profit and disallowed the losses. Other courts have come to the same conclusion regarding similar transactions. In Starr v. Commr (T.C. Memo. 1991610), the court held that a taxpayer failed to meet the burden of proof in showing that he entered into a straddle transaction primarily for profit within the meaning of section 108(a) of the Deficit Reduction Act of 1984. In contrast, in Laureys v. Commr (92 T.C. 101, 130, 1989), the court allowed the deduction of losses on straddles because the taxpayers primary purpose in engaging in the option, spread, butterfly, and specialty transactions was consistent with his overall portfolio strategy for making a profit, and because the taxpayer was a member of the Chicago Board Options Exchange (CBOE) and an appointed market maker in certain CBOE options.
Consider the Tax Implications

A multinational corporations foreign currency trading strategies should be structured to minimize economic risk. Nonetheless, complex tax issues should be addressed before the trading commences. Corporations and their tax advisors should have a working knowledge of the rules for tax planning to overcome the IRSs potential tax challenges and avoid unforeseen tax consequences. Lee G. Knight, PhD, is the Hylton Professor of Accountancy at Wake Forest University, Winston-Salem, N.C. Ray A. Knight, JD, CPA, is a visiting professor of practice, also at Wake Forest University.
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F I N A N C E not-for-profit organizations
The Need for Hybrid Businesses

Examining Low-profit Limited Liability Companies and Benefit Corporations
By Valeriya Avdeev and Elizabeth C. Ekmekjian
he economic recession has highlighted the need for socioeconomic reform. As businesses find themselves in the aftermath of the housing crisisaccompanied by an ongoing credit crunch with unprecedented unemployment rates, massive federal bailouts, plunging state revenues, and incomprehensible budget deficitsthey are forced to reconsider and restructure their traditional methods of doing business. Similar to forprofit enterprises, nonprofit organizations are now searching for ways to generate a return. As the lines between the nonprofit and for-profit worlds blur, entrepreneurs worldwide continue to search for new legal structures that better suit the present eco-
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nomic reality. Some are turning to hybrid entities, including the low-profit limited liability company (L3C), which was specifically designed to increase the number of program-related investments that private foundations can make to such socially centered businesses. The discussion below focuses on limited liability companies (LLC) and the need for hybrid entities, specifically benefit corporations (B corporations) and L3Cs. Nonprofit organizations and program-related investment rules under the Internal Revenue Code (IRC) are also addressed. CPAs should remain abreast of L3C legislation and current developments in this area, as well as the intended use of
L3Cs for program-related investments and other purposes.
An Overview of LLCs
Prior to August 1988, only two states had adopted LLC legislation: Wyoming in 1977 and Florida in 1982. Before the IRS released Revenue Ruling 88-76 and its check-the-box regulations in 1997, an LLCjust like an L3C todaywas viewed as an unfamiliar and confusing business structure. Today, all 50 states have laws authorizing LLCs; in fact, LLCs are becoming the most popular business structure in the United States. An LLC is a very flexible and efficient business entity. Unlike an S corporation, an LLC has no limitation on the number and the type of owners; unlike a corporate entity, an LLC is not bound by complex state compliance laws; and unlike limited partners in a partnership, members of an LLC are not subject to potential vicarious liability for acts committed by co-owners in the ordinary course of business. Tax-planning opportunities for individuals interested in creating an LLC are almost endless. LLCs can take the form of almost any business type. Specifically, an LLC with two or more members may be treated as a tax partnership; as a tax corporation, if it makes the necessary election; or as a taxexempt organization, with some limitations. In its Limited Liability Company Reference Guide Sheet, the IRS sets out the following 12 conditions that an LLC must meet in order to satisfy the tax-exempt status requirements under IRC section 501(c)(3): The organizational documents must include a specific statement limiting the LLCs activities to one or more tax-exempt purposes. The organizational language must specify that the LLC is operated exclusively to further the charitable purposes of its members. The organizational language must require that the LLCs members be IRC section 501(c)(3) organizations, governmental units, or wholly owned instrumentalities of a state or political subdivision thereof. The organizational language must prohibit any direct or indirect transfer of any membership interest in the LLC to a transferee other than an IRC section 501(c)(3) organization or governmental unit or instrumentality.
The organizational language must state that the LLC, interests in the LLC (other than a membership interest), or its assets may only be availed of or transferred (directly or indirectly) to any nonmember, other than an IRC section 501(c)(3) organization or governmental unit or instrumentality, in exchange for fair market value. The organizational language must guarantee that, upon dissolution of the LLC,
the assets devoted to the LLCs charitable purposes will continue to be devoted to such purposes. The organizational language must require that any amendments to the LLCs articles of organization and operating agreement be consistent with IRC section 501(c)(3). The organizational language must prohibit the LLC from merging with or converting into a for-profit entity.
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The organizational language must require that the LLC not distribute any assets to members who cease to be IRC section 501(c)(3) organizations or governmental units or instrumentalities. The organizational language must contain an acceptable contingency plan in the event that one or more members cease, at any time, to be an IRC section 501(c)(3) organization or a governmental unit or instrumentality. The organizational language must state that the LLCs exempt members will expeditiously and vigorously enforce all of their rights in the LLC, and will pursue all legal and equitable remedies to protect their interests in the LLC. The LLC must represent that all its organizing document provisions are consistent with state LLC laws and are enforceable at law and in equity. (http://www.irs.gov/pub/ irs-tege/llc_guide_sheet.pdf) The IRS established these 12 conditions to ensure that tax-exempt LLCs were
operated exclusively to further their social purpose, rather than generate net income. But some statesCalifornia, Indiana, Iowa, Maryland, Minnesota, New York, North Dakota, Rhode Island, Texas, Utah, Virginia, and the District of Columbia require in their respective statutes that an LLC be organized for a business profit. Thus, it is questionable whether an LLC organized in those states will be respected as a tax-exempt entity. In order to avoid this predicament, entrepreneurs can organize their entity as a tax-exempt LLC in other states and then operate in the states listed above. Finally, an LLC with one member may be treated as a tax corporation, if it makes the necessary election, or as a pass-through disregarded entity, wholly owned by a nonprofit organization. Even under the elaborate variety of todays business forms, it is likely that one single entity cannot successfully operate both a nonprofit and a for-profit structure. If the entity has a for-profit purpose,
its managers will find themselves bound by the decisions of the board of directors, which will require an overriding for-profit motive in most of the entitys undertakings. Likewise, if the entitys purpose is to be a tax-exempt organization, its managers will find themselves bound by strict statutes that preclude any meaningful financial gain by the owners, regardless of the social benefit accomplished. Combining a profit motive with a social purpose in a single entity requires the organization of a new business form. There are two known methods of creating such a hybrid entitya B corporation and an L3C.
B Corporations
A B corporation is a new, purposedriven hybrid structure that creates benefits for all of its stakeholders: the business itself, the community in which the business operates, and the environment. B corporations are business organizations that elect to obtain certification from B Lab, a nonprofit organization dedicated to using the power of business to achieve a socially desirable business purpose and address systemic problems. B Labs stated goals are to build a community of certified B corporations with a social purpose and promote legislation creating new corporate forms that meet higher standards of corporate purpose, accountability, and transparency (http://www.benefitcorp.net/ for-attorneys/legal-faqs). In order to obtain certification from B Lab, a B corporation must abide by certain requirements, such as meeting comprehensive and clear social and environmental performance standards, institutionalizing stakeholder interests, and building a collective voice through the power of a unifying brand. Only after meeting those requirements will an entity obtain the right to use the certification as a B corporation. This allows the entity to network with similar organizations and to use the B corporation designation for marketing purposes. Unlike the name suggests, B corporation status is not limited to corporations only; B corporations can take a corporate form, but they can also be LLCs or even limited liability partnerships. New York legislation. In December 2011, New York became the seventh state to pass legislation to allow businesses to organize as
CASE STUDY
OOMilk, a recently formed L3C, is a perfect example of an L3C used for purposes other than PRIs. Vaughn Chase, an owner of one of 10 small farms in Maine, and other farmers created a company to process and distribute organic milk locally under their own brand, Maines Own Organic Milk Company, or MOOMilk. MOOMilk was organized as an L3C under Vermonts statute because, at that time, Maine had not yet passed similar L3C legislation. Chase, an organic dairy farmer, had received a notice from his processor, H. P. Hood, that it would no longer be taking milk from Chases farm. The refusal to process Chases milk came just after he had invested substantial personal funds to convert his 600-acre family farm to meet the U.S. Department of Agricultures organic certification standards. Unable to find another organic processor, Chase thought that he would be forced out of business. Because an L3C is a for-profit entity that is eligible for regular investments, however, Chase and the other farmers were able to create a new business and attract the necessary capital to MOOMilk. The companys operating agreement specified that the farmers receive 90% of the profits each month, as well as a predetermined price for their milk. Furthermore, the agreement specified that investors would only receive a return upon exiting the enterprise. One attorney who worked on structuring MOOMilk commented, Nobodys going to get rich investing in this L3C. But if the goal is to save family farms, that is going to happen (Malika Zouhali-Worrall, For L3C Companies, Profit Isnt the Point, CNNMoney, http://money.cnn.com/ 2010/02/08/smallbusiness/l3c_low_profit_companies). The case of MOOMilk illustrates how an L3C can serve as a catalyst for increased investment in socially beneficial enterprises.
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B corporations. Prior to the adoption of this legislation in New York, some uncertainties still existed regarding B corporations and their organizational structure. For example, even if the original investors were in agreement with the limitation on a for-profit motivation inherent in a B corporation, it was unclear whether, under corporate law, any successor investor would be bound by the limitation on managements obligation to maximize profit. Under the Silver-Squadron legislation (A.4692-A/S.79-A) that was signed into law, companies organized as B corporations in New York must pursue a general public benefit, measured by material positive impact on society and the environment, taken as a whole, assessed against a third-party standard (http://benefitcorp. net/selecting-a-third-party-standard). B corporations in New York do not have to follow the B Lab certification process; according to the legislation, an independent third-party standard is sufficient. The legislation defines a third-party standard as a recognized standard for defining, reporting and assessing general public benefit that is developed by an independent person, is transparent, and is publicly available (http://benefitcorp.net/ selecting-a-third-party-standard). In addition, section 1707 of the law mandates that directors and officers of B corporations consider the effects of their actions on their shareholders, employees, workforce, and the interests of their customers.
tion 401(c)(3), other than organizations described in IRC section 509(a)(1) through (4), and is exempt from income tax under IRC section 501(a). Private foundations are not considered public charities under IRC section 501(c)(3) or supporting organizations; however, private foundations nonetheless qualify as IRC section 501(c)(3) organizations and are required to maintain charitable,
educational, religious, or other social purposes. In the United States, private foundations primarily engage in grant-making activities to other nonprofit organizations. In order to qualify as a private foundation under IRC section 501(c)(3) and IRC section 509, an entity must be organized and operated exclusively for one or more exempt charitable purposes. If more than
Nonprofit Organizations and Program-Related Investment Rules

The following three types of organizations are not organized for profit: Those organized for public benefit under IRC section 501(c)(3), known as charities or public benefit organizations, including private foundations Those organized for the mutual benefit of other owners, such as business leagues or homeowners associations Religious organizations. Each of these organizations is exempt for federal income tax purposesthat is, except for unrelated business taxable income, such entities are not subject to tax on the income that they derive pursuant to IRC section 501(a). A private foundation is a domestic or a foreign organization described in IRC secAUGUST 2012 / THE CPA JOURNAL
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an insubstantial part of the organizations activities is in furtherance of a for-profit motive, the organization will lose its taxexempt status. As such, any private foundation must be organized and operated so that no part of its net earnings benefits a private shareholder or individual, and not confer more than an incidental private benefit on any such individual. Moreover, under IRC section 4944(a), if a private foundation invests in another entity in such a manner as to jeopardize the carrying out of any of its exempt purposes, a tax equal to 10% of the jeopardizing investment will be imposed on the foundation. The foundation will be charged an additional tax of 25% if the jeopardizing investment is not corrected in a timely fashion. An exception does exist, if such an investment was program related. Pursuant to IRC section 4944(c) and Treasury Regulations section 53.4944-3, the tax is not imposed on a private foundation if the program-related investment (PRI) meets all three of the following requirements: The primary purpose of the investment is to accomplish one or more of the purposes described in IRC section 170(c)(2)(B). No significant purpose of the investment is the production of income or the appreciation of property. No purpose of the investment is to accomplish one or more of the purposes
described in IRC section 170(c)(2)(D). IRC section 170(c)(2)(D), in turn, restricts activities that involve influencing legislation and participating in political campaigns. By enacting the PRI exception,
PRIs are much more attractive to private foundations than grant distributions. Most often, PRIs are repaid and can even earn a profit.
from gross investment income calculations. PRIs also qualify as an exception to the excess business holdings rule under IRC section 4943. Lastly, PRIs require greater accountability to the foundation because they will likely be repaid. As of today, most private foundations do not engage in PRI arrangements. In order for a private foundation to be confident that its specific PRI meets the applicable IRS requirements and will not be subject to the 10% tax or cause the entity to lose its taxexempt status, it must seek a costly and timeconsuming private letter ruling from the IRS. But another hybrid entitythe L3Cwas specifically designed to overcome these obstacles and meet the PRI requirements under the IRC.
L3C Legislation
In April 2008, Vermont became the first state to enact legislation creating a new form of business entitythe L3C. An L3C is a subset of LLCs and was intended to bridge the gap between for-profit and nonprofit enterprises. As a for-profit entity, an L3C is neither tax-exempt nor eligible to receive taxdeductible charitable contributions. Moreover, an L3C is required, by law, to have as its primary purpose the advancing of a charitable or educational social goal, rather than the maximizing of profits. The Vermont Limited Liability Company Act defines L3Cs as follows: (27) L3C or low-profit limited liability company means a person organized under this chapter that is organized for a business purpose that satisfies and is at all times operated to satisfy each of the following requirements: (A) The company: (i) significantly furthers the accomplishment of one or more charitable or educational purposes within the meaning of Section 170(c)(2)(B) of the Internal Revenue Code of 1986, 26 U.S.C. Section 170(c)(2)(B); and (ii) would not have been formed but for the companys relationship to the accomplishment of charitable or educational purposes. (B) No significant purpose of the company is the production of income or the appreciation of property; provided, however, that the fact that a person provides significant income or capital appreciation shall not, in the absence of
Congress recognized that private foundations exempt activities were not limited to mere grant-giving activities. PRIs are much more attractive to private foundations than grant distributions. Most often, PRIs are repaid and can even earn a profit. Moreover, under IRC section 4940, capital gains on PRIs are excluded
ADDITIONAL RESOURCES
2011 Instructions for Form 990-PF, IRS, p. 3, www.irs.gov/pub/irs-pdf/i990pf.pdf Benefit Corporation Information Center, www.benefitcorp.net B Lab: The Nonprofit Behind B Corps, B Lab, www.bcorporation.net/ The-Non-Profit-behind-B-Corps Limited Liability Company, IRS, www.irs.gov/businesses/small/article/0,,id= 98277,00.html Richard A. McCray and Ward L. Thomas, Limited Liability Companies as Exempt OrganizationsUpdate, pp. 36, www.irs.gov/pub/irs-tege/eotopicb01.pdf Tax Information for Private Foundations, IRS, www.irs.gov/charities/foundations/ index.html What Is the Difference Between a Private Foundation and a Public Charity? Foundation Center, www.foundationcenter.org/getstarted/faqs/html/pfandpc.html
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other factors, be conclusive evidence of a significant purpose involving the production of income or the appreciation of property. (C) No purpose of the company is to accomplish one or more political or legislative purposes within the meaning of Section 170(c)(2)(D) of the Internal Revenue Code of 1986, 26 U.S.C. Section 170(c)(2)(D). (D) If a company that met the definition of this subdivision (23) at its formation at any time ceases to satisfy any one of the requirements, it shall immediately cease to be a low-profit limited liability company, but by continuing to meet all the other requirements of this chapter, will continue to exist as a limited liability company. The Vermont Limited Liability Company Act further provides: (a)(2) The name of a low-profit limited liability company as defined in subdivision 3001(23) of this chapter shall contain the abbreviation L3C or l3c. The Vermont statute discussed above is a mirror image of the IRC section 4944(c) PRI requirements. Since L3Cs were specifically designed to qualify for the PRI exception, such resemblance is not a coincidence; the drafters of L3C legislation are hopeful that the IRS will soon issue a corresponding revenue ruling accepting L3Cs as a suitable mechanism for using PRIs, thus eliminating the need for private foundations to request private letter rulings each time they wish to enter into a new PRI arrangement. Along with Vermont, L3Cs can be formed in eight additional states: Illinois, Louisiana, Maine, Michigan, North Carolina, Utah, and Wyoming. A new L3C formed in any of these states can legally operate in any state. Legislation allowing the formation of L3Cs is also being considered in numerous other states, including Arizona, Arkansas, Hawaii, Indiana, Iowa, Kentucky, Maryland, Montana, New York, Oklahoma, Oregon, and Rhode Island. The states that have enacted L3C legislation have adopted language very similar to that used in the Vermont Limited Liability Company Act. Similar to Vermont, all of the other states require the following basic elements: The entity must further the accomplishment of a charitable or educational
purpose within the meaning of IRC section 170(c)(2)(B). The entity would not have been formed but for its relationship to the accomplishment of a charitable or educational purpose. Neither the production of income nor the appreciation of property is a significant purpose of the entity. The entity has no political or legislative purpose within the meaning of IRC170(c)(2)(D). Furthermore, in some states, such as Vermont and Utah, the educational or charitable purpose requirement for an L3C is
ed liability protection against the actions and debts of the L3C business. Likewise, there are no limitations on who can be a member of the L3C.
Additional Uses of L3Cs

As mentioned above, an L3C is a hybrid type of business that combines the strengths of the LLC structure with the social benefits of an exempt entity. The primary purpose of an L3C is to promote charitable or educational purposes, whereas earning a profit is a secondary objective. Moreover, an L3C allows its investors the flexibility to account for different investment objectives, as well as varying financial considerations. An L3C has the potential to increase the flow of capital from exempt organizations, beyond private foundations interested in PRIs. For example, L3Cs might be particularly well-suited for joint ventures with taxexempt hospitals or similar operating charities. L3Cs could also be used as subsidiaries of an exempt organization in order to provide limited liability protection to its parent and segregate different charitable activities. For a real-life example of how an L3C was used, see the sidebar, Case Study.
An L3C allows its investors the flexibility to account for different investment objectives, as well as varying financial considerations.
Looking Forward
The arrival of hybrid entities, such as B corporations and L3Cs, represents a potential breakthrough for individuals and organizations that are dedicated to achieving social change. L3Cs are especially likely to cause a substantial increase in the availability of both private and nonprofit capital to entities that need it mostthose designed to further charitable and educational purposes. CPAs can help such entities by understanding the scope of these organizations, the rules that govern their use, and continual developments in this area. For more information, readers should visit the links in the sidebar, Additional Resources. Valeriya Avdeev, JD, LLM, and Elizabeth C. Ekmekjian, JD, LLM, are professors in the department of accounting and law at Cotsakos College of Business, William Paterson University, Wayne, N.J. The authors would like to acknowledge Ann Thomas, AB, JD, at New York Law School, and John Wilcox, PhD, at Manhattan College, for their continued guidance and support.
included in the definition provisions of the states LLC act, and no specific language is expressly required to be contained in the L3Cs articles of organization. In other states, such as Michigan, the educational or charitable purpose, together with the prohibition on lobbying and political campaign activity, is required to be expressly stated in the L3Cs articles of organization. Because the articles of organization are public and the operating agreement is not, the IRS would presumably prefer to have the requirements specifically stated in the articles of organization. All of the states that passed L3C legislation did so by supplementing their existing LLC statutes to permit the creation of this new social-purpose business entity. Because an L3C is a subset of an LLC, it should similarly be treated as a passthrough entity for income tax purposes, assuming that the L3C does not elect to be treated as a corporation. Similar to an LLC, an L3C provides its members with limit-
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M A N A G E M E N T practice management
The Increased Importance of Non-Compete Agreements for Accounting Firms

By Michael C. Lasky and David S. Greenberg
t has been said that it is wise to keep your friends close and your enemies closer. In these challenging economic times, accounting firms are increasingly following this maxim when it comes to postemployment restrictions for departing professionals. In fact, growing numbers of accounting firms are making certain that they have the right form of non-compete and protective covenant agreements in place with their employees, managers, and partners in order to ensure that accountants cannot leave the firm and take their books of business and client relations to a competitor. More and more well-known New York accounting firms are going to court to enforce their rights under such agreements when once-loyal accountants leave the firm and then seek to service former clients or hire employees from their former firm. Many accounting firms recognize the importance of including the correct and updated form of a protective covenant in their employment agreements. Others, however, rely on covenants drafted many years ago, neglecting to revise agreements to reflect changes in an employees seniority, market conditions, or the law. Even accounting firms that periodically update their protective covenants often implement them on a forward-looking basis only. Thus, these firms fail to require existing employees to agree to the updated provisions and are left without complete protection. The discussion below explores some of the best practices for designing and updating protective covenants, as well as practical tips for implementing revised
agreements with existing staff and for hiring accountants with preexisting contractual obligations. It will also focus on leading and recent court cases involving New York accounting firms.
Leading New York Court Case

The leading New York court case concerning the enforcement of postemployment protective covenants concerned a national accounting firm. The case BDO Seidman v. Hirschberg, 93 N.Y.2d 382 (1999)demonstrates why accounting firms should include carefully drafted protective covenants in their employment, partnership, and shareholder agreements. In BDO Seidman, the defendant Hirschberg was an accountant whose local Buffalo firm had been acquired by BDO.
When Hirschberg was promoted to manager at BDO, he signed an agreement that prohibited him from servicing BDOs clients for 18 months after the termination of his employment. In addition, it required that if Hirschberg violated the agreement, he would have to pay BDO 150% of a particular clients fees from the fiscal year prior to his departure from BDO. When Hirschberg resigned four years after his promotion, he then provided accounting services to several BDO clientsthe equivalent of $138,000 in revenues to BDO in the year prior to his departure. The New York Court of Appeals examined BDOs agreement with Hirschberg to determine whether it was enforceable. The law is clear that, regardless of the actual lanAUGUST 2012 / THE CPA JOURNAL
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guage in the covenant, only reasonable restrictions will be enforced. A restraint is reasonable only if it: (1) is no greater than is required for the protection of the legitimate interest of the employer, (2) does not impose undue hardship on the employee, and (3) is not injurious to the public (BDO Seidman, pp. 388389). The court emphasized that restrictions of this type are more likely to be enforceable against learned professionals who provide specialized services, such as accountants. It also scrutinized Hirschbergs covenant to determine whether BDO was indeed protecting a legitimate interest, and whether the covenant was tailored only as restrictively as necessary to protect that interest. The court ultimately held that the covenant was overly broad because it prohibited Hirschberg from servicing all BDO clientseven those Hirschberg himself recruited prior to joining BDO and those with whom Hirschberg had not developed any relationship as the result of his employment (BDO Seidman, p. 393). Rather than simply discarding the overly broad covenant, however, the court next considered whether the covenant should have been enforced to the extent that it was reasonable. It found no evidence of BDOs deliberate overreaching, bad faith, or coercive abuse of superior bargaining power. Because of this, the court rewrotethat is, blue-penciled the covenant to effectively narrow it by precluding Hirschberg only from servicing those clients with whom he had developed a relationship as a result of his employment with BDO (BDO Seidman, pp. 394395). The court then sent the case back to the trial judge to determine whether BDO was entitled to receive damages based on the formula of 150% of the clients prior years revenue, as specified in the covenant (BDO Seidman, p. 397). This case demonstrates how valuable protective covenants can be in guarding an accounting firms business interests. But BDO Seidman also highlights the importance of choosing appropriate covenants for given employees and carefully drafting such covenants so that they contain reasonable and clearly defined terms.
Types of Protective Covenants

Protective covenants come in a variety of forms, and selecting the right covenant is the first step in protecting a business.
The following sections examine five different types of covenants. Noncompetition provision. The most restrictive covenant is the blanket noncompetition provision, which prevents employees from working in competition with their former firm for a specified period of time following the termination of employment. Because this type of covenant imposes the greatest restraints on an employees ability to earn a living, courts are most reluctant to enforce it. A blanket noncompetition provision is appropriate for only the most senior members of an organizationif at all and it is often utilized in the context of a larger firms buyout of a smaller firm and the hiring of that smaller firms principals as partners or senior executives. Blanket noncompetition provisions might also be appropriate for senior-level employees with wide-ranging access to sensitive confidential information, which would necessarily be disclosed if the employee were to go to work for a competitor. Nonsolicit/nonservice provision. This provision is less restrictive than the blanket noncompetition provision; it prohibits former employees from soliciting or providing services to firm clients for a specified period of time. Because non-solicit provisions are narrower in scope than noncompetes, they are relatively easier to enforce when properly drafted. Non-solicit/nonservice provisions are appropriate for a broader range of employees than blanket noncompetition provisions, and firms commonly use them for both senior- and midlevel employees. These covenants can be appropriate even for junior employees who will have ongoing contact with firm clients. Moreover, such covenants can sometimes be expanded in scope for more senior employees who join the firm in the context of a buyout or merger, such that the covenants protect even those employees preexisting clients brought to the firma category that is generally not protectable. (See Weiser LLP v. Coopersmith, 74 A.D.3d 465, 467 [1st Dept 2010].) Nonraid/nonhire provision. A nonraid/nonhire provision bars an employee from soliciting other firm employees for a period of time after departure. A nonraid provision can be useful when a given employee has few direct or exclusive relationships with firm clients, but works closely with other employees who do. Like
nonsolicit/nonservice provisions, nonraid/nonhire provisions are commonly used for a wide range of employees at various levels of seniority. Extended notice provision. This type of provision simply requires employees to give advanced notice of their resignation. The long lead time gives the firm a better chance to retain a client by introducing other personnel into the relationship, and it can assist the firm in retaining clients that the departing employee brought to the firma category of client that a nonsolicit/nonservice provision might not reach. Extended notice provisions can be appropriate for employees at all levels, regardless of whether those employees have contact with clients. The amount of notice required before resignation should be tailored to the employees level of seniority, with longer periods appropriate for more senior employees. Employment agreement. Last, employment agreements can contain an agreement that employees will not use the firms confidential or proprietary information after departure. While the law itself prohibits departing employees from improperly using confidential information, a contractual provision can broaden the definition of confidential information and can eliminate disputes about whether specific types of information are protected from an employees use. Such covenants are appropriate for employees at all levels.
Choosing and Drafting a Covenant

It often makes sense to use several of the provisions described above in combination in order to protect a companys interests. Firms should take a close look at the types of services being rendered by a given category of employees, the closeness of the employees relationships with clients and other employees, and the nature of information to which the employees have regular access. Next, firms should select the appropriate blend of covenants to fit a situation; different types of employees might require different covenants, and firms might impose greater restrictions on partners or owners because of their contractual and fiduciary relationships with the firm and its other partners or owners. Once a firm has chosen the appropriate covenants, it must refine them to make them more effective by not only defining
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the firms protective covenants carefully and completely, but also by reasonably limiting their scope. The sections below describe the key strategies that accounting firms should use in working with legal counsel to draft protective covenants and avoid common pitfalls. Leave nothing to guesswork. A protective covenant that fails to adequately define what it seeks to protect and prevent could fall short when put to the testin other words: when in doubt, spell it out. By assuming that everyone knows what a given term means, firms run the risk that a court will end up defining that term for themand the results might not work in favor of the firm seeking to enforce the covenant. For example, the New York Court of Appeals recently decided a case defining what solicitation of a client means. In Bessemer Trust Company v. Branin, 16 N.Y.3d 549 (2011), an executive sold his wealth management company, began working for the buyer of his company, and then later resigned and joined a competitor. While the executive had not agreed to any specific protective covenants pursuant to the deal, New York law imposes certain nonsolicit obligations on the seller of a business because the purchaser is considered to be buying the sellers goodwill and ongoing client relationships. Despite these obligations, the court held that the executive was still permitted 1) to answer a former clients questions about the competitors business, 2) to assist the competitor in creating a pitch strategy for the former client, and 3) to even attend a meeting between the competitor and the former client (Bessemer, pp. 559560). In the courts view, none of these constituted improper solicitation under the implied covenant inherent in the sale of a business. Bessemer illustrates several important lessons. First, firms should not leave defining the terms in protective covenants or filling in missing provisions to the courts. An employment agreement should specifically define critical terms, such as what constitutes solicitation and who qualifies as a client subject to protection. Second, firms should examine their existing covenants to ensure they prohibit departing employees from not only soliciting clients, but also from servicing them. Otherwise, departing employees might find it easy to circumvent their protective covenants.
Defining the scope of protections: keep it reasonable. In addition to being clearly defined, a firms protective covenants must be reasonable in scope. As BDO Seidman illustrated, courts will not enforce overly broad covenants. Thus, firms must be reasonable in defining their protected interests and their employees prohibited conduct. Firms should not overreach; if a court sees overreaching, coercion, or bad faith by a firm, it will decline to partially enforce the agreement and will simply throw out the protective covenant in entirety. It is true that the New York Court of Appeals blue-penciled the protective covenant in BDO Seidman and that, more recently, another appellate court blue-penciled an overly broad covenant entered into between accounting firm Weiser LLP and its partners (Weiser LLP, p. 469). Other New York courts, however, have refused to blue-pencil agreements between accounting firms and their employees; instead, they struck down the covenant in entirety. For example, in Scott, Stackrow & Co., CPAs, P.C. v. Skavina, 9 A.D.3d 805 (3d Dept 2004), a New York appellate court refused to partially enforce an overly broad protective covenant that the accounting firm sought to impose on a staff accountant who joined the firm when it acquired her previous firm. The court noted that that the accounting firm had deliberately imposed the overly broad covenant on the accountant, prohibiting the defendant from servicing the firms entire client base (regardless of whether she had any dealings with these clients), and had insisted that she sign the covenant each year despite offering her no promotion or increase in responsibilities (Scott, Stackrow, pp. 807808). Notably, the Scott, Stackrow decision illustrates the importance of routine checkups for a firms protective covenants. The court specifically mentioned that the firm had continued to impose the overly broad covenant, even though the BDO Seidman decision had explained the reasonable limits of such covenants only a few years prior. Good protective covenants impose clear but reasonable limits and conditions on what a departing employee can do. In the case of a blanket noncompetition covenant which might be appropriate only for senior partners or key executives involved in firmwide strategy who have access to specific
types of highly confidential information the agreement should define competition. Where possible, the covenant should also specify those competitors for whom the employee may not work, and it should appropriately limit the period of time and the geographic area, if applicable, in which the employee may not compete. This type of covenant will more likely be enforced if the departing employee receives some continued compensation during the term of the noncompetition period. A nonsolicit/nonservice provision should set forth a reasonable, definite time period of effect and should specifically define clients to include only actual or prospective firm customers that the firm last serviced within a specific, limited period prior to the employees departure. The covenant should define clients to include only customers that the employee personally serviced or pitched. As with the term competition, the terms solicitation and service should be clearly defined. Service should list the variety of services performed by the employee or offered by the firm (e.g., accounting, auditing, tax, management, consulting services). Similarly, solicitation should include direct or indirect efforts, such as assisting another person, to cause a firm client not only to engage the employees new firm, but also to reduce, in any way, the amount of business the client does with the original firm. A nonraiding provision concerning the recruitment of other employees should likewise explicitly prohibit indirect efforts to recruit, such as assisting a new employer in doing so. Put a price tag on a violation. Finally, when drafting clear and well-defined protective covenants, it can be advantageous for firms to set forth specific remedies in the event that departing employees violate their covenants. Because the damages arising from client loss can be difficult to quantify, accounting firms now commonly include liquidated damages provisions in their protective covenants. Such provisions require the exiting employee to pay a set sum (or a sum derived from a set formula) in the event of a violation of the agreement. Courts will enforce a liquidated-damages clause if it does not result in the employee paying a sum that is considered grossly disproportionate to the harm anticipated at the time the parties signed the agreement. For example, in BDO Seidman,
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the court approved, in theory, a liquidateddamages formula based on 1.5 times the prior years billings of the lost client, where the protective covenant lasted 18 months (BDO Seidman, p. 396). More recently, a New York court required a currency trader who competed with his former employer in violation of his covenant to pay an amount equal to the traders average monthly commissions, multiplied by the number of months remaining in his covenant (GFI Brokers LLC v. Santana, 2008 WL 3166972 [S.D.N.Y 2008]). Likewise, a New York court approved a liquidated damages payment amounting to a consultants contractual share of one years estimated annual billings to a client lost to the consultants subcontractor (Crown It Services Inc. v. Koval-Olsen, 11 A.D.3d 263 [1st Dept 2004]). In all of these situations, the accounting firms designed the covenants to provide the revenue stream of the lost client, rather than trying to stop a once-trusted employee from servicing an unhappy client. Another common and powerful remedy for breach of a protective covenant is an injunctionthat is, a court order commanding the departed employee to stop working in violation of the covenant. The key to obtaining an injunction is a firms demonstration that it will suffer irreparable harm if the employee continues violating the covenant. Courts generally recognize that the loss of client relationships and goodwill constitutes irreparable harm (e.g., Ticor Title Ins. Co. v. Cohen, 173 F.3d 63, 69 [2d Cir. 1999]). While the law itself provides for injunctive relief when the proper conditions have been met, protective covenants nonetheless often include an employees explicit acknowledgement that a violation of the covenant would result in irreparable harm and that the firm, therefore, has the right to seek an injunction in the event of a breach; however, this acknowledgment would not necessarily prevent a court from finding that monetary damages would be sufficient to compensate the former employer for its loss, which could serve as an obstacle to securing the injunction. There are at least two other difficulties with relying on injunctive relief. First, the accounting firm seeking to enforce the covenant has a very high burden of proof and needs to prove its case (typically on
an emergency basis) before pretrial discovery. Meeting this high burden at such an early stage can be daunting. For example, in April 2011, a New York court refused to issue a preliminary injunction against J.H. Cohn LLP in a case involving several managing directors and partners who had departed RSM McGladrey, and who had allegedly violated covenants prohibiting their solicitation or servicing of McGladrey clients and their hiring of other McGladrey personnel (RSM McGladrey Inc. v. J.H. Cohn LLP, No. 650523-2011, slip op. at 14 [Sup. Ct. N.Y. County, April 8, 2011]). Despite the fact that McGladrey was able to secure injunctive relief against the managing directors and partners themselves in other state courts, the New York court found that McGladrey could not demonstrate a likelihood of success on the ultimate merits of its claims against J.H. Cohn and did not find that McGladrey would actually suffer irreparable harm in the absence of an injunction (RSM McGladrey, pp. 1112). Second, former employees are likely to argue that it was their former firms failure to service a clients business properly that caused the client to terminate his business relationship with the firmrather than the employees violation of the covenant. In other words, a departing employee will typically decide that the best defense is to go on offense and put the conduct of his former accounting firm on trial. This is another reason why preset contractual remedies, such as liquidated damages, have become increasingly common in accounting firms restrictive covenants.
bonuses for the current year. The firm can present its new covenants to the employees and ask that the employees sign and return the new covenants by a date prior to the announcement of salary increases and bonuses. In addition, accounting firms must consider any preexisting obligations that candidates have to their previous firms. Firms should always ask potential new hires if they are subject to protective covenants, confidentiality agreements, or any other agreements with their former firm; they should also insist on receiving and reviewing copies of such covenants during the interview process, ideally along with the firms employment counsel. When possible, accounting firms should also make new accountants employment contingent on their representation that they have provided the firm with all prior protective covenants, and that no prior agreements prevent them from working in the new position. This process ensures that an accounting firms investment in a new accountant is protected not only against future loss of its client relationships, but also against claims by another firm seeking to protect its own such relationships.
The Bottom Line

Protective covenants offer accounting firms a powerful means of protecting their most valuable assets: their client relationships and their employees. It is critical for a firm to make sure its professionals agree to protective covenants that reduce the likelihood of losing clients or employees. With the right combination of protectionsand provisions that clearly define those protectionssavvy managing partners and executive committees of accounting firms can ensure that their firms covenants will preserve the value of their business and include the latest industry trends and legal developments. These proactive measures can be the difference between the minimal disruption of losing one accountant and waving goodbye to a substantial book of business, rev enues, and employees. Michael C. Lasky is a senior partner and cochair of the litigation department at Davis & Gilbert LLP, New York, N.Y. David S. Greenberg is an associate in the litigation department at Davis & Gilbert LLP.
Updating Covenants and Due Diligence in Hiring

Unlike some other jurisdictions, New York law recognizes that continued employment in an at will relationship is sufficient consideration to support new protective covenants. Thus, from a purely legal standpoint, an accounting firm does not need to offer employees any additional compensation in exchange for their agreement to sign new (and more stringent) protective covenants. As a practical matter, however, many accounting firms find that the best time to implement new covenants is in the third quarter, when many firms begin to consider salary increases for the following year and
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E S P O N S I B I L I T I E S
& L E A D perceptions of the profession
E R S H I P
Advisory Services Rise Again at Large Audit Firms

Like a Phoenix, Revenues Reborn amid Renewed Concerns
By R. Mithu Dey, Ashok Robin, and Daniel Tessoni
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early one decade ago, most of the large accounting firms divested their advisory services business. The divestitures were motivated not only by business and management reasons, but by regulatory pressures as well. In particular, regulators were concerned that audit quality could suffer if advisory services threatened auditor independence. As a result of the divestitures and the adoption of the Sarbanes-Oxley Act of 2002 (SOX), advisory services revenue represented only a small share of accounting firms revenues circa 2007. In recent years, however, advisory services revenue has risen again, renewing concerns of its potential effects on audit quality. But auditor independence is no longer
viewed as the primary threat to audit quality; instead, concerns revolve around the audit firms culture and the quality of the resources allocated to advisory versus assurance services. The following is an examination of the rise and falland rise againof advisory services within public accounting firms.
Background
Advisory services revenue grew rapidly at public accounting firms during the late 1990s; yet, by the early 2000s, all but one of the thenBig Five had spun off or sold these business lines. Three factors drove these divestitures: 1) internal management tensions because
of the faster revenue growth and perceived higher margins of advisory services as compared to assurance services; 2) the opportunity to unlock higher values and raise capital through sales to publicly traded corporations or via an initial public offering (IPO); and 3) the pressure applied, and regulations adopted, by policymakers aimed at ensuring auditor independence. Beginning in the early 2000s, advisory services revenue shrank due to divestitures and the adoption of SOX. At the same time, assurance services revenue soared as SOX fueled rapid increases in the demand for assurance services from clients. As a result, advisory services played a diminished role in accounting firms beginning in the early 2000s to about 2007. Since 2007, however, advisory services have represented a rising share of revenue for accounting firms, triggering renewed concerns. Over the years, observers have raised management and policy concerns about the role that advisory services play in the accounting industry. Arthur Wyatt, a former FASB and International Accounting Standards Board (IASB) board member and Arthur Andersen senior partner, has discussed concerns about internal conflict in accounting firms that may adversely affect audit quality (Accounting ProfessionalismThey Just Dont Get It! Accounting Horizons, March 2004; Accounting Professionalism: A Fundamental Problem and the Quest for Fundamental Solutions, The CPA Journal, March 2004). According to Wyatt, such internal conflict might have a bearing on the allocation of resources and talent, and might result in a shift in client focus from the investing public (audit realm) to company managers (advisory realm). On the policy front, most of the concerns in the late 1990s and early 2000s focused on auditor independence, which was viewed as a contributing factor in the collapse of major corporations such as Enron, WorldCom, and Adelphia. These policy concerns about auditor independence appeared to be largely addressed through SOX, which essentially prohibited the primary auditors from also providing advisory services. Recently, however, advisory services have again become important to accounting firms. These firms have found ways to sell advisory services to clients for which they are not the primary auditor. This rebirth of advisory services has generated renewed policy and management concerns. A Treasury report
(Final Report of the Advisory Committee on the Auditing Profession [ACAP] to the U.S. Department of the Treasury, October 2008) on the auditing industry raised concerns about the adverse role advisory services might be playing in public accounting firms. Although the ACAP report was silent in its recommendations about the firms scope of services because the issue was not part of the committees charge, the co-chairs commented on the scope of services issue in their transmittal letter accompanying the report. Specifically, they expressed concern that as non-audit services grow at a faster rate than audit services, fewer resources will be allocated for audit work. Their concern shifted from the issue of independence (alleviated by SOX) to that of resource allocation in accounting firms and the potential implications for audit quality. Other commentators (Dana R. Hermanson, How Consulting Services Could Kill Private-Sector Auditing, The CPA Journal, January 2009) have
expressed concern that talent and resources might be diverted from auditing toward the faster- growing, and apparently more lucrative, advisory side of the business. If advisory services growth continues on its current trajectory, these concerns are likely to become more important in the very near future, potentially leading to some kind of policy or management response. The authors believe that it is in the best interest of the accounting profession to take a proactive approach in addressing that potential policy response. The fact that the Big Four are delivering value for their advisory services clients is indisputable. The markets clearly recognize their prowess as consultants. In an April 2010 Gartner report of all consulting providers, the Big Four are included in the list of Top 10 Consulting Service Providers Revenue, Growth and Market Share, 20082009 for North America (http://www.gartner.com/id=1362249). At
EXHIBIT 1 Advisory Services Revenue from All Clients, 19962010
$ in Millions 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 E&Y Advisory Services Revenue Deloitte Advisory Services Revenue PwC Advisory Services Revenue KPMG Advisory Services Revenue
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issue, however, is not whether the Big Four are doing a good job of consulting, but whether strong consulting businesses inside audit firms pose a threat to audit quality and firm culture. The authors focus is on whether the return to consulting is harmful to audit qualityan issue of significant concern to investors and regulators.
Prior Round of Divestitures

Around 2000, all of the thenBig Five, with the exception of Deloitte, divested their advisory services practices. The divestitures were driven by one or more of the factors described earlier: management tension, opportunity for unlocking value, and pressure from regulators. Each of the Big Fives experiences is described below. Arthur Andersen. Management tension caused the breakup at Andersen Worldwide, the parent company of Arthur Andersen (AA), and Andersen Consulting (AC). A formal profit-sharing agreement between AA and AC was struck in 1989, just before the IT boom contributed to the lucrative environment for advisory services during the 1990s. The agreement required that the more profitable firm
share profits with the less profitable one; fueled by IT, AC grew much faster and was more profitable than AA. Thus, this agreement caused a great deal of tension between AC and AA management. The conflict, as reported in the press, lasted for about three years, until AC finally split off by paying AA $1 billion and foregoing the rights to the Andersen name (Brown, Andersen Consulting Wins Independence: Arbitrator Tells Firm to Pay Auditing Arm $1 Billion; Parents Role Criticized, Wall Street Journal, August 8, 2000), with AC becoming Accenture. Subsequent to the split, AA restarted its advisory arm, often competing for the same clients as Accenture. Ernst & Young. Ernst & Young (E&Y) sold its advisory group for $11.1 billion to French IT firm Capgemini in March 2000, at the very peak of the Nasdaq stock market boom. According to interviews with leading executives at E&Y, the advisory services business was sold for financial, regulatory, and strategic reasons (Malhotra and Pierroutsakos, An Assessment of Cap Geminis Cross-Border Merger with Ernst & Young Consulting, Multinational Business
Review, summer 2005). Financially, the offer of 2.75 times the advisory services units annual revenue allowed E&Y partners to monetize the advisory services asset investments of the 1990s. Regulatory pressure brought to bear by the SEC to separate audit from non-audit functions in order to ensure auditor independence also motivated the sale. A final reason given for the divestiture was that it allowed management to focus more closely on its audit practice: E&Ys CEO claimed this was an important reason E&Y outperformed other large audit firms. On March 26, 2001, Chairman James Turley noted, The year after we announced the sale of our advisory business, we won three and a half times more revenue than the rest of the Big Five combined! I am not saying that our sale of advisory directly led to that, but I really do believe that the focus that we are now putting on the core businesses played a part in that (http://newman.baruch. cuny.edu/digital/saxe/saxe_2001/turley_2001.ht m). In spite of the proclamation that focusing on core business was a key competitive advantage, E&Y started to build its advisory practice soon after its non-compete agreement with
EXHIBIT 2 Top 100 Accounting Firm Revenues

Total Revenues $21,221.90 25,469.80 31,665.80 36,739.69 34,772.60 35,362.33 28,422.61 30,643.26 33,154.08 38,010.71 41,795.83 40,854.65 44,600.48 42,638.90 42,500.06 Assurance (Percentage of Total) $7,910.99 37% 8,393.81 33% 9,550.72 30% 10,920.39 30% 12,872.10 37% 13,176.18 37% 11,517.70 41% 13,871.01 45% 15,594.98 47% 19,003.03 50% 22,792.29 55% 21,544.75 53% 22,978.19 52% 19,001.83 45% 18,351.48 43% Advisory (Percentage of Total) $8,302.14 39% 10,903.39 43% 14,847.70 47% 17,695.50 48% 12,824.03 37% 11,270.82 32% 7,144.62 25% 5,893.86 19% 6,690.24 20% 7,658.91 20% 8,511.31 20% 8,538.60 21% 9,389.17 21% 11,225.05 26% 12,252.89 29% Tax (Percentage of Total) $5,008.62 24% 6,148.38 24% 7,267.38 23% 8,123.80 22% 9,076.48 26% 10,915.33 31% 9,760.29 34% 10,878.39 36% 10,868.86 33% 11,348.76 30% 10,492.22 25% 10,771.30 26% 12,233.12 27% 12,412.02 29% 11,895.69 28%
Top 100 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
All amounts in millions of dollars Source: 1997 to 2011 Accounting Today Top 100 Firms published annually
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Capgemini expired in 2005. Ironically, the rebuilding of advisory capabilities was performed under Turley, who earlier had argued for an increased focus on assurance services. KPMG. In 2001, KPMG spun off its advisory practice, which it named Bearing Point, through an IPO. KPMG disclosed its IPO plan in May 2000, two months after the Nasdaq peaked. The IPO was delayed due to the turbulent market conditions. Nevertheless, management pushed ahead in the belief that the IPO would provide the advisory practice greater freedom in partnering with and investing in the equity of clients. Such opportunities are severely limited for advisory units affiliated with an accounting firm because of the potential conflicts of interest concerning audit clients (IPO Still On For KPMG Consulting, Larry Greenemeier, InformationWeek, January 8, 2001). Subsequent to the expiration of its non-compete agreement with Bearing Point in 2006, KPMG began rebuilding its advisory practice. PricewaterhouseCoopers. A similar story unfolded at PricewaterhouseCoopers (PwC), where the primary reason for the divestiture
appeared to be pressure from the SEC. PwC experienced at least two failed attempts in divesting its advisory unit. In 2000, near the peak of the IT bubble, computer giant Hewlett Packard (HP) offered PwC $18 billion in cash and stock for its advisory unit, but HP later dropped the offer because an agreement could not be reached. PwC also attempted an IPO, named Monday, in the summer of 2002, but the market for new issues had collapsed at that time. Subsequent to these two failed attempts, and with the adoption of SOX, many of PwC's largest clients decided to either cut their advisory relationship with PwC or to reduce it. In 2002, for example, 22 of the 100 largest audit clients did not want to hire PwC for advisory services, and 16 wanted to reduce the amount of advisory services sourced from PwC (Goodbye Monday, Economist, August 1, 2002). Eventually, in October 2002, PwC sold its advisory services to IBM for $3.5 billion in cash and stock, less than one-fifth the amount HP had offered just two years earlier. Like the other firms, once its non-compete agreement expired in 2006, PwC began rebuilding its advisory practice.
Deloitte. The sole member of the Big Five not to successfully divest its advisory practice was Deloitte. Deloittes attempt to divest through a managementled buyout fell through in March 2003. Borrowing costs for the capital needed to finance the buyout skyrocketed in the wake of Andersens closure, and revenue sank as cautious audit clients canceled non-audit contracts. On March 31, 2003, the firm scrapped its divesture plans; in hindsight, the firms management viewed this as a blessing in disguise. In a strange kind of way, were very fortunate, said Barry Salzberg, CEO of Deloitte & Touche USA. By serendipity, we ended up with a strategy that is unique (Nanette Byrnes, The Comeback of Consulting, BusinessWeek, September 3, 2007). In terms of absolute advisory revenue, as well as a percentage of total revenue, Deloittes advisory services are significantly larger than those of the other large accounting firms. The Big Four accounting firms have reentered the advisory services market by targeting non-audit clients. In addition, they
EXHIBIT 3 Ernst & Young: Breakdown of Total Revenues

Total Revenues $3,570.00 4,416.00 5,545.00 6,375.00 4,270.00 4,485.00 4,515.00 5,260.00 5,511.36 6,330.64 6,890.00 7,561.00 8,232.10 7,620.00 7,100.00 Assurance (Percentage of Total) $1,392.30 39% 1,589.76 36% 1,885.30 34% 2,231.25 35% 2,433.90 57% 2,601.30 58% 2,663.85 59% 3,261.20 62% 3,692.61 67% 4,558.06 72% 4,960.80 72% 5,292.70 70% 5,597.83 68% 3,124.20 41% 2,982.00 42% Advisory (Percentage of Total) $1,392.30 39% 1,810.56 41% 2,384.35 43% 2,805.00 44% 213.50 5% 134.55 3% 135.45 3% 157.80 3% 165.34 3% 63.31 1% 68.90 1% 75.61 1% 164.64 2% 1,981.20 26% 1,846.00 26% Tax (Percentage of Total) $785.40 24% 1,015.68 23% 1,275.35 23% 1,338.75 21% 1,622.60 38% 1,749.15 39% 1,715.70 38% 1,841.00 35% 1,653.41 30% 1,709.27 27% 1,860.30 27% 2,192.69 29% 2,469.63 30% 2,514.60 33% 2,272.00 32%
E&Y 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
All amounts in millions of dollars Source: 1997 to 2011 Accounting Today Top 100 Firms published annually
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are able to offer nonprohibited advisory services to audit clients with advanced audit committee approval under SOX section 201(a). The current barrier to entry now appears to be lower for accounting firms. The significant brand recognition and recruiting strength of the Big Four provide them access to large clients and qualified advisory services candidates. As the growth in advisory services accelerates, will regulatory pressure force the public accounting firms to replay the divestitures of the early 2000s? At the present time, the advisory business is thriving among the Big Four, with revenues exceeding $1 billion at each firm. The rebirth of advisory services appears to have been a fairly easy undertaking, inhibited only by non-compete agreements in certain cases. Of course, audit firms are also delivering advisory services that are highly valued by their clients. With audit revenues flat or declining, due to greater standardization since SOX, advisory services are beginning to play an increasingly important role in driving accounting firm revenue and profit growth.
The Increasing Role of Advisory Services in Recent Years: Understanding the Trend
The authors analysis shows that advisory services revenue has grown since 2007, both in absolute terms and also as a share of total revenue for public accounting firms. The data are compiled from surveys published by Accounting Today in its annual Top 100 Accounting Firms from 1996 to 2010. The survey instrument requests firms to provide data on their net U.S. revenues and their fee split as a percentage of total revenue. Total revenues (U.S. public and private clients) are disaggregated into three components: assurance, tax, and the remainder as advisory. Starting with the 2002 Top 100 Accounting Firms, a fourth revenue component, other, was added, including elements such as financial planning, litigation support and valuation work, payroll, and benefit plan administration. To provide consistency over time, advisory services are defined as other and management advisory services. Exhibit 1 shows the changes in advisory services revenue for the Big Four from 1996
to 2010. During the late 1990s and early 2000s, advisory services revenue increased rapidly for all of these firms. Advisory services revenue then dropped significantly for three of the Big Four, due to the aforementioned divestitures. And even in the case of Deloitte, which did not divest, revenue declined beginning in 2001. From 2005 onwards, advisory services revenue began to increase again for most of these firms. In 2010, advisory services revenue, as a percentage of total revenue, accounted for a significant share of Big Four revenues: 19% for PwC, 26% for E&Y, 28% for KPMG, and 45% for Deloitte. If the Big Four (Five) are eliminated from the Top 100 accounting firms, one finds that revenue from advisory services was close to 30% from 2000 to 2005 and has been near 20% since 2006. This may indicate that the Big Four are taking advisory services business away from nonBig Four firms. In the early 2000s, the assurance business took center stage while the advisory business declined. As discussed earlier, most of the Big Four divested their advisory businesses and SOX increased demand for audit services. From 2003 to 2005, in spite
EXHIBIT 4 KPMG: Breakdown of Total Revenues

Total Revenues $2,530.00 3,000.00 3,800.00 4,656.00 5,400.00 3,400.00 3,400.00 3,793.00 4,115.00 4,715.00 4,801.00 5,357.00 5,679.00 5,076.00 4,889.00 Assurance (Percentage of Total) $1,012.00 40% 1,230.00 41% 1,368.00 36% 1,629.60 35% 1,890.00 35% 1,496.00 44% 1,496.00 44% 2,541.31 67% 2,962.80 72% 3,630.55 77% 2,448.51 51% 2,571.36 48% 2,725.92 48% 2,436.48 48% 2,248.94 46% Advisory (Percentage of Total) $1,037.30 41% 1,020.00 34% 1,520.00 40% 2,002.08 43% 2,322.00 43% 612.00 18% 680.00 20% * 0% * 0% * 0% 1,296.27 27% 1,553.53 29% 1,533.33 27% 1,269.00 25% 1,368.92 28% Tax (Percentage of Total) $480.70 19% 750.00 25% 912.00 24% 1,024.32 22% 1,188.00 22% 1,292.00 38% 1,224.00 36% 1,251.69 33% 1,152.20 28% 1,084.45 23% 1,056.22 22% 1,232.11 23% 1,419.75 25% 1,370.52 27% 1,271.14 26%
KPMG 1996 1997 1998 1999 2000 2001 2002 2003* 2004* 2005* 2006 2007 2008 2009 2010
All amounts in millions of dollars Source: 1997 to 2011 Accounting Today Top 100 Firms published annually * For 2003, 2004, and 2005, KPMGs advisory revenues are included in assurance revenue.
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of the drop in advisory services revenue, increases in assurance services revenue more than made up the difference, resulting in overall revenue increases for all of the firms. Assurance services revenue increases were driven by increases in liability risks for auditors and clients alike, as well as increases in engagement hours. With the passage of SOX and the implementation of SOX section 404, assurance revenues soared. Due to SOX section 404 compliance, audit fees nearly doubled from 2003 to 2004, and remained high in 2005, according to several studies (e.g., a Financial Executives Institute member survey report, March 2006). The Public Company Accounting Oversight Boards (PCAOB) Auditing Standard (AS) 2 also caused an increase in audit hours. In addition, top executives of publicly traded corporations are now required to take more personal responsibility for their financial statements, leading to greater reliance on auditors for assistance. From 2006 to 2007, several factors including a backlash from clients over high engagement feesimpacted assurance revenues of the Big Four (Freeman, Whos Going to Fund the Next Steve Jobs? Wall Street Journal, July 18, 2008). Auditors reduced their hours and audit revenues dropped (Reilly, Audit Fees Rise, But at a Modest Pace, Wall Street Journal. March 27, 2006). A primary catalyst for this was AS 5, which allowed auditors to take a more risk-based approach in the audit and place more reliance on the work of others, such as internal auditors. In addition, by this time auditors and clients had progressed along the learning curve of SOX section 404, thereby reducing audit hours and audit fees. Furthermore, the financial crisis and recession of 2007 likely contributed to a reduction in aggregate audit revenue. The recession may have also led clients to negotiate more forcefully with auditors to reduce prices. Companies were likely capturing a greater share of the savings generated by the regulatory shift to AS 5 and the learning curve cost reductions resulting from SOX section 404. Other competitive pricing pressure came from second-tier auditors who had become more serious competitors to the Big Four; this competition, of course, was limited to certain sectors of the markets in which the second tier was most capable of auditing. Because of these
developments, there was increased economic pressure on the Big Four to seek additional nonassurance revenues (Byrnes 2007). During this same 20062007 period, most of the non-compete agreements on advisory services expired. Thus, as assurance revenues started to stagnate or decline, audit firms had a strong motivation to make up
those revenues through other business lines; thus, managers recultivated advisory services. Deloittes success in maintaining and growing its advisory services, even with the strong regulatory constraints in place, provided a blueprint for the other firms to resuscitate their advisory services. The years following 2007 clearly indicate that advisory services are on the rise.
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Since 2008, advisory services revenues have continued to grow for the Big Four, while assurance services revenues have stagnated. Based on this rapid growth, it seems clear that firms are focusing their growth strategy on advisory services. For example, advisory services revenue for PwC grew as a share of total revenue from 14% to 19% between 2008 and 2010, and Deloittes advisory services grew from 34% to 45%. The 19962010 timeframe can be divided into four periods. The first period, in the late 1990s, was one of rapid growth in advisory services. The second period, 20002005, was characterized by divestitures in advisory services coupled with a post-SOX boom in auditing services. The third period, 20062007, saw stagnation in audit revenues and an opportunity to reconsider advisory services. The final period, since 2007, has seen a full-blown rebirth of advisory services. Exhibit 2 takes a big picture look at revenue components of the Big Four. The three primary components of revenues for audit firms are assurance, advisory, and tax, and
each has taken a different path over the 19962010 timeframe. Assurance services revenues were $7.9 billion in 1996, accounting for 37% of overall revenues. Its share of revenue peaked at 55% in 2006, but has declined to just 43% by 2010 as assurance revenues stagnated over that period. Advisory services revenues, on the other hand, were $8.3 billion in 1996, slightly higher than assurance services revenues and accounting for 39% of overall revenue. Advisory services revenues peaked in 1999 at $17.7 billion and 48% of overall revenues, before declining to a mere $5.9 billion, or 19% of revenues, in 2003. Since 2003, advisory services revenues have been increasingfirst slowly and, more recently, rapidlyto account for 29% of overall revenues. Tax services revenues more than doubled between 1996 and 2001 to $10.9 billion, growing its share of overall revenues from 24% to 31%. Since 2001, tax revenues have been relatively flat, fluctuating in a narrow range between $9.8 billion and $12.4 billion. Tax revenues accounted for 28% of overall revenues in 2010.
A Closer Look at Each of the Big Four

Ernst & Young. E&Y sold its advisory services to Capgemini in 2000 and was excluded from the advisory market for five years due to a non-compete agreement (Commission of the European Communities, Regulation [EEC] No. 4064/89 Merger Procedure, May 17, 2000). As shown in Exhibit 3, total revenue for the firm peaked at $6.4 billion in 1999 before the sale, and decreased to $4.3 billion in 2000; however, total revenue has steadily increased since then, to $7.1 billion in 2010. The steady increase in total revenue from 2000 to 2010 was only partially due to increases in advisory revenues. Advisory revenues stood at $2.8 billion in 1999, dropped after the Capgemini sale to marginal levels, and remained there until 2009 when it increased to $2.0 billion in 2009. The increase in total revenues from 2000 to 2008 came from steady increases in both assurance and tax services revenues. In the case of assurance services, revenues increased each year after the Capgemini sale, to peak at $5.6 billion in 2008. And tax services revenues increased steadily each year,
EXHIBIT 5 PricewaterhouseCoopers: Breakdown of Total Revenues

Total Revenues $4,135.00 4,844.50 5,862.00 6,750.00 8,878.00 8,057.00 5,174.00 4,850.00 5,189.50 6,167.00 6,922.38 7,463.77 7,578.30 7,369.44 8,034.00 Assurance (Percentage of Total) $1,656.85 37% 1,819.16 36% 1,055.16 18% 2,362.50 35% 2,903.11 33% 2,819.95 35% 3,000.92 58% 3,007.00 62% 3,373.18 65% 3,885.21 63% 4,153.43 60% 4,403.62 59% 4,243.85 56% 3,979.50 54% 4,097.34 51% Advisory (Percentage of Total) $1,569.40 40% 2,009.65 42% 4,103.40 70% 3,037.50 45% 4,439.00 50% 3,625.65 45% 620.88 12% 242.50 5% 259.48 5% 678.37 11% 969.13 14% 1,044.93 14% 1,060.96 14% 1,105.42 15% 1,526.46 19% Tax (Percentage of Total) $908.75 23% 1,015.70 22% 703.44 12% 1,350.00 20% 1,535.89 17% 1,611.40 20% 1,552.20 30% 1,600.50 33% 1,556.85 30% 1,603.42 26% 1,799.82 26% 2,015.22 27% 2,273.49 30% 2,284.53 31% 2,410.20 30%
PwC 1996* 1997* 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
All amounts in millions of dollars Source: 1997 to 2011 Accounting Today Top 100 Firms published annually * For 1996 and 1997, data for Price Waterhouse and Coopers & Lybrand are merged to be consistent with the following years data.
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from $1.6 billion in 2000 to a peak of $2.5 billion in 2009. As E&Y CEO Turley noted, the firm was able to focus on its core business after the sale of its advisory services. In 2009, advisory services revenues grew by more than an order of magnitude, to $2.0 billion or 26% of overall revenues, up from a mere 2% in 2008. KPMG. As previously mentioned, KPMG spun off its advisory arm, named Bearing Point, in an IPO in 2001. Its noncompete agreement expired in 2006. Exhibit 4 shows that total revenues peaked at $5.4 billion in 2000, before the spinoff, and decreased to $3.4 billion in 2001, immediately after. Since then, total revenues have steadily increased to a new peak of $5.7 in 2008. The increase in total revenue from 2002 to 2005 was entirely due to increases in assurance services. Advisory services were reintroduced in 2006 and promptly accounted for 27% of revenue. Tax revenues have remained relatively unchanged at nearly $1.2 billion during the entire decade. Accounting for more than one quarter of its revenues, advisory services have been a critical source of business for KPMG for the past five years. PricewaterhouseCoopers. PwCs advisory business accounted for 40% of its revenues in 1996. PwC sold its advisory arm to IBM in October 2002, shortly after the passage of SOX. Exhibit 5 shows that before the sale in 2001, total revenue was $8.1 billion but dropped to $4.9 billion in 2003. It has steadily increased back to the pre-sale level of $8.0 billion in 2010. All three business segments assurance, advisory, and taxhave contributed to the increase in total revenues. Assurance services revenues increased from $2.8 in 2001 to a peak of $4.4 billion in 2007, and they now stand at $4.0 billion. Tax services revenues have grown steadily from $1.6 billion in 2002 to $2.4 billion in 2010. Advisory services revenues grew from a low of $242 million to a peak of $1.5 billion in 2010, accounting for nearly one-fifth of total revenues. Deloitte. Deloitte is the outlier among the Big Four because it never divested its advisory services business. Its overall revenue increased more than threefold, from $2.9 billion in 1996 to $10.9 billion in 2010, as shown in Exhibit 6. Assurance services revenues grew at a slightly slower rate, from $1.2 billion to $3.7 billion, during that span. But like the other firms, Deloittes
assurance services got a big boost from SOX, peaking at $4.8 billion in 2008 and accounting for 44% of total revenue. Compared to the other Big Four, its advisory services are a larger source of revenue. Advisory services revenue was $1.2 billion (41% of revenue) in 1996 and increased to $4.9 billion (45% of revenue) in 2010. The share of revenue contribution from each of
the business lines has changed little since SOX. And in absolute terms, Deloittes advisory services revenue is larger than the other Big Four combined.
Policy and Management Concerns: Framing the Debate

Policymakers were especially concerned about the outsized role advisory services were
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playing at the large accounting firms during the late 1990s and early 2000s. In particular, they questioned whether auditors could be independent if a large share of a firms revenueand an even larger share of its profitscame from its non-assurance work. Could a client use the leverage of advisory business to impair the objectivity of the audit and threaten auditor independence? Policymakers promulgated increasingly stringent regulations, culminating in SOX, which prohibited primary auditors from performing a wide range of non-assurance services. Title II of SOX says in very clear language that it shall be unlawful for a registered public accounting firm (and any associated person of that firm, to the extent determined appropriate by the Commission) that performs for any issuer any audit required by this title to provide to that issuer, contemporaneously with the audit, any nonaudit service, including nine prohibited advisory services activities. The justification for limiting advisory work performed by the primary auditor was to ensure that auditors were both independent in fact and in appearance
with respect to their audit clients. According to an analysis of fees paid to primary auditors in the Audit Analytics database, auditors served as both auditor and consultant to 90% of their public clients before the passage of SOX. For clients who received both auditing and advisory services, advisory services accounted for 65% of total revenue. As a result of SOX, at least until 2006, audit firms appeared to refocus their efforts on assurance services and deemphasized their advisory services. In recent years, advisory services accounted for only 10% of total revenue from clients where the auditor provides both audit and advisory services. Thus, as expected from SOX compliance, advisory revenue from audit clients is relatively low. The criticism that was leveled at auditors regarding independence softened after SOX was implemented. SOX was successful at enforcing audit independence at the primary auditor level, but now a new issueaudit qualityhas risen. Auditors are not constrained from providing advisory services to non-audit clients, and the large firms have increased these services. The Big Four rank among the top 10 consulting firms, reflect-
ing their ability to successfully deliver those services (Gartner Dataquest Research Note G00200370, April 2010). As noted above, concerns about the growth in non-audit services have been expressed by others recently (Wyatt 2004, ACAP 2008, Hermanson 2009). The cochairs of the ACAP committee expressed the following concern in their statement in the beginning of the report: The rate of growth for non-audit services, especially advisory services offered to nonaudit clients, now exceeds the rate of growth for audit services. We realize that the allocation of investment dollars and professional talent is in many cases interchangeable, and that some auditing firms are working a delicate balance in allocating resources amongst their various practices. As Co-Chairs of this Committee, we strongly believe that the audit practice should always be the highest priority. Hermanson, who served on the American Accounting Association committee that commented on ACAPs recommendations, expressed concern that this issue was not part of ACAPs agenda and
EXHIBIT 6 Deloitte: Breakdown of Total Revenues

Total Revenues $2,925.00 3,600.00 4,700.00 6,750.00 5,838.00 6,130.00 5,933.00 6,511.00 6,876.00 7,814.00 8,769.00 9,850.00 10,980.00 10,722.00 10,938.00 Assurance (Percentage of Total) $1,170.00 40% 1,260.00 35% 1,457.00 31% 2,362.50 35% 1,809.78 31% 2,022.90 33% 2,135.88 36% 2,539.29 39% 2,750.40 40% 3,438.16 44% 3,946.05 45% 4,334.00 44% 4,831.20 44% 3,967.14 37% 3,718.92 34% Advisory (Percentage of Total) $1,199.25 41% 1,620.00 45% 2,350.00 50% 3,037.50 45% 2,919.00 50% 2,819.80 46% 2,551.19 43% 2,343.96 36% 2,337.84 34% 2,656.76 34% 2,893.77 33% 3,349.00 34% 3,733.20 34% 4,181.58 39% 4,922.10 45% Tax (Percentage of Total) $555.75 19% 720.00 20% 893.00 19% 1,350.00 20% 1,109.22 19% 1,287.30 21% 1,245.93 21% 1,627.75 25% 1,787.76 26% 1,719.08 22% 1,929.18 22% 2,167.00 22% 2,415.60 22% 2,573.28 24% 2,296.98 21%
Deloitte 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008* 2009 2010
All amounts in millions of dollars Source: 1997 to 2011 Accounting Today Top 100 Firms published annually * 2008 total revenue is an Accounting Today estimate.
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that future waves of audit failures could lead to government-run audits. Audit quality has clearly become the central focus of the debate. Building on Wyatts discussion of advisory services and audit firm culture (2004), Hermanson (2009) described five negative effects of advisory services on audit firm culture. First, the culture of the firm might no longer be consistent with accounting professionalism. Second, the reason for the firms existenceauditmight become diluted by advisory work. Third, the identity of the client might shift from the investing public (audit realm) to company managers (advisory realm). Fourth, as evidenced in the pre-divestiture environment by Andersen and others, internal management tensions might arise. Auditors and consultants might expend considerable effort arriving at an agreement about compensation and profit sharing, based on the perception that advisory services are often a higher margin business. Such internal squabbles might take energy away from providing high-quality auditing services. Auditors might feel pressure to cut costs on their audits in order to make their margins and profits more comparable to those of the consultants. Finally, the reward system within the firm might focus too much on revenue and profit generation, and not enough on technical ability and accounting professionalism. The authors are concerned that audit quality might be impaired as firms refocus on advisory services. Specifically, how will this affect the focus of CPA firm employees and clientsfor example, when it comes to resource allocation, will audit or advisory services garner the larger share of the most qualified talent in the firm? As advisory services expand, its very likely that the competition for high-quality performers will increase. There are several reasons for believing that top accounting graduates might choose advisory over the assurance arm, including higher compensation, better opportunities for advancement, more potential clients, declining revenues in the assurance segment, and a broader range of work experience to place on a resume. Of course, even if the Big Four were not actively providing advisory services, top students might choose to work for an advisory-only firm. Finally, high-quality candidates might be more likely to shy away from auditing, given the riskier audit environment and their greater individual liability exposure.
The route to a partnership and what follows differs for an advisory partner, versus an assurance partner; the legal and financial risks from SOX and the PCAOB are greater in the assurance field. Some audit firms also extract financial penalties from audit partners for errors in judgment. This could contribute to assurance personnel constantly second-guessing their work and looking over their shoulder, creating an uncomfortable work environment. In addition, the authors question how auditors will view prospective clients: as a potential audit client, or an advisory client? If advisory services are more profitable, will auditors only become the client's primary auditor when the probability of doing advisory work is low? Reviewing ads in the popular press, the authors note that marketing ads appear to focus on the overall firm, or individually on tax and advisory services, but rarely on assurance services. It would appear that the large firms are leading with their non-assurance services in targeting potential clients. The constraints placed by the PCAOB have increased the risk profile of audit engagements and of auditors, whereas such burdens and oversight are not apparent in the advisory arena.
A Public Discussion
Advisory services have once again become a significant share of the Big Fours overall revenues. Observers of the auditing profession have expressed renewed concerns about the adverse effects this may have on audit quality. While auditor independence does not appear to be threatened, other concerns have been raised about firms allocation of key resources, especially talent. The data show very clearly that advisory services have been growing, and given that assurance revenues have remained relatively flat, the profession ought to begin a public discussion on the role of advisory services and its possible impact on audit quality. Paraphrasing E&Y CEO James Turley, jettisoning its advisory services helped E&Y improve its assurance and tax offerings; bringing advisory services back on a large scale may now cause assurance and tax services to suffer. The lucrative nature of advisory services has been, and likely will continue to be, a major draw for accounting firms. In the early 2000s, when the role of advisory ser-
vices was last debated within the profession, prominent observers predicted that it would play a significant role at audit firms. Robert K. Elliott, AICPA chairman and KPMG partner, predicted that, in the long run, all the public accounting firms will be in advisory, (After Andersen War, Accountants Think Hard About Consulting, by Reed Abelson, New York Times, August 9, 2000). Wyatt (2004) discussed the cultural changes that have occurred within the large accounting firmswhich might still dominate the firm culturesince the last round of advisory services growth. Since the 1960s, firms culture started to change from an emphasis on professionals with technical skills, experience, and knowledge about diverse accounting issues to an emphasis on growing revenues, profitability, and hiring staff without accounting degrees. Success in generating high-margin advisory fees offered consultants an increasing voice in firm management that slowly started to change the culture of the firms. Specifically, Wyatt stated that pleasing the client and doing what was necessary to retain the client reached a prominence unseen prior to the rise of the successful advisory services arms. A cultural shift was occurring within the accounting firms, and the recent return of firms to advisory services may indicate that SOX did not reverse the behaviors and culture that once existed. A change is observable in the structure of the large accounting firms revenue streams. Clearly, advisory services are becoming a more important source of revenue for the Big Four. The authors believe that this raises legitimate concerns about the possible impact on the quality of audits performed by these firms. These concerns are unlikely to go away. It would thus be beneficial for the accounting profession to publicly recognize these concernsand to develop a framework for addressing them. R. Mithu Dey, PhD, CPA, is an assistant professor of accounting, Ashok Robin, PhD, is a professor of finance, and Daniel Tessoni, PhD, CPA, is an assistant professor of accounting, all at the Saunders College of Business at the Rochester Institute of Technology, Rochester, N.Y.
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E C H N O L O G Y
it management
Business E-mails and Potential Liability

Protecting Privilege and Confidentiality Through Disclaimers and Prudent Use Policies
By John Ruhnka and Windham E. Loopesko
-mail is the predominant method of communication used by most businesses today. But companies can suffer liabilities from the improper use of email, as amply demonstrated in relevant case law. The presence of lengthy legal disclaimers in business e-mails has increased for example: Our organization accepts no liability for the content of this e-mail, or for the consequences of any actions taken on the basis of the information provided, unless that information is subsequently confirmed in writing. If you are not the intended recipient, you are notified that disclosing, copying, distributing, or taking any action in reliance on the contents of this information is strictly prohibited. Such disclaimers, addressed to recipients of business e-mails, are intended to limit the potential liability that a sender can face. Some disclaimers, such as the IRS federal tax advice disclaimer, are required by law. But disclaimers have generally not been as effective as their users have hoped, and their use is best seen as one part of a broader proactive policy for proscribing or limiting unauthorized or inadvertent e-mails. For example, no U.S. court case yet has allowed a company to rely on a disclaimer to avoid liability for breach of a duty of confidentiality or for workplace sexual harassment in an e-mail transmission. While current case law has indicated that such disclaimers are of limited value, the law is likely to evolve as courts continue to rule on the effectiveness of disclaimers for specific types of liabilities. The discussion below examines the impetus for the growing use of disclaimers in business e-mails, and it explains their role in a company-wide e-mail use policy, which can minimize improper or unauthorized e-mail communications that might result in liability.
Areas of Potential Liability

Under the doctrine of vicarious liability, a business can be liable for its employees or agents communications with third parties if it is reasonable for the recipient to believe that the sender was acting on the business behalf, even if the communication was not authorized or not specifically prohibited. In addition, under the doctrine of respondeat superior, a business can be held liable for its employees wrongful or criminal actssuch as defamation, sexual harass-
ment, or gender discriminationif they are committed within an employees scope of employment. Vicarious liability means that the employee or agent committing the harmful or illegal act is primarily liable to the injured party, but the businessas the employeris secondarily liable as well. To reduce unauthorized or inadvertent e-mail communications that might result in vicarious liability, many companies turn to employee policies governing e-mail use and the safeguarding of conAUGUST 2012 / THE CPA JOURNAL
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fidential information. When such preventive policies fail to prevent accidental, unauthorized, or harmful employee communications through the companys e-mail system, businesses rely on disclaimers for the content in such e-mails as an additional line of defense in order to try to reduce liability claims. Although not an exhaustive list, the following are important areas of potential liability that could result from inadvertent or unauthorized business e-mail communications. Accountant-client confidential information. Rule 301 of the AICPA Professional Standards provides that a member shall not disclose any confidential client information without the specific consent of the client. The exception to this rule occurs when a CPA must respond to a validly issued and enforceable subpoena or summons or is complying with applicable laws and government regulations. Furthermore, 24 states have enacted various rules protecting accountant-client confidential communications to varying degrees. Texas, for example, has a privilege rule that prohibits CPAs from voluntarily disclosing information communicated by a client in connection with an engagement without the client's prior consent. Some state protections do not apply to criminal proceedings; others do not prevent disclosures to law enforcement if an accountant has a reasonable basis for believing that a client violated federal, state, or local laws. While federal law does not recognize an accountant-client privilege, it creates a criminal offense (arising from a very narrow confidentiality requirement imposed by Internal Revenue Code [IRC] section 7216) for tax return preparers who knowingly or recklessly disclose or use tax return information obtained or generated in the preparer-client relationship, unless the preparer has express client consent or a court order has been issued. The IRS defines tax return preparers as individuals participating in the preparation of tax returns for taxpayers, includingbut not limited to individuals practicing or presenting themselves as preparers, compensated casual preparers, electronic return originators, electronic return transmitters, intermediate service providers, software developers, and reporting agents. Whereas the AICPA rules are professional standards, the IRS prohibition is statutory, and a failure to comply
can create criminal liability. Both an accountant and client must treat the tax return information as confidential in order for the privilege to apply. If this information is divulged to third parties, then it is not considered confidential. Accordingly, CPAs must ensure that they have appropriate taxpayer consent for the disclosure of confidential client and tax preparation information; they must also keep clients fully informed if they are served with a subpoena to release the
tions, aside from the very narrow FATP privilege? Most case law predates the FATP, and the U.S. Court of Appeals for the Ninth Circuit has ruled that communications pertinent merely to preparing a tax return do not involve giving or receiving legal advice and thus are not privileged (United States v. Gurtner, 474 F.2d 297 [9th Cir. 1973]). The Eighth Circuit, meanwhile, has held that tax returns are not privileged because they are intended for disclosure to a third party (the IRS) and, thus, no expectation of con-
While federal law does not recognize an accountant-client privilege, it creates a criminal offense for tax return preparers who knowingly or recklessly disclose or use tax return information obtained or generated in the preparer-client relationship.
clients accounting or tax records or submit to a deposition or interview regarding tax matters. State regulations sometimes impose additional confidentiality requirements. CPAs can ordinarily meet both the IRS and AICPA rules by receiving a clients written permission to release the information. If the party seeking client records is not the client, the CPA should ask the requestor to obtain the clients written consent before complying. Federal tax practitioner privilege. A federal tax practitioner privilege, established by the IRS Restructuring and Reform Act of 1998, applies to CPAs and protects tax-related communications between federally authorized tax practitioners (FATP) and their clients from government use against them in noncriminal IRS or federal court tax proceedings if the communication would be considered privileged if it had been between a taxpayer and an attorney. Both the FATP and the client must treat the tax advice as confidential in order for the FATP privilege to apply. FATPs include nonattorneys authorized to practice before the IRSspecifically CPAs, enrolled agents, and enrolled actuaries. Promoters of a tax shelter may not assert the tax practitioner privilege. Does a general confidentiality privilege exist for tax return preparation communicafidentiality is justified. A minority opinion holds that a tax practitioner privilege might cover communications about what to claim on a return if such communications would constitute legal advice. IRS-required tax advice disclaimer. Treasury Department Circular 230, Regulations Governing Practice Before the Internal Revenue Service, requires tax practitioners to caution their clients with the following: any U.S. federal tax advice contained in this communication, including all attachments, is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any taxrelated matter(s) addressed herein. Attorney-client confidentiality, privilege, and work product. The American Bar Associations Model Rules of Professional Conduct, adopted by most states, imposes a general duty of confidentiality on attorneys for discussions with potential clients, even if no attorney-client relationship subsequently ensues. But not all state rules are adaptable to the Internet, where no readily apparent jurisdictional boundaries exist. In a Ninth Circuit case, a law firm posted a questionnaire on its website soliciting information for a potential class action
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from persons who had taken the drug Paxil (Barton v. U.S. Dist. Court for the Central Dist. of Cal., 410 F.3d 1104 [9th Cir. 2005]). The e-mail solicitation contained a disclaimer that filling out the questionnaire created no attorney-client relationship. When the drug manufacturer subsequently tried to get the law firm to disclose the online questionnaire answers to use at trial, the Ninth Circuit held that because the e-mail solicitation disclaimer
The court warned that blindcopying a client on a message to opposing counsel gave rise to a foreseeable risk that (the client) would respond exactly as he did.
did not specifically address confidentiality, prospective class action clients completing the questionnaire could assume that a duty of confidentiality existed; this, in turn, enabled them to claim attorneyclient privilege for their answers. The Ninth Circuit indicated that a clear statement written in plain English, providing that the solicited information would not be held confidential and that respondents were not being solicited as potential clients, might have prevented the duty of confidentiality from arising and the subsequent formation of attorney-client privilege. The attorney-client privilege under common law is a narrower rule protecting confidential attorney-client communications made to secure legal advice from subsequent discovery or use by opposing counsel at trial. The clientnot the attorney holds the legal privilege, and only the client may waive it. Inadvertent disclosure of confidential information to a third party will not normally constitute a waiver if a client did not intend to waive the privilege; however, a waiver may occur without intent if, for example, the client carelessly
allows the information to be disclosed to others or fails to object to a disclosure demand in litigation. While the attorneyclient privilege does not cover accountants, an attorney may, in some instances, extend protection over an accountant by retaining the accountant as an expert (U.S. v. Kovel, 296 F2d 918 [2d Cir 1961]). In assessing whether disclaimers are effective, courts look to the totality of the circumstances. In Charm v. Kohn, 27 Mass. L.R. 421 (2010), an attorney sent an e-mail to opposing counsel (with no confidentiality notice) and with a blind copy to his client. The client, replying to his attorney with additional privileged information, inadvertently used reply all and copied the opposing counsel as well. The attorney realized the mistake and immediately phoned the opposing counsel to notify him that the clients transmission was in error and that the information was confidential. The Massachusetts Superior Court ruled that no waiver of the attorney-client privilege occurred, due to these immediate steps to protect the privilege; however, the court warned that blind-copying a client on a message to opposing counsel gave rise to a foreseeable risk that (the client) would respond exactly as he did. Negligent misstatement. If an employee gives unauthorized or unintended professional advice in an e-mail, the employer can be liable for any advice that the recipient, or even a third party, reasonably relies upon. Companies can address this risk with a disclaimer stating that no professional advice is offered or implied unless specifically identified as such. Entering into web-based contracts. Written business communications, including e-mails, can form legally binding contracts if a sender has actual or apparent authority to offer or accept a contract on a companys behalf. To limit or prevent this possibility, a statement should be included in the e-mail that notes that any offer or acceptance requires written approval by a specifically identified company officer in order to bind the company to a contract. Defamation. No disclaimer can protect against e-mails that contain actual libelous or defamatory content. A disclaimer against unauthorized defamatory or harmful personal comments can help show that a defamatory communication was expressly prohibited and
thus not within the scope of employment; however, companies still need to take prompt action responding to and remedying such harmful acts as soon as they become aware of them. Business can also reduce liability by linking disclaimers to specific company e-mail use policies, codes of conduct, and training programs prohibiting employees from providing employment references; requiring employees to avoid personal or potentially defamatory references; and taking prompt remedial actions as soon as the company learns of such prohibited or harmful communication. Transmission of viruses. An employee sending or forwarding an e-mail containing a computer virus can expose a company to liability. In addition to implementing software to block viruses entering and leaving the companys e-mail system, some companies use a disclaimer stating that an e-mail might contain viruses and that the recipient is responsible for checking messages.
Internal and External E-mail Disclaimers

Businesses should include disclaimers on internal e-mails as well as external e-mails because both can produce potential legal liability if disclosed. Required statutory warnings and professional advice issues apply mainly to external e-mails, but potential defamation, sexual harassment, and implied contract claims can be just as relevant for internal e-mail. In numerous cases, for example, employees have successfully sued their employers for internal e-mails containing sexual, discriminatory, or other offensive content. Internal e-mails can also constitute a greater risk for breaches of employee confidentiality because it is more probable that a colleague will accidentally read a confidential e-mail or that an insider will recognize the importance of confidential information sooner than an outsider.
Disclaimer Specificity and Location

Companies should not indiscriminately attach specific disclaimers to all e-mail communications; in such a case, a company runs the risk of not being able to subsequently argue that the disclaimer represented a focused effort to prevent unintended liability. Businesses should only use confidentiality warnings on messages that contain confidential information.
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The question of whether to place such a disclaimer before or after the main text of the e-mail depends upon the confidentiality level of the e-mail communication and the importance of its contents. A law firm sending privileged information or a CPA firm providing tax advice might want to place disclaimers at the top of e-mails in order to ensure that they meet statutory notice requirements. For most companies, however, placing disclaimers at the end of e-mail messages is probably sufficient.
Recommended Features of Business E-mail and Internet Use Policies

Using unilateral (i.e., sender-generated) e-mail disclaimers that are not statutorily mandated will generally not eliminate potential liability for harmful e-mail transmissions. Targeted disclaimers can, however, help reduce vicarious liability for improper or unauthorized e-mail disclosures if a company can demonstrate that its company-wide e-mail and Internet use policy informs employees of proper use of company e-mail, establishes prohibitions or prior authorization requirements for specific e-mail activities, safeguards confidential and client information, and limits and monitors employees e-mail and Internet activities. Companies should require all employees to sign and return such policies before granting them e-mail access and password authorization. E-mail use policies should contain sanctions up to and including suspension, termination, and referral for criminal prosecution for policy breaches. In addition, a company should link e-mail use policies with standards under a corporate employee code of conduct, similar to those prohibiting sexual harassment or workplace discrimination, disclosure of proprietary or confidential information, and conflicts of interest. Business e-mail and Internet use policies often include the following features: They require employees to check their e-mail in a consistent and timely manner and manage their mailboxes. They prohibit employees from using company e-mail in any way that violates the companys employee code of conduct, policies, or rules. They prohibit inappropriate uses of company e-mail for unlawful purposes, including libel and slander, defamation, fraud, sexual harassment, obscenity, intimAUGUST 2012 / THE CPA JOURNAL
idation, impersonation, copyright infringement, or political campaigning. They prohibit viewing, altering, forwarding, or deleting e-mail accounts or files belonging to the company or other employees without permission or authorization. They include warnings to exercise caution when transmitting company or client confidential or proprietary information via e-mail. They limit personal use of company e-mail and Internet access with respect to conducting or soliciting for noncompany commercial activity and to downloading materials for nonbusiness use. They include warnings about safeguarding the company e-mail system against viruses by not opening attachments from unknown or unverified sources, and by not tampering with the computer system. They notify employees that the company retains the right to monitor all email traffic passing through or stored in the system to ensure compliance with e-mail use policies, including review of employee e-mails by the legal department. Companies often require that employees consent to the monitoring of their e-mail and Internet usage. A company should notify employees that it might keep archival and backup copies of all e-mails (regardless of whether they have been deleted by the employee) in order to meet electronic records discovery requests for litigation or governmental inquiries. A number of specialized corporate compliance consulting companies can assist businesses and organizations in establishing or updating e-mail and Internet use policies (e.g., Info-Tech Research Group), as well as employee and Internet use monitoring (e.g., InterGuard, Spector Soft, GlobalITSecure, SoftActivity). In addition, information technology providers offer software systems that can automatically add specific e-mail disclaimers to company e-mail messages or e-mail signatures using Microsoft Exchange and Outlook; this can help companies comply with regulatory requirements and reduce potential liability for business e-mails (e.g., Exclaimer, Policy Patrol, Symprex).
vertent e-mails; they need to be part of a much broader e-mail use policy that the company not only announces but actively implements. An article in The Economist, discussing the increasing use of e-mail disclaimers, concluded that disclaimers are assumed to be a wise precaution. But they are mostly, legally speaking, pointless. Lawyers and experts on Internet policy say no court case has ever turned on the presence or absence of such an automatic e-mail
The growing dominance of e-mail in business communications is expected to produce legal changes in this arena that will limit liability from clearly unauthorized and unintended business e-mails.
footer in America (April 7, 2011, http://www.economist.com/node/18529895). But just as the requirements for what constitutes a binding international sales contract are evolving to adapt to new electronic technologies, the growing dominance of e-mail in business communications is expected to produce legal changes in this arena that will limit liability from clearly unauthorized and unintended business emails. This trend suggests that targeted email disclaimers in specific critical areas of business operations, used in conjunction with a comprehensive and actively policed business e-mail use policy, are prudent because such policies can potentially help to reduceif not eliminateliability resulting from unauthorized or improper business e-mail communications. John Ruhnka, JD, LLM, is a professor of law and ethics, and Windham E. Loopesko, JD, is a member of the international business faculty, both in the business school at the University of Colorado Denver.
An Ongoing Trend
Under current law, disclaimers alone are not enough to protect a company from liability brought about by unauthorized or inad-
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T E C H N O L O G Y what to bookmark
Website of the Month: Accountability Central

By Susan B. Anders
ccountability Central, at www. accountability-central.com, is a collection of resources that address corporate governance, globalization, ethics, and other related topics. Sponsored by the Governance & Accountability Institute Inc., whose mission is to provide education and guidance to leaders to do the right thing for the right reasons, the website is presented as a central resource for many free materials, such as news, research papers, external links, and commentary, as well as customized services and subscription-based publications. Accountability Central is organized around three major categories: environmental and energy issues, social issues and concerns, and corporate governance. Each category houses specific topics, or channels, that are detailed in the main menu and consistently appear on the left side of the home and main pages. The center of the homepage presents a rather busy selection of featured resources. The main pages for each topic, however, are easier to navigate; the content is categorized under news and updates, research and insights, and commentary and opinion. Users can access relevant links in the upper right-hand corner of the page. Another menu bar, running along the top of every webpage, provides links to special features that include commentaries, blogs, and a navigational dashboard. The website brings together resources from a large number of original sources that would be very difficult for an individual user to gather. Current events, news, articles, and reports are collected from a variety of Internet sources, such as USA Today, the Washington Post, and the Journal of Accountancy, as well as international sources and Governance & Accountability Institute staff. Although frequent overlap between the
content and topic groupings can be overwhelming, it does increase the likelihood of locating desired materials. The resources are updated daily, and several years of archives are also accessible. Because one of the Governance & Accountability Institutes missions is educational, many topic pages provide brief background information on the subject at hand. For example, the accounting/
disclosure/financial reporting webpages provide an interesting introduction to the history of accounting and accountability. The shareholder activism section includes an introduction that discusses its origins; the concept of corporate ownership; current actors, such as faith-based investors; and comments on the topic from several sources, including MarketWatch and CNN Money.
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Corporate Governance
The corporate governance section, as a whole, addresses policies and practices of corporate boards and executives, as well as their relationships with stakeholders. The corporate governance section includes subcategories for general corporate governance; government/political governance; accounting, disclosure, and financial reporting; shareholder activism; capital markets; enterprise risk management; and investor relations. Under the corporate governance subsection, a brief overview, News and Updates on Corporate Governance, discusses historical information, the current state of corporate governance, burning issues, and commentaries from a variety of sources. Recent corporate governance resources, under the research and insights subcategory, include an article from the Wall Street Journals MarketWatch that addressed the release of an Ernst & Young LLP study that reported strengthened corporate governance and improved audit quality in the 10 years following the passage of the Sarbanes-Oxley Act of 2002 (SOX). A Journal of Accountancy article summarized the impact of SOX section 404 on the internal control environment, and a USA Today article followed up on security failures at LinkedIn and eHarmony; the article recommended updating passwords, along with several specific password guidelines. The capital markets section features a New York Times article summarizing a Financial Stability Oversight Council report that identifies several threats to the United States market stability and calls for money market fund reforms, greater consumer protection standards, and regulation of high-speed trading. A summary of a U.S. Treasury Department survey of foreign portfolio holding of U.S. securities, located under the research and insights category, includes tables of holdings by type of security and country, along with links to the original report. The capital markets connection center, found in the navigation box in the upper right-hand corner, provides readers with a useful collection of links to membership organizations, such as the Chartered Financial Analyst Institute and Financial Executives International, as well as links to major stock and mercantile exchanges. The enterprise risk management section features articles that cover a wide
range of topics, including natural disasters, financial disasters, and hydraulic fracturing. Under the commentary and opinion subcategory, an interesting article on supply chain sustainability summarized lessons from the pastfor example, companies being held accountable for suppliers labor practices must look beyond the first tier of vendors. The author recommends that supply chain sustainability should be aligned with an organizations goals and objectives. A Washington Post article examined the recent debates concerning outsourcing, the reasons behind the trends, and the benefits and detriments. The relevant web links tab, located in the upper right-hand corner, offers a collection of sites for business continuity and disaster recovery planning, emergency management, family disaster planning, and hurricane preparedness. Articles featured in the investor relations section encompass the specific corporate function of that name along with the relationship between the corporation and key stakeholders. Located under the news and updates subcategory, the Fox Business News article, What to Do with Proxies that You Get in the Mail, explained what proxy statements are, how shareholders can vote or submit proxy ballots, how shareholders can submit their own initiatives, and why shareholder participation matters. Climate Spectator: Separating Good Companies from Bad, from Business Spectator, discussed evidence that environmental, social, and governance indicators positively correlate with stock price and return on equity. Several articles make connections between sustainability and profits, performance, and growth as well.
of the most recent Ethics Resource Centers biannual survey is available and reports some disturbing findings, such as an increased percentage of employees suffering negative consequences from reporting violations and an increased percentage of companies with weak ethics cultures. The list of relevant web links is extensive and covers a variety of institutions, organizations, and publications. The globalization section focuses on world trade issues and current events, with China and Europe receiving significant coverage. A summary of a World Bank study, from the Toronto Globe and Mail, under the research and insights subcategory, reports that more than half of all global growth is expected to come from six emerging economies by the year 2025: Brazil, China, India, Indonesia, Russia, and South Korea. Furthermore, the relevant web links contain a small, but useful, selection that includes the U.S. Department of Commerce, Federal Reserve banks, United Nations resources, and China.org.
Special Features
The featured commentators and bloggers sections of the website, accessed from the top menu bar, collect and organize columns authored by nearly two dozen commentators, making it easier for users to follow a particular author. The special sections dropdown menu, also located along the top bar, provides access to the Accountability Matters blog and the Sustainability HQ website. Hot topics are news articles and commentaries flagged as emerging, controversial, and thought provoking on areas such as executive compensation, global warming, and healthcare. Another useful feature in the special sections tab is the news and information dashboard. It provides links to groupings of website news and articles beyond the main menu categories, as well as connections to external news media websites. The dashboard also offers links to outside organizations, such as the Brookings Institution, found under the think tanks subcategory, and U.S. government agency the news pages, including the Department of the Treasury and the SEC. Susan B. Anders, PhD, CPA, is a professor of accounting at St. Bonaventure University, St. Bonaventure, N.Y.
Social Issues and Concerns

The ethics subcategory, under the social issues and concerns section, offers a collection of current events items; articles; and reports on business ethics, fraud, tax evasion, and other similar topics. Several articles such as those from AccountingWeb, Law.com, and MarketWatchsummarize the findings of a joint AICPA and Chartered Institute of Management Accountants study on global business ethics. The AccountingWeb piece even adds actual accounting firm ethical policies. In the research and insights subcategory, a summary
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CLASSIFIED
PROFESSIONAL OPPORTUNITIES
NASSAU COUNTY / NEW YORK CITY CPA FIRM Established firm with offices in NYC and Long Island, which has successfully completed transactions in the past, seeks to acquire or merge with either a young CPA with some practice of his own or a retirement-minded practitioner and/or firm. Call partner at 516.328.3800 or 212.576.1829.
M A R K E T P L A C E
FOR
PROFESSIONAL OPPORTUNITY l SPACE FOR RENT l SITUATIONS WANTED l FINANCIAL ACCOUNTING & AUDITING l PRACTICE WANTED l PRACTICE SALES l HOME OFFICE PEER REVIEW l PROFESSIONAL CONDUCT EXPERT l EXPERIENCED TAX PROFESSIONALS WANTED l POSITIONS AVAILABLE l EDUCATION
SALE l BUSINESS SERVICES l TAX CONSULTANCY
WALL STREET CPA looking for right individual to share and merge into my office space. Move in ready with ultra high tech hardware and software built in. info@goldfinecpa.com 212-714-6655. Are you an entrepreneurial CPA with quality public accounting, audit and tax experience? Would you like to acquire a $500,000 Long Island practice from a retiring CPA ratably over the next five years? If so, provide background for consideration to NassauCPAfirm@gmail.com.
Rotenberg Meril, Bergen Countys largest independent accounting firm, wants to expand its New York City practice and is seeking merger/acquisition opportunities in Manhattan. Ideally, we would be interested in a high quality audit and tax practice, including clients in the financial services sector, such as broker dealers, private equity and hedge funds. An SEC audit practice would be a plus. Contact Larry Meril at lmeril@rmsbg.com, 201-487-8383, to further discuss the possibilities. Rockland County CPA firm (3 Partners) seeking energetic dynamic sole proprietor CPA with small practice to presently rent open office space and share services with the primary objective of a long term association with potential buyout and transition. Contact Lance Millman at: lmillman@ms-cpas.com. Two retirement-minded partners looking to affiliate with energetic sole practitioner for future buyout. Our firm is well established in Putnam County, with a diversity of clients. Contact: jeff@bolnickandsnow.com.
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Peer Review If you need help, the first step is Nowicki and Company, LLP 716-681-6367 ray@nowickico.com
Westchester CPA with boutique high net worth, high quality, tax and financial planning practice seeks to acquire or merge with similar minded professional. Cash available. Contact westcpacfp@aol.com. Small NYC CPA firm is looking for per diem CPA, taxes, F/S Avnerk868@gmail.com. Nassau County peer reviewed sole practitioner with Masters in Taxation has available time to assist overburdened practitioner. Open to merger, buyout or other arrangements. bcpa11@yahoo.com. Successful Midtown NYC Firm (founded 1958) with $3M+ practice seeks a firm grossing $500K - $1M with retirement minded owners for merger and eventual transition. Contact in confidence. 212-901-6114. Small, long established Great Neck CPA firm seeking energetic solo practitioner CPA with existing business. Potential partnership a strong possibility. starcollp@aol.com. Synergy for Growth I run a single partner firm with audit and tax practices and wish to share facilities, staff, expertise and potentially combine with one or a few compatible CPAs. I will take on a major technology initiative soon or use yours if well established. I am located in Grand Central area and larger space is available in same building. Please reply to synergycpa12@gmail.com. Highly successful, $3.5 million, midtown CPA firm seeks merger with firm/practitioner grossing $1-7.5 million for continued growth and profitability. Steady growth and attractive offices make for unique opportunity. E-mail nyccpaoppty@yahoo.com.
TAX ADMINISTRATOR WANTED The U.S. Securities and Exchange Commission seeks tax compliance and administrative services for settlement funds/Qualified Settlement Funds under Section 468B(g) of the Internal Revenue Code (IRC), 26 U.S.C. 468B(g), and related regulations, 26 C.F.R. 1.468B-1 through 1.468B-5. A statement of requirements describing the work to be performed and the procedures for submitting proposals is available at http://www.sec.gov/nb/tax_ admin.pdf. Proposals must be submitted by email to: taxadm@sec.gov no later than 11:00 p.m. on Friday August 31, 2012.
Young, energetic and dynamic husband and wife accounting team seeks retirement-minded practitioner with write-up and/or tax preparation practice in New York City area for merger and eventual buy-out. Contact: anthony@c-allc.com. Full service midtown CPA firm w/ 12 professionals, providing personalized services to closely held businesses and successful individuals, seeks growth through acquisition or merger. Professional, congenial environment. Modern offices and procedures. BTSD2012@gmail.com. Growing North Jersey CPA firm seeks CPA with strong audit and tax experience looking to transition into a near term partnership opportunity. Email resume to: acc2143@yahoo.com. Established Long Island CPA firm seeks to expand. We are interested in acquiring a retirement-minded small to medium-size firm in the NY Metro Area. We have a successful track record of acquiring practices and achieving client retention and satisfaction. Please contact Andrew Zwerman at azwerman@wzcpafirm.com. Goldstein Lieberman & Company LLC one of the regions fastest growing CPA firms wants to expand its practice and is seeking merger/acquisition opportunities in the Northern NJ, and the entire Hudson Valley Region including Westchester. We are looking for firms ranging in size from $300,000 - $5,000,000. To confidentially discuss how our firms may benefit from one another, please contact Phillip Goldstein, CPA at philg@glcpas.com or (800) 839-5767.
SALE OF YOUR PRACTICE. If you have a small (100K - 200K) practice and would like to assure continuity and give you and your clients the chance to experience a successful transition, please write to us in confidence. We are a midtown firm with lots of experience with small and medium-sized businesses and have successfully acquired practices with excellent results for all. Give us the opportunity to help you. Write to NYSSCPA, Box 220, Horsham, PA 19044. Three-Partner CPA Firm in Rockland County seeking a young practitioner with a small practice to presently rent open office space and share resources with the primary goal of partnership, merger and succession. Contact us at rocklandcounty3cpa@gmail.com. Long Island CPA with solid diversified practice of $175,00 - $200,000 seeks affiliation with eventual buyout. Open to any agreement that is mutually beneficial. Practitioner to retire within 10 years. Practitioner has the available to work for form. If interested contact: hdf99@aol.com.
CPA FIRMS OR PARTNERS We represent a number of quality CPA firms who would like to merge with other CPA firms or Partners with business. Offices are in the Metropolitan area. This is an opportunity to insure your future as well as help your clients by expanding your services to them. Why settle when you can select? For further info: please contact: Len Danon at D&R Associates Inc. 212-661-1090 ext 14 SERVING THE CPA COMMUNITY SINCE 1939
CPA Partner Opportunity in small business tax firm Nassau County. Two Partners with million dollar practice seek another CPA with small tax practice for employment- partnership opportunity. Must be experienced a-z with small business, individual tax, Lacerte, Quickbooks. Experience in Certified Audits, Reviews also required. Location: South Shore Nassau Compensation: package and benefits to be discussed. Principals only. eladesor@aol.com ed1040tax@aol.com Fax 516-783-1720.
SPACE FOR RENT

OFFICE SPACE AVAILABLE THROUGHOUT MANHATTAN 300 square feet to 15,000 square feet. Elliot Forest, Licensed Real Estate Broker, 212-447-5400. AAA PROFESSIONAL OFFICES FOR RENT. NASSAU COUNTY. 1-, 2-, 3-room suites facing Hempstead Tpke. FREE UTILITIES. FREE FRONT PARKING. 516-735-6681.
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Melville Long Island on Rte 110 Two windowed offices in a CPA Suite; Full service building with amenities including use of a conference room. Cubicles also available. Contact Lenny at 212-736-1711 or Bradley@smallbergsorkin.com. Windowed Office in CPA Suite, Plainview. Includes Secretary/Bookkeeping Services. NJR11804@aol.com. Midtown CPA firm has nicely decorated offices to sublet/share with us, fully furnished and computerized, for up to 20 people. All or part available. Convenient and cost effective. Merger possible. cparentalnyc@gmail.com. PREMIUM OFFICES FOR RENT (Merrick) Multiple Professional Suites 516-623-9409 info@commodorecompanies.com. 650 rsf on 5th Avenue @ 34th St. $50 sf. 2 offices. Avenue views. 24/7 access. Elliot @ 212-447-5400. WALL STREET CPA looking for right individual to share and merge into my office space. Move in ready with ultra high tech hardware and software built in. info@goldfinecpa.com 212-714-6655. Bergen County. CPA firm has two furnished windowed offices with all services. 201-871-0033.
BUSINESS OPPORTUNITIES
Westchester CPA firm seeks to acquire accounts and/or practice. Retirement minded, sole practitioners, and small firms welcome. High retention and client satisfaction rates. Please call Larry Honigman at (914) 762-0230, or e-mail Larry@dhcpas.biz.
Peer Review Services HIGH QUALITY / PRACTICAL APPROACH Peer reviews since 1990. Review teams with recognized experts in the profession. David C. Pitcher, CPA / Gregory A. Miller, CPA DAVIE KAPLAN, CPA, P.C. 585-454-4161 www.daviekaplan.com
BUSINESS SERVICES
NEED TO INCORPORATE? Complete Incorporation Package Includes: PreparationState Filing Fees Corporate Kit via UPS Registered Agent Services Available NEED TO DISSOLVE or REINSTATE or AMEND? Qualified Staff to Help Accomplish Your Corporate or LLC Goals! All 50 States. Simply Call. INTERSTATE DOCUMENT FILINGS INC. Toll Free 800-842-9990 margenjid@yahoo.com
CASH MANAGEMENT SERVICES

for small business (646) 823 - 6383 info@zwanepoel.com www.zwanepoel.com PEER REVIEWS Providing Peer Reviews since 1990 Available for Consulting. Pre-Issuance Reviews and Monitoring Kurcias, Jaffe & Company LLP (516) 482-7777 ijaffe@kjandco.com emendelsohn@kjandco.com
PROFESSIONAL CONDUCT EXPERT

PROFESSIONAL CONDUCT EXPERT Former Director Professional Discipline, 25 Years Experience, Licensure, Discipline, Restoration, Professional Advertising, Transfer of Practice; AICPA and NYSSCPA Proceedings, Professional Business Practice. Also available in Westchester County ROBERT S. ASHER, ESQ. 295 Madison Avenue, New York, NY 10017 (212) 697-2950
SITUATIONS WANTED
New York City Metro Technical Accounting/Auditing Pro seeks issues-oriented and financial statements completion-type work, such as draft footnotes and statement format, on a project or other basis at a reasonable professional rate for CPAs in need of this type of temporary help. Also available for audit, reviews or compilations workpaper or report review. Can serve in SOX/PCAOB concurring partner review function or independent monitoring function under new Engagement Quality Review (EQR) in years between smaller firm AICPA Peer Reviews. Call 516-448-3110. Need assistance answering SEC comment letters? SEC/GAAP reporting expert will help research/ respond to comment letters; prepare filings/ financial statements. 516.526.2085. Sr. Accountant, Duluth, GA: Master's degree in Accountancy plus at least 2 yrs. of public accounting and audit exp. req'd. Resume to W. Alex Choi, CPA, PC, 2550 Pleasant Hill Rd., Ste. 421, Duluth, GA 30096.
HELP WITH PREPARING FOR PEER REVIEW.

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

PREPARE FOR PEER REVIEW Yehuda@bunkercpa.com 718-438-4858 Yehuda Bunker, CPA 30 years not for profit accounting. CPE courses in auditing available. PEER REVIEW SPECIALIZING IN EMPLOYEE BENEFIT PLANS CIRA, BROKER DEALERS INSPECTIONS & REVIEW SERVICES JOHN M SACCO, CPA JMSacco@SAccoManfre.com 914-253-8757 SACCO MANFRE CPA PLLC
CALL SHIMON D. EINHORN, CPA

(917) 318-7498 s.einhorn@juno.com
Peer Review If you need help, the first step is Nowicki and Company, LLP 716-681-6367 ray@nowickico.com
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TAX CONSULTANCY
INNOVATIVE STRATEGIES
for sales and use tax compliance, audits, refunds, appeals, and bankruptcy. Extensive multistate experience.
SALES TAX, AUDITS, APPEALS, & CONSULTATIONS. Experience: Many years with New York State Sales Tax Bureau as auditor and auditor supervisor. Jack Herskovits. 718-436-7900. SALES TAX, ISAAC STERNHEIM & CO. Sales tax consultants, audits, appeals, & consultations. Principals with many years of experience as Sales Tax Bureau audit supervisors. (718) 436-7900.
SALES TAX PROBLEMS? More than 25 years of handling NYS audits and appeals. CPAs, attorney, and former NYS Sales Tax Auditor on staff. All businesses, including service stations, pizzerias, restaurants. Free initial consultation. Rothbard & Sinchuk LLP 516-454-0800, x204
Jeffrey J. Coren, CPA

212-594-6970
SALES TAX PROBLEMS?

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

Do your clients require a Retirement Plan, 403(b) Plan and/or a Health & Welfare Plan Accountants Audit Report for Form 5500?
CONTACT US
Certified Public Accountants & Profitability Consultants Our Employee Benefits & Executive Compensation Accounting and Tax Services Group provides the experience and expertise your clients deserve Avery E. Neumark, CPA, JD, LLM Rosen Seymour Shapss Martin & Company LLP 757 Third Avenue, New York, NY 10017 Tel: 212-303-1806 Fax: 212-755-5600 aneumark@rssmcpa.com www.rssmcpa.com A Member of the AICPA Employee Benefit Plan Audit Quality Center
Buxbaum Sales Tax Consultants

www.nysalestax.com (845) 352-2211 (212) 730-0086 A Leading Authority in Sales & Use Tax For the State of New York Sales Tax Audits Resolution with Client Satisfaction Tax Appeals Representation Results at the NYS Division of Tax Appeals Collection Matters Resolving Old Debts & New Liabilities Refund Opportunities Recovering Sales & Use Tax Overpayments More than 40 years of successful results! See our published decisions
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Ad Index & FAXFORMATION Service. Heres the quickest and easiest way to receive information from the advertisers in this issue of The CPA Journal. Simply circle the name of the company/product you are interested in and fax this page or a copy to us at: FAX # 800-605-4392.
Ad Index & Website Connections

AD INDEX Page# INTERNET ADDRESS Find our advertisers on the Web. AD INDEX Page# INTERNET ADDRESS Find our advertisers on the Web.
Camico Sterling National Bank Audimation Services, Inc. NY DOI
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41 74 C3 C4
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new york state society of
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certified public accountants
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Gain exclusive online access to The CPAs Guide to Business in New York, a members-only resource. Utilize the new CCH TaxAware Center and gain FREE access to federal and state tax news, information and updates, including customizable preferences and searches. As a member, you get unlimited 24/7 access at no cost to you. Join one of our more than 60 technical committees. Committee service is one of the most effective ways for you to perfect your skills and knowledge, while contributing to your profession. Its simple to join. Apply at www.nysscpa.org or contact N. Gomez, Manager of Committees and Administrative Services, at ngomez@nysscpa.org. Become an active member in one our 15 regional chapters and network with local professionals at CPE and social events. Contact our members-only Technical Hotline with your questions on taxes, auditing, financial planning and consulting services. Save up to $125 on your next Foundation for Accounting Education CPE webinar or live session. Keep up-to-date with your FREE subscriptions to our publications, The CPA Journal and The Trusted Professional. Dont be left out of the loop! Join the Society that focuses on your professional development. Contact Philip Federowicz at 212-719-8313, or apply online at www.nysscpa.org/join.
NYSSCPA
78
Your Partner in the Profession
C O N O M I C
& M A R K E monthly update
A T A
Fort Capitals Selected Statistics

U.S. Equity Indexes S&P 500 Dow Jones Industrials Nasdaq Composite NYSE Composite Dow Jones Total Stock Market Dow Jones Transports Dow Jones Utilities Selected Interest Rates Fed Funds Rate 3-Month Libor Prime Rate 15-Year Mortgage 30-Year Mortgage 1-Year ARM 3-Month Treasury Bill 5-Year Treasury Note 10-Year Treasury Bond 10-Year Inflation Indexed Treas. 6/30/12 1,362 12,880 2,935 7,802 14,209 5,209 481 6/30/12 0.10% 0.46% 3.25% 3.04% 3.69% 3.55% 0.09% 0.71% 1.64% -0.50% YTD Return 8.30% 5.40% 12.70% 4.30% 8.40% 3.80% 3.60% 5/31/12 0.17% 0.47% 3.25% 3.07% 3.74% 3.55% 0.06% 0.59% 1.44% -0.61% Fort Capital's Proprietary Market Risk Barometer Market Valuation Monetary Environment Investor Psychology Internal Market Technicals Overall Short-Term Outlook Overall Long-Term Outlook Equity Market Statistics Dow Jones Industrials Dividend Yield Price-to-Earnings Ratio (12-Mth Trailing) Price-to-Book Value S&P 500 Index Earnings Yield Dividend Yield Price/Earnings (12-Mth Trailing as Rpt) Price/Earnings (Estimated 2011 EPS) 5.71 6.99 Bullish 10 9 8 7 Neutral 6 5 4 6 8 6 5 As of 6/30/12 6/30/12 2.75% 14.02 2.75 7.20% 2.29% 13.88 13.13 5/31/12 2.83% 13.96 2.65 7.49% 2.34% 13.36 12.56 Bearish 3 2 1
Key Economic Statistics National Producer Price Index (monthly chg) Consumer Price Index (monthly chg) Unemployment Rate ISM Manufacturing Index ISM Services Index Change in Non-Farm Payroll Emp. New York State
Most Recent
Prior Month
Chart of the Month

Chain Store Sales
8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0%
0.10% 0.00% 8.20% 49.70 52.10 80,000
-1.00% -0.30% 8.20% 53.50 53.70 69,000
Jul 2011
Mar 2012
Apr 2012
May 2012
Jan 2012
Nov 2011
Aug 2011
Sep 2011
Dec 2011
Consumer Price Index - NY, NJ, CT (monthly) -0.10% Unemployment Rate NYS Index of Coincident Indicators (annual) 8.9% 0.20%
0.10% 8.60% 0.40%
Source: Federal Reserve
Commentary on Significant Economic Data This Month Retail chains year-over-year growth of same-store sales, excluding drugstores, slowed to 2.6% for the month of June. This represented the lower end of expectations that had already been revised downward to the 2.5%3.3% range. Slow job growth, limited income growth, and weaker consumer confidence dragged sales growth lower. Weak sales were seen across all segments except the luxury store subcategory, where there was a 7.6% gain. Drugstores represented the worst-performing subcategory, with a 7.8% year-over-year decline. Same-store sales for the month of July were expected to grow in the 3%3.5% range.
The information herein was obtained from various sources believed to be accurate; however, Fort Capital does not guarantee its accuracy or completeness. This report was prepared for general information purposes only. Neither the information nor any opinion expressed constitutes an offer to buy or sell any securities, options, or futures contracts. Fort Capitals Proprietary Market Risk Barometer is a summary of 30 indicators and is copyrighted by Fort Capital LLC. For further information, visit www.forte-captial.com, send a message to info@forte-capital.com, or call 866-586-8100.
Feb 2012
Jun 2012
Oct 2011
79
E D I T O R I A L a message from the editor-in-chief
The SEC Staff Report on IFRS

Kicking the Decision Down the Road
or those who have been waiting for the SECs policy decision on whetherand if so, how and when International Financial Reporting Standards (IFRS) will be incorporated into financial reporting for domestic issuers, the July 13, 2012, final staff report, Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers, does not provide an answer (http://www. sec.gov/spotlight/globalaccountingstandards/ ifrs-work-plan-final-report.pdf). In this case, however, the SECs indecision speaks volumes: most people seem to agree that, having a single set of high-quality global accounting standards, applied and enforced consistently, makes good business sense on a conceptual level, but achieving this goal has been elusive. The SEC staff explored various options, ranging from no action, to incorporating IFRS, to pursuing the designation of the standards of the IASB [International Accounting Standards Board] as generally accepted for purposes of U.S. issuers financial statements. According to the report, the vast majority of participants in the U.S. capital markets do not support the adoption of IFRS as authoritative; thus, it seems that the last option on the SECs list is off the table, at least for now. The report cited the following primary obstacles to incorporating IFRS: A desire to maintain some level of jurisdictional control over accounting standards setting in order to ensure the suitability of IFRS within the U.S. framework The burden of direct conversion to IFRS, including the cost of updating accounting policies, systems, controls, and procedures The significant effort required to change references from U.S. Generally Accepted Accounting Principles (GAAP) to IFRS throughout the various laws, reg-
ulations, and private contracts that would be affected.
Report Recommendations
Given these obstacles, the SEC staff focused their efforts on recommending conditions that would likely enhance a potential U.S. transition to IFRS. The staff recommendations included the following: Developing IFRS in those areas that are underdeveloped, such as the insurance industry Providing timely, authoritative guidance on issues arising from current IFRS Using national standards setters to assist with individual projects for which they have expertise, perform outreach for individual projects to the national standard setters home country investors, identify areas in which there is a need to narrow diversity in practice or issue interpretive guidance, and assist with post-implementation reviews Enhancing the consistent global application and enforcement of standards Creating mechanisms that specifically consider and protect the U.S. capital markets Obtaining funding from U.S. sources, whereby the IASBs reliance on the large public accounting firms would be eliminated Improving investor engagement and education regarding the development and use of accounting standards.
ognizing and measuring asset impairment losses; the threshold (i.e., GAAPs likely versus IFRSs more likely than not) for recognizing certain nonfinancial liabilities (e.g., contingencies); asset (re)valuation; the use of last-in, first-out (LIFO) for inventory costing; the timing of recognition for research and development costs; the difference in accounting for uncertain tax positions; and asset componentization (i.e., separate depreciation for each component of an item of property, plant, and equipment).
Going Forward
Although making a decision on whether to incorporate IFRS into the U.S. financial reporting system was beyond the scope of the staff report, the work plan does establish the groundwork for a possible endorsement-like approach toward IFRS in the United States. With the issuance of the work plan, how far are we from a single set of highquality global accounting standards? Probably too far for its supporters and too close for its opponents. As always, I welcome your comments. Mary-Jo Kranacher, MBA, CPA/CFF, CFE Editor-in-Chief ACFE Endowed Professor of Fraud Examination, York College, The City University of New York (CUNY) mkranacher@nysscpa.org The opinions expressed here are my own and do not reflect those of the NYSSCPA, its management, or its staff.
Convergence
Over the past decade, the IASB and FASB have made significant progress in their efforts to minimize the differences between IFRS and U.S. GAAP. But despite years of work on the convergence project, some significant discrepancies still exist. Among these are the methodology for rec-
80

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Advisory Services Rise Again at Large Audit Firms

20 Accounting & Auditing

58 Responsibilities & Leadership

Website of the Month: Accountability Central By Susan B. Anders

74 Classied Ads 79 Economic & Market Data 80 Editorial

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2011 Max Block Awards Presented

About Max Block

Determining the Winners

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Looking to the Future

Teaching and Advising a New Generation of Accounting Students

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CPA Licensure: New York State Update

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Material Internal Control Weakness Reporting Since the Sarbanes-Oxley Act

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2005 MW1 MW11 MW20 MW2 MW19

2006 MW1 MW11 MW2 MW20 MW19

2007 MW1 MW11 MW2 MW20 MW7

2008 MW1 MW11 MW2 MW7 MW19

2009 MW1 MW11 MW2 MW20 MW7

2010 MW1 MW11 MW2 MW20 MW4

EXHIBIT 5 Persistent Material Weakness

EXHIBIT 6 Average Number of Material Weaknesses

Large Accelerated Filers

AUGUST 2012 / THE CPA JOURNAL