the cpa journal

Views from Regulators and the Profession

• Options Under IFRS • Audit Fees and Ethics • Mandatory Partner Rotation

Plus

Baruch College's 10th Annual Financial Reporting Conference

Fine-TuningFinancial Reporting

ESSENTIALS

44 Accounting & Auditing❙ International Accounting

Accounting Policy Options in IFRS:Weighing the Choices Upon First-Time Adoption

By Eva K. Jermakowicz and Barry Jay Epstein

❙ AccountingAccounting for Stock Options:

A Comparative Simulation for Straight-Lineand Graded Vesting Attributions Methods

By David G. DeBoskey and Kevin M. Lightner

54 Taxation❙ Federal Taxation

Revenue Procedure 2010-13 Provides Guidancefor Passive Activity Groupings

By Robert S. Barnett

56 Finance❙ Banking

Cultural Aspects of Credit Risk Management: A Lesson from the Microfinance Industry

By Rahnuma Ahsan

60 Management❙ Practice Management

Reducing the Potential Negative Effectsof Mandatory Partner Rotation

By Brian Daugherty, Denise Dickins,and Julia Higgs

64 Responsibilities & Leadership❙ Ethics

Audit Fees and Engagement Profitability:An Approach to Strengthen Compliance

with Standards of Ethical BehaviorBy Raymond N. Johnson and Gaylen R. Hansen

68 Technology❙ The CPA & the Computer

Semi-Markov Process and Microsoft Excel:Using Mathematical Tools to Improve Operations

By August A. Saibeni

❙ What to BookmarkWebsite of the Month:

Global Corporate Governance ForumBy Susan B. Anders

C O N T E N T S

a u g u s t 2 0 1 1

44

16 Fine-Tuning Financial Reporting:Views from Regulators and the Profession

On May 5, 2011, Baruch College’s Robert ZicklinCenter for Corporate Integrity held its 10th Annual

Financial Reporting Conference, bringing together a collection of regulators, preparers, auditors, and users

to discuss the state of financial reporting. Featuredspeakers were FASB Chairman Leslie Seidman,

SEC Chief Accountant James Kroeker, and PCAOBChairman James Doty. Four panel discussions

covered the following: current issues at the SEC,accounting for financial instruments, developments

impacting the private sector, and new models for revenue recognition and leases.

6 PerspectivesProfile of Jacob K. Lasser:

New York CPA and a Famous Name in Tax Guides

Publisher’s Column: CPAPAC:How Does It Work for You?

2010 Max Block Awards Presented

PCAOB Proposed Standards on the Auditor’s Reporting Model

Inbox: Letters to the Editor

80 EditorialThe Audit Reporting Process:

An Opportunity for Fundamental Change

79 Economic & Market Data

74 Classified Ads

Permission to reprint The CPA Journal articles is granted with few exceptions. Written requests indicating title, author, publication date, and intended use of the reprint should be made prior to each use by writing to the Associate Editor. The views expressed in articles published in The CPA Journal are those of the authors and not necessarily those of The CPA Journal, unless otherwise indicated. Articles con-tain information believed by the authors to be accurate as of original publication. The reader should not construe the content included in The CPA Journal as accounting, legal, or other professional advice. Ifspecific professional advice or assistance is required, the services of a competent professional should be sought.

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v o l . L X X X I / n o . 8

IN FOCUS16PERSPECTIVES6

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THE CPA JOURNAL (ISSN 0732-8435, USPS 049-970) is published monthly by The New York StateSociety of Certified Public Accountants, 3 Park Avenue, New York, NY 10016-5991. Copyright 2011 by TheNew York State Society of Certified Public Accountants. Subscription rates: NYSSCPA Members (BasicRate): $15.00. Non-members, United States possessions, Canada, one year $42.00; Students (Undergraduateand Graduate) $21.00; Foreign $54.00; Single copy $5.00. All sub scriptions and remittances may be sent inUnited States funds to The CPA Journal, The New York State Society of Certified Public Accountants, P.O. Box 10489, Uniondale, NY 11555-0489. • Periodicals postage paid at New York, NY and additionalmailing offices. The matters contained in this publication, unless otherwise stated, are the statements andopinions of their authors and are not promulgations by the Soci ety. Publishers Copy Protection Clause:Advertisers and advertising agencies assume liability for all con tent (including text, representation, andillustrations) herefrom made against the publisher. POSTMASTER: Please send address changes to: TheCPA Journal, 3 Park Avenue, New York, NY 10016-5991, Attn: Sub scription Department. The CPA Journalis a registered trademark of The New York State Society of CPAs.

Susan B. Anders

C. Richard Baker

William Bregman

Thomas Buckhoff

Douglas R. Carmichael

Robert H. Colson

Robert A. Dyson

Andrew Fair

Julie Lynn Floch

Dan L. Goldwasser

Kenneth J. Gralak

Neville Grusd

Elliot L. Hendler

Neal B. Hitzig

Ronald J. Huefner

Peter A. Karl III

Laurence Keiser

Stuart Kessler

Michael Kraten

Joel Lanz

Mark H. Levin

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Edwin B. Morris

Bruce Nearon

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Lawrence A. Pollack

Arthur J. Radin

Stephen F. Ryan III

Stephen Scarpati

Rona L. Shor

Arthur Siegel

Lynn Turner

Elizabeth K. Venuti

George I. Victor

Paul D. Warner

Robert N. Waxman

THE CPA JOURNAL EDITORIAL BOARD

Participating in one or more of the Society’s 60

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Committee serviceallows you to:� Build leadership skills� Network with peers and use your

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NYSSCPAn e w y o r k s t a t e s o c i e t y o f

c e r t i f i e d p u b l i c a c c o u n t a n t s

AUGUST 2011 / THE CPA JOURNAL6

History of a ClassicDuring the late 1930s, Simon &

Schuster Inc. encouraged two businessauthors to write highly successful books:Dale Carnegie’s How to Win Friendsand Influence People and J.K. Lasser’sYour Income Tax. When Lasser firstpublished his handbook in 1939, it soonbecame a bestseller. That first volumesold 23,000 copies, which was ameaningful number during the closingdays of the Great Depression when therewas not yet the mass tax that originat-ed during World War II. At that time,only about 6% of the American popu-lation even paid taxes. Lasser revisedthe volume annually for the remainderof his life. The 1946 edition, whichfollowed the increase in the tax rollsbrought about during World War II, sold7 million copies, and Lasser became thebest-known tax accountant in thecountry. A companion volume, YourCorporation Tax, was started in 1941.The timing of the publication of thesevolumes was ideal, because the WorldWar II tax policy had changed theincome tax from a “class tax” to a “masstax,” and most Americans were nowlooking for legal methods of avoidingthe highly progressive income tax. OnJanuary 11, 1943, Lasser addressed theNYSSCPA’s meeting on federal taxa-tion at the Waldorf-Astoria Hotel and

commented, “We have had a greatmany drastic changes in our tax laws.… Fundamentally, these changes looklike the tax man’s paradise.” While thesechanges were a boon to tax preparers,they came at a time when the profes-sion was ill-equipped to take on largevolumes of additional work because ofcritical manpower shortages. The com-plexity brought about by frequentchanges in the tax laws may haveappeared to be “a tax man’s paradise”to Lasser, but it had turned into anightmare for the average citizen andwas approaching a level of complexitythat even accounting experts could nottolerate. As a result, Lasser’s taxguides became bestsellers.

Lasser had long been viewed as atax expert even before he became ahousehold name. Prior to his 1946bestseller, Lasser had been selected asthe “expert” to write the tax materialsfor the very first continuing profession-al education (CPE) course published bythe American Institute of Accountants—a volume designed to reacquaint return-ing soldiers to the profession that theyhad been away from for up to four years. That volume, ContemporaryAccounting, was edited by Thomas W.Leland of Texas A&M University,with authors selected from the best-known experts in the country (John L.Carey, The Rise of the AccountingProfession to Responsibility andAuthority: 1937–1969, AICPA, 1970).

In addition to his writing, Lasser’sspeeches about taxes throughout thenation appeared with tax tips on earlytelevision programs. The State ofVermont even asked him to develop asimplified income tax law for that state,

By Dale L. Flesher and Tonya K. Flesher

ow entering its 71st year, J.K. Lasser’s Your Income Tax is America’s best-

selling tax guide for the general population. The book was first written by

Jacob Kay Lasser, whose legacy lives on today through his books, the tax

institutes he founded, and the J.K. Lasser Institute. Lasser was more than

just a writer of guidebooks; he was also a respected and honored professional

CPA who was active in both the AICPA and the NYSSCPA.

Profile of Jacob K. Lasser

N

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

h i s t o r i c a l p e r s p e c t i v e

(Continues on page 8)

New York CPA and a Famous Name in Tax Guides

AUGUST 2011 / THE CPA JOURNAL 7

p u b l i s h e r ’ s c o l u m n

Twelve years ago, the NYSSCPABoard of Directors voted to support

the Uniform Accountancy Act (UAA),model legislation that would update theNew York State law that regulates the prac-tice of public accountancy through multi-ple provisions that affect almost everyaspect of the profession: CPE, peer review,prelicensure experience, substantialequivalency, and CPA firm ownership.At the time, the state law had not been sig-nificantly updated in more than 50 years.

With the passage of UAA section 23mobility earlier this year by the New YorkState Legislature (as of press time, the gov-ernor has not yet signed the bill into law),and the passage of the accountancy reformlaw in 2008, almost every provision thatthe Society board voted to support at thatmeeting 12 years ago—albeit with somemodifications to that position over time—will have been passed by the state legisla-ture. The work may have been done piece-meal, but we accomplished what we setout to do. These legislative successes maynot have been possible if not for anothervote the board took at that same meeting—to endorse the formation of a politicalaction committee (PAC), which would beknown as CPAPAC, to participate inNew York’s political process.

Some Society members may not beaware that the Society has a PAC orknow what it does. That might be becausethe PAC is an organization separate fromthe NYSSCPA. While the NYSSCPA, asa 501(c)(6) organization, can lobby on itsmembers’ behalf, a PAC cannot; howev-er, it is one of the most important tools inour advocacy toolkit. The PAC has a sep-arate set of bylaws and a board of trusteesthat includes a representative from eachof the Society’s 15 chapters as well as theNYSSCPA president, president-elect, andimmediate past president. The PAC has asole purpose—to collect from membersand CPA firms monetary donations that itwill later distribute to the political cam-paign committees of New York elected

officials or candidates who have been iden-tified by the PAC trustees as supportersof the legislative goals of the NYSSCPA

or who are in a position to promote the profession through legislation thatprotects the profession and the public trust. CPAPAC is truly nonpartisan.Contributions are never based on partyaffiliation; they are distributed only inplaces where the profession will ultimate-ly benefit.

The Power of the PACIn the past, I’ve spoken about the power

of our collective voice as a CPA society. Ihave also asked you, our members, to thinkabout what it means to be involved in yourprofessional association. Contributing toCPAPAC is one of the ways to get involved.A single campaign contribution of $50 froma CPA to a political candidate does not makeas much of an impact as a PAC that has apool of $1.4 million to distribute to candi-dates, which is how much the PAC wouldhave in its coffers if each of our 28,000members donated $50 to it. Campaign con-tributions, including those to CPAPAC, arenot tax deductible, but unlike individual

donations to candidates, contributions thatcome directly from CPAPAC create a pos-itive identification between NYSSCPAmembers and the candidate who receives thatcontribution. The strength of a PAC is direct-ly related to its size. Imagine how strongwe could be if we had just half of that $1.4 million in our PAC.

Unfortunately, contributions to CPAPACdipped precipitously over the past severalyears, with donations down between 30% and50% of previous levels. What will happen ifdonations to CPAPAC continue to decline?The answer is simple: Our influence in thepolitical process in New York will wane. Ifyou have contributed to CPAPAC in the past,have you done so this year?

While the current economic climatehas led to a reduction in supplementaryspending for many New Yorkers, a dona-tion to CPAPAC should not be considereddiscretionary spending for Society mem-bers—it is essential to the empowermentof our profession in New York State. It isalso important to know that a contributionto CPAPAC in no way duplicates any con-tributions to the AICPA’s PAC. Whilethe Society may advocate for CPAs on anational level, CPAPAC contributions areput to work closer to home—the PAC’sfocus is only on New York State legisla-tors and statewide elected officers—gov-ernor, attorney general, and statecomptroller. CPAPAC is clearly an impor-tant political tool—especially whenpaired with the Society’s other advocacyefforts—but only if we leverage theSociety’s advocacy efforts with donationsfrom the PAC. Make our voice heard inAlbany: Donate to CPAPAC today via thecontribution form available on the Society’swebsite at www.nysscpa.org/legislative/cpapacform.pdf. Your profession needsyou. ❑

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

CPAPAC: How Does It Work for You?

which was subsequently adopted (J. K.Lasser, “Tax Simplification in Vermont,”National Tax Journal, no. 1, 1948, pp.62–66.). These new Vermont tax laws moreclosely conformed to federal income tax laws.

Personal Life Lasser was born in Newark, New Jersey,

on October 7, 1896, the son of immigrantsfrom Austria-Hungary. While working as abookkeeper in a factory, he took night class-es in accounting at New York Universityfrom 1915 to 1917. During World War I, he

served in the U.S. Navy on a submarinechaser and then as petty officer who checkedwar contracts. After the war, he enrolled atPennsylvania State University and earned anundergraduate degree in mechanical engi-neering in 1920 and a master’s degree inindustrial engineering in 1923. At his deathdue to a heart attack at the age of 57, he wassurvived by his wife, his mother, a son, a daughter, and a sister (“J. K. Lasser Dies: Expert on Taxes,” New York Times,May 12, 1954).

Lasser was called “Yoc” by his friends,and “his reading was prolific, and variedbeyond that of almost anyone I have known”(Paul A. McGhee, “J. K. Lasser,1896–1954,” eulogy presented at New YorkUniversity’s 13th Annual Institute on FederalTaxation, November 3, 1954). His workfor nonprofit groups is illustrated by hisefforts on behalf of many unrelated religiousorganizations, including the AmericanBaptist Convention, the Board of ForeignMissions of the Presbyterian Church, theAmerican Bible Society, the National

Council of the Churches of Christ inAmerica, and the Federation of JewishPhilanthropies (McGhee 1954). He took aspecial interest in colleges and universities,giving advice about fund raising or helpingto establish a new program or educationalservice. His volunteer service was extendedto the following schools, which were not hisclients: Bard College (as Trustee andTreasurer), Berea College, Dartmouth,Dickinson, Fairleigh-Dickinson, Loyola,the University of Miami, the New Schoolfor Social Research, NYU, Penn State, andPomona College (McGhee 1954).

Professional and Writing CareerLasser had become a CPA in 1923

after having passed the examination in1921 while on the staff of Touche, Niven& Co. (now Deloitte) in New York.Eventually, he was certified in NewYork, New Jersey, Illinois, and California.While working at Touche, Niven & Co.,his tax knowledge was so widely recog-nized that it was rumored that Lasser hadmemorized the compendium of regulationsassociated with the Revenue Act of 1916.It was likely that this early exposure toJohn Niven, the best-known tax expert inthe country and editor of the Journal ofAccountancy’s “Tax Clinic” column, waswhat led Lasser into a career in taxation.

During a temporary leave from publicaccounting, he started writing as a tax con-sultant in 1922. It was during this periodthat he became involved in a company’stax dispute with the Bureau of InternalRevenue and further developed his taxcompetencies (Paul J. Miranti and LeonardGoodman. “Lasser, Jacob Kay,” American

National Biography, Oxford UniversityPress, 1999, p. 224). In 1923, Lasserstarted his own firm at 1440 Broadway inNew York. Lasser was a pioneer in thedevelopment of the regional accountingfirm practice, and his firm developed aniche market with clientele from NewYork’s publishing and printing industries(Miranti and Goodman 1999).

When the NYSSCPA celebrated its 50thanniversary in 1947, it was Lasser who wasasked to prepare an article on “The Growthof Tax Accounting.” In the introduction,Lasser noted that we have “a tax lawalmost entirely based upon our account-ing concepts; and a host of barnacles thatwill always need attention.” The use of theterm “barnacles” is an apt description ofsome of the differences between taxaccounting and GAAP. He concludedthat these differences provided “a lot of funfor the strange breed in our group who burnso much midnight oil with tax studies.”The “barnacles” included such things asprepaid rental income and other differenceswith respect to treatment of accruals, manyof which had been previously outlined ina Journal of Accountancy feature articletitled “Tax Accounting Incongruities”(March 1947, pp. 221–228). As withmost of Lasser’s journal articles, the cen-tennial piece was replete with lengthyexplanatory footnotes. Lasser was indeeda scholar in the field, which he dubbed “thescience of taxation.” Lasser concluded hisanniversary article with a salute to someof the tax researchers whom he admired:

And sheer fright (for fear of missing afew) has prevented me from referring indetail to the strange breed in our ownmidst who devote nearly all their hoursto research in this field. For them I mightrecord that their labor has been enor-mous. Their [contribution] to the publicwelfare has been and is a continuedornament to the profession.Despite his “fear of missing a few,”

Lasser included a footnote wherein he didpay tribute to those whose “perspirationand intelligence in contributions to ourtax literature have added so much to ourprofessional standing.” The names he choseto list included Robert H. Montgomery,Joseph J. Klein, Walter A. Cooper,Benjamin Harrow, Isidor Sack, Maurice


(Continued from page 6)

Lasser was a pioneer in the development of the regional accounting firm

practice, and his firm developed a niche market with clientele from

New York’s publishing and printing industries.

Austin, Benjamin Grund, V. H. Maloney,Leslie Mills, Mark E. Richardson, MaxRolnik, Paul D. Seghers, J. S. Seidman,Troy G. Thurston, Russell S. Bock, andCharles Melvoin. Six of these tax contrib-utors—Montgomery, Klein, Austin, Grund,Richardson, and Seidman—are past pres-idents of the NYSSCPA.

From 1943 to 1954, Lasser served aseditor of the “Tax Clinic” column in theJournal of Accountancy, a segment that hadbeen pioneered by John B. Niven in1913. Lasser received no compensation forhis 11 years of monthly articles—a seriesthat ran until his death. (His last articleappeared the month after his death becausehe had submitted the manuscript early.)Following his death, Lasser was lauded bythe editor of the Journal of Accountancyin the following words:

The editors of the Journal of Accountancyare deeply in Lasser’s debt. He con-tributed greatly to this magazine’s growthin circulation and prestige, not onlythrough his writing, but by business andfinancial advice and aid. More important,the entire accounting profession is inLasser’s debt, we believe, for his part inestablishing the solid position of the CPAin tax practice. By his books and arti-cles, by his participation in tax confer-ences, by his service on committees ofprofessional societies, he contributed to the prestige of the tax accountant. (“J. K. Lasser, 1896–1954,” Journal ofAccountancy, June 1954)In addition to the “Tax Clinic” column,

Lasser also often had feature articles pub-lished in the Journal of Accountancy,which appeared in addition to his regularcolumn. The feature articles often includ-ed checklists for practitioners.

Lasser was also an adjunct professor atNew York University, where he foundedthe university’s annual Institute on Taxationin 1942. He served as the institute’schairman until his death. His eulogistreferred to the NYU Institute on Taxationas a “great memorial to him” (McGhee1954). He later became chairman of theInstitute on Taxation at his alma mater,Pennsylvania State University. When hismother moved to Miami, he becameinvolved with the University of Miami TaxConference. In 1949, he served as the sixth

president of the Tax Institute Inc., (whichmerged with the National Tax Associationin 1972), a nonprofit organization that con-ducted research and educational programsin public finance (“J. K. Lasser Dies…,”1954). He also served as a director of theTax Institute from 1945 to 1951. His bookswere used as texts in more than 160 col-leges and universities (NationalCyclopedia, 1979, p. 412).

Lasser was active in the AmericanInstitute of Accountants (the predecessorto the AICPA), the New York State andNew Jersey Societies of CPAs, theNational Association of Cost Accountants,and in many not-for-profit groups. Heserved nine years on the AICPA’s taxationcommittees, three years on its council, fouryears on the publications committee, and three years on the Journal ofAccountancy editorial advisory board. Atthe NYSSCPA, he chaired the Committeeon Federal Taxation. He received the StateSociety’s first Distinguished Service Awardwhen the award was inaugurated in 1946.He was also active on the tax committeesof the New Jersey Society of CPAs.

Lasser was author or editor of approxi-mately 50 books and numerous articles(McGhee 1954). He wrote many otherbooks besides his bestseller, including acollaboration with noted columnist SylviaF. Porter on How to Live Within YourIncome. Other special-interest volumesincluded his 1945 book titled How to SpeedUp Settlement of Your Terminated WarContract. He also wrote on estate and gifttaxes, and even published a 1951 volumetitled Handbook of Auditing Methods. Costaccounting had been addressed in the 1949Handbook of Cost Accounting Methods,which Lasser edited; thus, his interests werenot solely directed at taxation. In additionto writing his many books, he also editedthe J. K. Lasser Reports on Taxes, a bi-weekly newsletter that was distributed tocorporate officers, CPAs, and lawyers(National Cyclopedia 1979). The man wasa publishing machine, with taxation his pri-mary field of endeavor. His annual tax vol-ume is still published today through theauspices of the J. K. Lasser Institute, whichlives on within the publishing house ofJohn Wiley & Sons Inc. The J.K. LasserInstitute now operates as a publisher of tax,

financial, and business books, and newslet-ters, and as media tax experts.

Lasser Merger with Touche RossThe Lasser firm continued to grow after

the founder’s death in May 1954, where-upon the 13 partners in 1954 continued thefirm’s operations in the same niche that J. K. Lasser had attempted to fill. ToucheRoss & Co. took a major step into the taxconsulting business with its 1977 acquisi-tion of J. K. Lasser and Co, the best-knowntax services firm in the country, The merg-er also moved Touche off the “bottom rungof the Big Eight ladder” (Deborah Rankin,“Biggest Accounting Merger Joins ToucheRoss with J. K. Lasser,” New York Times,August 23, 1977, pp. 49, 51).

The New York Times called the mergerthe largest in the history of the publicaccounting profession. At the time, Touchehad about 700 domestic partners, while

Lasser had about 100 partners; Touche hadannual domestic billings of an estimated$200 million and Lasser billed about $40million annually. According to the Times,the merger “would catapult the firm fromnear the bottom of the list of the country’slargest accounting firms—known collectivelyas the Big Eight—to somewhere in the mid-


The man was a publishing

machine, with taxation his primary

field of endeavor. His annual

tax volume is still published

today through the auspices of the

J. K. Lasser Institute.

dle” (Rankin 1977). The merger movedTouche up to third place in size, behind Peat,Marwick, Mitchell & Co., and ArthurAndersen. The article called Touche Ross“one of the most aggressive and growth-oriented of the big accounting firms.” Themerger was primarily designed to enableTouche Ross to grow and to become moreinvolved in taxation; the two firms hadoffices primarily in the same cities. Themerger resulted in no additional offices forTouche, except for one in Syracuse, N.Y.For its part, the managing partner of J. K.Lasser & Co., Herbert P. Sillman, indicatedthe reason for the merger was the cost pres-sures his firm faced in areas such as employ-ee training, research and development, andinsurance coverage. Sillman became a seniorpartner at Touche Ross and joined thecombined firm’s board of directors and exec-utive committee.

In addition to its strength in tax work,the Lasser firm was well respected in otherareas of accounting as well. For example,executive office partner Arnold I. Levinewas one of the seven members of the1971–1972 Wheat Committee of theAICPA that recommended the creation ofFASB. Levine was one of only three pub-lic accountants on the committee.

Critics from other firms quickly regard-ed the Touche acquisition as meaningless.One competitor, a managing partner atanother Big Eight firm, stated, “The Lasserfirm has been going downhill for years,and the competence of those people is verylow. We wouldn’t touch them with a 10-foot pole” (Rankin 1978). There werealso reportedly some objections to themerger within Touche Ross.

The Lasser firm was known for itsstrength in the field of tax services, despitethe fact that it had no connection with thepopular tax preparation book, J.K. Lasser’sYour Income Tax, taken over by the pub-lishing house of John Wiley & Sons afterLasser’s death. The Lasser firm had inaddition to its tax business also auditedabout 100 publicly held companies, includ-ing a large number in the media andcommunications field. This clientele pro-vided Touche with a foothold in anindustry wherein it was not already strong.

The long-term success of the Lassermerger with Touche Ross is subject to

question. A 1984 New York Times articlestated:

The last directory of Lasser partners pub-lished before the merger listed 158 part-ners, and 80 percent voted in favor ofthe merger, according to PublicAccounting Report, an industry newslet-ter. A total of 144 were invited to jointhe combined firm and 130 accepted. By1981 (four years later), only 44remained. (Gary Klott, “Merger Movesin Accounting,” New York Times,October 3, 1984)The above number of partners does not

reconcile with the 1977 Times article thatmentioned that Lasser had “about 100 part-ners”; however, it is presumed that the dif-ference relates, at least partially, to for-eign partners. Given the specificity of the158 and 130 members mentioned in the1984 article, it might be supposed that thelater numbers are more accurate. Thelater article noted that partners in the sec-ond-tier acquired firms might not be enthu-siastic about merging with a nationalfirm, given the history of the Lassermerger into Touche Ross.

Touche Ross acquired the best-knownname in the tax business, albeit without thesignature annual tax preparation handbook,which was not included in the merger deal.Still, managing partner Russell Palmer andthe Touche Ross executives got whatthey wanted—growth and a broadenedscope of services.

LegacyPerhaps the best summation of J. K.

Lasser’s life was expressed in his eulogygiven by McGhee:

His influence will continue to be uponall of us, on all members of his profes-sion and the tax fraternity at large; onthe laws and regulations under which welive and do business, and on humblepeople whom he never knew. Just lastweek an elevator operator at [NYU] saidto me: ‘My wife told me she neverunderstood anything about taxes untilshe heard Lasser on television. He madeeverything so clear and simple!’ The eulogist was correct in predicting

that Lasser’s influence would continue asit has through the continuing publicationof Your Income Tax and its many imita-

tors and through the J.K. Lasser Institute.This assessment of Lasser’s work is con-trary to Lasser’s own description of hiswritings. In a review of the 1951–1952 edi-tion of Montgomery’s Federal Taxes,Lasser compared Montgomery’s books totax literature of the type that consists of“daily, weekly, monthly letters and book-lets giving reports, trends, advice, what todo, what not to do, when not to move—and when to get going in what you arethinking about.” This category of litera-ture—“I do my share of it,” Lasser admit-ted— “shouts out the tale of what it sees,and hears. It is quickly forgotten”(Accounting Review, October 1952).

There is an element of truth in Lasser’sappraisal of tax publications that exist toimpart knowledge and advice about theever-changing tax laws. These writingsbecome obsolete and are not often quot-ed. However, the measure of the servicethat these documents provide is perhapsincalculable. Lasser and his successorsoffered guidance through the maze of taxlaws to help tax professionals and ordinarytaxpayers remain in compliance with thelaws and thereby generate revenue for thegovernment. This is a legacy that deservesmore respect and praise than Lasser waswilling to acknowledge. In the tax guidepublishing business, there is no morefamous name than J.K. Lasser. But morethan being an author of consumer taxguides, Lasser was a tax scholar and a con-tributor to the accounting profession. It wasfor his service to the profession that theNYSSCPA recognized Lasser in 1946, notfor his best-known publication. He accu-mulated wealth through his tax publica-tions, but at the same time he was alsowriting for his fellow professionals. Hebuilt a firm that became an integral partof one of today’s Big Four firms, but hislegacy has remained through the J. K.Lasser Institute. ❑

Dale L. Flesher, PhD, CPA, is the ArthurAndersen Alumni Professor and associatedean, and Tonya K. Flesher, PhD, CPA,is the Arthur Andersen Alumni Professor ofAccountancy and former dean, both at thePatterson School of Accountancy at theUniversity of Mississippi, University, Miss.


2010 Max BlockAwards Presented

The winners of the 2010 Max BlockDistinguished Article Awards were

honored during The CPA Journal EditorialBoard meeting on June 20. The presenta-tions were made by Editor-in-ChiefMary-Jo Kranacher. Two authors, AlanReinstein and Vincent J. Love, were pre-sent at the meeting to accept their awardsin person.

The Max Block Distinguished ArticleAward recognizes excellence in three cate-gories that reflect the mission of The CPAJournal. The 2010 winners are as follows.

Technical Analysis. “Recent Developmentsin Fair Value Accounting,” by Avinash Aryaand Alan Reinstein, August 2010.

This article analyzes three FASB StaffPositions (FSP) that provide additionalapplication guidance to Statement ofFinancial Accounting Standards (SFAS)157 and enhance disclosures regarding fairvalue measurement of assets and liabilitiesand impairments of debt securities.

Avinash Arya, PhD, MBA, is an asso-ciate professor of accounting at the ChristosM. Cotsakos College of Business, WilliamPatterson University, Wayne, N.J. AlanReinstein, DBA, CPA, is the George R.Husband Professor of Accounting in theschool of business administration at WayneState University, Detroit, Mich.

Informed Comment. “When Rules MayWeaken Principles: Enhancing Independence,Integrity, and Objectivity,” by Vincent J.Love, March 2010.

This article makes the case that only astrict application of auditing principles—after compliance with rules—will provideall of the necessary safeguards to protectindividuals and the profession.

Vincent J. Love, CPA, CFE, is a man-aging director of Finance Scholars Group,New York, N.Y., and a member of TheCPA Journal Editorial Board.

Policy Analysis. “The SubprimeLending Crisis and Reliable Reporting:Limitations to the Use of Fair Value inUnstable Markets,” by Benjamin P.Foster and Trimbak Shastri, April 2010.

This article compares operating cashflows and net income of companies in

industries involved in subprime lendingfrom 2003 to 2006. The authors’ analysesindicate that although fair value-basedreported net income was substantially sim-ilar for all companies, operating cashflow differed significantly between com-panies that eventually experienced prob-

lems with subprime lending and compa-nies that did not experience problems.

Benjamin P. Foster, CPA, CMA, is a pro-fessor of accountancy and Trimbak Shastri,CA, CMA, CIA, is an associate professor ofaccountancy, both in the College of Businessat the University of Louisville, Ky.

The Max Block Distinguished ArticleAwards are determined by the members ofThe CPA Journal Editorial Board and EditorialReview Board, who rank a selection of arti-cles from a list of nominees determined by theeditorial staff. The editors thank all of the board

members who judged the nominated articlesfor the Max Block Awards.

About Max BlockMax Block (1902–1988), a founding part-

ner of Anchin, Block & Anchin LLP, isdescribed by many who knew him as a

visionary whose ideas have formed the basisfor many reporting and practice-managementconcepts in use today. Block was managing edi-tor of the NYSSCPA’s Journal (now The CPAJournal) from 1958 to 1972. Each year since1975, The CPA Journal has recognized his con-tributions and achievements by bestowing theMax Block Distinguished Article Award on themost outstanding articles. Although the judgingand selection procedures continue to evolve, thecriteria remain: “An innovative and stimulat-ing article which is of current significance andwhich is likely to be of lasting value.” ❑


a n n o u n c e m e n t

Max Block Award winner Vincent J. Love with Mary-Jo Kranacher.

Max Block Award winner Alan Reinstein with Mary-Jo Kranacher.

a u d i t i n g

PCAOB Proposed Standards

on the Auditor’sReporting Model

On June 21, 2011, the Public CompanyAccounting Oversight Board

(PCAOB) issued a concept release to dis-cuss alternatives for changing the auditor’sreporting model (pcaobus.org/Rules/Rulemaking/Docket034/Fact_Sheet.pdf).Comments on the concept release are dueSeptember 30, 2011.

James R. Doty, PCAOB chairman, gavethe following comments about the conceptrelease at the board meeting:

The proposed concept release on the audi-tor’s reporting model before the board todayis an important step to enhance the relevanceof audits to the investing public.

The recent financial crisis has prompt-ed serious concerns about the role andvalue of audits. While auditors most cer-tainly did not cause the financial crisis,some people have legitimately questionedwhether audits adequately served investors’needs in the months and years before andduring the crisis.

For decades, the auditor’s report hasidentified the financial statements that wereaudited, described the general nature of theaudit, and presented the auditor’s opinionas to whether, taken in their entirety,those statements present the company’sfinancial results and position fairly in allmaterial respects.

Given the effort involved in an audit ofa large company, and the complexity ofmany financial statements, investors wantdeeper insight from the auditor. This con-cept release explores several ways thataudit reports could better serve investors.

The alternatives the release describes arenot mutually exclusive. A revised auditor’sreport could include one or a combinationof these alternatives, or elements of thesealternatives. Commenters may also suggestother alternatives to consider.

I commend the staff for bringing thesealternatives forward. They are the result ofseveral months’ of engagement withinvestors and others to identify concrete

ways in which audit reports can beimproved. This outreach was critical, sinceunlike most other standard setting projects,this project required us to understand userneeds before we could develop means ofmeeting those needs.

In this regard, we have come a longway. In the early stage of the project, wefaced generalized investor dissatisfaction withthe pass-fail model, and generalized frustra-tion with auditors who had issued unquali-fied opinions on the financial statements ofbanks that later failed. (This dissatisfaction

was not new. It has been studied by variousgroups over many decades.)

The project thus began as an inquiry intothe phenomenon called the “expectationgap.” Depending on where one sat, thismeant either that investors expect too muchfrom audits or that auditors do too little.

This concept release, however, carriesthe discussion well beyond any expecta-tion gap. It’s not about deciding thatinvestors should expect less than absoluteassurance, or that auditors should domore to obtain reasonable assurance.

This project is about what investors wantfrom audit reports in the future, and howaudit reports can be more useful to soci-ety. It’s about how audits can provideinvestors more insightful assessments ofmanagement stewardship.

The alternatives described in the releaseare thus focused on enhancing the relevanceof the auditor’s communication to investors.They would not change the fundamental roleof the auditor to perform an audit andattest to management’s assertions as embod-

ied in management’s financial statements.They are not intended to put the auditor inthe position of reporting financial informa-tion for management.

That said, together with several other ini-tiatives the board will consider in the com-ing weeks, they are intended to spur debateover how to change auditing, from a cul-ture that emphasizes client service to a cul-ture that emphasizes public service. Ouroversight should foster conduct consistentwith the franchise our federal securitieslaws accord the audit profession.

I am mindful that culture does notchange quickly. It would be naïve tothink that merely changing the auditor’sreport would trigger the culture change weneed. This is why I have advocated a holis-tic approach aimed at enhancing the cred-ibility and transparency of audits as wellas their relevance.

Before I turn to my fellow board mem-bers for discussion, let me say a word aboutcosts. Depending on the nature and extent ofadditional information to be communicated inthe auditor’s report, new auditing requirementsmight be necessary or appropriate. Further,some alternatives might increase the scopeof audit procedures to extend to disclosuresbeyond the financial statements.

These possibilities may prompt somecommenters to point out that increasingscope will likely increase audit fees. To besure, increasing procedures or scopeinvolves cost, but so does investor doubtabout the reliability of management’s state-ments. I will be interested in feedback onall of these kinds of costs. ❑


This project is about what investors want from audit reports

in the future, and how audit reports can be more useful to society.

It’s about how audits can provide investors more insightful

assessments of management stewardship.

Greed: Connecting the Dots

One of the valued traits of accountantsand auditors has been their canny

ability to decipher a plethora of data, ana-lyze it, describe it, classify it, and make ittransparent to readers of financial state-ments. Further investors, third parties, own-ers, and other interested stakeholders canmake informed business decisions basedon it. And through this logical rendition,the market and economy benefit.

Yet like so many people who lose theforest for the trees, the essential problemand issues are not seen or accounted for.This was so apparent in the three articlesthat appeared in June 2011 issue of TheCPA Journal.■ Mary-Jo Kranacher writes about howWaMu and Goldman Sachs deceived the pub-lic on securities they issued (“Financial MarketAlchemy: Turning Junk into Gold”). ■ R. Mithu Dey and Ashok Robin describein depth the quest of second-tier auditingfirms to be more recognized by large cor-porations, which would lead to more rev-enue and recognition (“Second-Tier AuditingFirms: Developments and Prospects”). ■ Paul A. Ashcroft explains how account-ing can attract new business in this trou-bled economic time (“Growth Potential ina Difficult Economy: Strategies forExpanding Client Services”).

What was faulty in these three well-researched articles is that the authors werenot seeing the big picture. It is like the oldtale of multiple blind people feeling partsof the elephant, addressing parts but not see-ing the whole animal. The issue all threeauthors missed was human behavior:■ For WaMu and Goldman Sachs, theirdrive was not for excellence, but for old-fashioned greed. ■ In the analysis of first-tier and sec-ond-tier firms, the number of lawsuitsthat each firm must defend itself againstwas not analyzed. In this respect, are thefirst-tier and second-tier firms that muchdifferent? Are the second-tier firms freeof lawsuits because they are somehowmore ethical than the Big Four? ■ In seeking to attract new business, whatstrategy is the CPA going to look at? If itis a traditional analysis, its way is for theclient to generate more wealth by finding

loopholes in the law or weaknesses in thecompetition. If this is the approach, is therereally anything new being said?

Hence, the issue is that as long asaccountants do not examine human behav-ior, a complete understanding of businessand its abuse cannot occur. And untilpeople are willing to look at their behav-ior and intent within our current financialstructure, the inevitable decline of theUnited States will continue.

Until accountants and society in gener-al act in self-righteous rage at the wasteof human potential in pursuit of profit, arti-cles such as those above will continuous-ly get published with no real answers.

Though society in the past may havebenefited from maximizing profit at allcosts, now this has a corrupting and cor-rosive effect on the fabric of society. TheUnited States no longer controls worldresources, so this endless spiral of ever-

increasing profits and the pressure thatcomes with it will continue to result in arti-cles that delude the reader into thinking,“As long as I play the game by these setrules, success will happen.”

We must, as a society, question the mostfundamental values of the pursuit of profitat all cost, and question all thoughts and con-cepts from that perspective. Perhaps businesswould improve by true organic growth andnot financial shenanigans. Perhaps when thislogical paradigm—the increasing bottomline—is truly questioned and rejected for amore creative and more natural relationshipfor this planet and universe, the fraudulentbehavior of the Goldman Sachses of theworld will end, lawsuits against accountingfirms for negligence will be reduced, andbusiness will increase for CPAs based onintelligence, collaboration, and collegial spir-it, as opposed to the whatever-you-can-getmentality. And when this day comes,


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

accountants will truly be able to see the fullelephant and connect the dots.

Larry Stack, CPANeuberger Berman, New York, N.Y.

Editor’s Response

Stack’s observation that human nature isintegral to understanding the dynamics

of business, especially as it relates to fraudand abuse, is right on. Fortunately, a grow-ing number of colleges and universities arerecognizing this fact and including interdis-ciplinary course material in accounting andbusiness curricula. Courses such as fraudexamination, corporate governance, riskassessment, and business ethics have begunto address behavioral aspects of the businessenvironment. Hopefully, this will serve toenlighten future accountants, auditors, and

business leaders about why, and how,some individuals betray the trust of othersfor personal benefit.

My editorial was meant to educate TheCPA Journal’s readers as to the findingsof the Levin report regarding “how a cul-ture of greed and deception managed toundermine our financial system and oureconomy” through financial shenanigans,not to provide answers to why some in oursociety prey on the trust of others. That,unfortunately, is a question that manyothers have been unable to answer. Thisis an area that is ripe for research but willnecessitate a collaboration between avariety of antifraud experts in the fieldsof psychology, criminology, accounting,technology, and law. The Institute for

Fraud Prevention (IFP), a coalition ofresearchers, businesses, and government,has taken on this challenge.

Mary-Jo Kranacher, MBA, CPA/CFF,CFEEditor-in-ChiefACFE Endowed Professor of FraudExamination York College, The CityUniversity of New York

Credit Ratings and the Financial Crisis

Ienjoyed the interview with RobertHerz in the February issue of The CPA

Journal. One of Herz’s responses espe-cially caught my attention: “And then, aglobal financial crisis came along!” I washoping there would be follow-up questions

dealing with the role of the accounting pro-fession as a whole, including the PCAOB,in bringing about this crisis. But the inter-view moved on to other topics.

There has been a lot of attention paidto whether the accounting profession exac-erbated the downside of the bubble byrequiring companies that had no need orintention to sell securities to mark themdown to fire-sale prices being realized bycompanies in financial distress. Somebelieve that the rebound in earnings report-ed by some financial institutions results, inpart, from the reversal (whether by write-up or sale) of losses that shouldn’t havebeen recorded to start with. That questionhas been widely discussed and is notdealt with in this letter.

Rather, my concerns deal with the roleof the accounting profession in the upside ofthe bubble and the shortcomings of mark-to-market (or fair value) in practice (asopposed to in theory). Some have said thatthe problem on the upside was bad loans,not bad accounting. This overlooks the basicfact that bad loans should not be accountedfor as though they were good loans.

The inflated market values used on theupside were based, at least in part, by theAAA ratings given by the rating agen-cies. These ratings were apparently usedwithout question, even though it was com-mon knowledge that loan underwritingstandards had declined significantly. Wenow know that the rating agenciesbestowed their highest ratings withoutdoing any meaningful analysis. Thus, fairvalues based on these rating were totallyunreliable but nevertheless widely used.

However, it appears that no one took thetime to investigate the rating agencies’ pro-cedures. There was a good precedent inauditing history to require such a step, butit was either overlooked or ignored. Irefer to the requirement in the early daysof computer processing that the work of aservice bureau had to be reviewed by anindependent person before reports from theservice bureau could be relied on. Basedon reports in the financial press, the sig-nificant shortcomings of the rating agen-cies’ procedures would have been obvi-ous almost immediately if an investiga-tion had been made.

Then, presumably, the ensuing financialcrisis would have been less severe, perhapssignificantly. But it never happened.

The financial crisis will be studied formany years, and there were many causesin addition to that mentioned above thatare beyond the scope of this letter. But,by applying the simple audit test describedabove, the accounting profession couldhave mitigated its impact.

Full disclosure: Herz and the authorwere colleagues in an accounting firm formany years and he succeeded the authoras senior technical partner for financialaccounting and reporting matters upon hisretirement.

Ronald J. Murray, CPA (retired)Stamford, Conn. ❑


Courses such as fraud examination, corporate governance,

risk assessment, and business ethics have begun to address

behavioral aspects of the business environment.

All upcoming FAE Conferences are also available via Live Webcast. Visit www.nysscpa.org/e-cpefor more information and to register for Live Webcasts.

Make sure to visit our new online course catalog to search through all of FAE’s CPE courses. Visit www.nysscpa.org/fae to find the course that is right for you.

Earn Your Summer CPE with FAE

FAE’s summer season is in full swing, so this is the perfect opportunity to fulfill your 2011 CPE requirements.

Register today for FAE’s important, timely and topic-rich programs across New York State and on the Web. With a variety of conferences, seminars, webcasts and other events, you are guaranteed to find courses designed for and applicable to you.

FAE’s Accounting UpdateAugust 1 – Binghamton (Course Code: 21111261)August 8 – Buffalo (21111281)August 22 – Manhattan/Bronx (21111211)

FAE’s Auditing UpdateAugust 2 – Binghamton (21112261)August 9 – Buffalo (21112281)August 23 – Manhattan/Bronx (21112211)

FAE’s Compilation and ReviewAugust 2 – Binghamton (21113261)August 9 – Buffalo (21113281)August 23 – Manhattan/Bronx (21113211)

FAE’s Individual Taxation – Mid Year ReviewAugust 17 – Northeast (21636241)August 18 – Binghamton (21636261)August 23 – Syracuse (21636251)August 25 – Manhattan/Bronx (21636211)August 26 – Westchester (21636231)August 30 – Suffolk (21636221)

FAE’s Solid Family Tax PlanningAugust 19 – Manhattan/Bronx (21625211)August 22 – Rochester (21625271)

FAE’s Ethics UpdateAugust 26 – Manhattan/Bronx (21277211)

August 3 – Ethics Conference (25901211)August 11 – Construction Contractors Accounting, Consulting and Taxation Conference (25540211)August 24 – Hedge Funds and Alternative Investments Conference (25530211)September 21 – Healthcare Conference (25545211)

FAE Update Seminars This Month:

Upcoming FAE Conferences

FAEf o u n d a t i o n f o r a c c o u n t i n g

e d u c a t i o n


In Focus

Fine-Tuning Financial Reporting

On May 5, 2011, Baruch College’s Robert Zicklin Center for Corporate Integrity held its

10th Annual Financial Reporting Conference in New York, N.Y. The event brought togeth-

er a collection of regulators, financial statement preparers and users, auditors, and others

in the private sector to discuss recent developments in the field. The featured speakers were

Leslie Seidman, chairman of FASB; James Kroeker, chief accountant of the SEC; and James

Doty, chairman of the Public Company Accounting Oversight Board (PCAOB).

The conference also featured four panel sessions that presented a wide variety of viewpoints.

The first panel explored current issues at the SEC, including its efforts at better communication,

improved enforcement, and gradual transition to global accounting standards. The second panel

looked at the complex standards regarding financial instruments and how FASB and the International

Accounting Standards Board (IASB) are endeavoring to find common ground on the topic. An after-

noon panel examined a variety of standards-setting developments affecting the private sector. The

final panel focused on FASB and the IASB’s progress in creating new models for the controver-

sial topics of revenue recognition and accounting for leases.

Following are edited transcripts and write-ups of the speakers and panel discussions from the

conference. The speakers’ comments represent their own views and are not necessarily those of

their respective organizations. All photos by Rob Horne.

Views from Regulators and the ProfessionFine-Tuning Financial Reporting


Updates from FASB and the SECMaking Progress on Convergence, Transparency, and Technology

Leslie Seidman has been a board mem-ber of the Financial AccountingStandards Board (FASB) since 2003.She was appointed FASB chair-

man in December 2010 when formerchairman Robert Herz retired. Seidmanbegan her career in public accountingat Arthur Young & Co. (now Ernst &Young), and she later set accountingpolicies for J.P. Morgan & Co. (nowJPMorgan Chase).

James Kroeker, SEC chief accountant,serves as the principal advisor to theSEC on accounting and auditing matters.Before joining the SEC, Kroeker was anaudit partner at Deloitte & Touche andserved as a practice fellow at FASB.

On May 5, 2011, Seidman and Kroekerkicked off Baruch College’s 10th AnnualFinancial Reporting Conference, hosted bythe Robert Zicklin Center for CorporateIntegrity, speaking on recent developmentsat FASB and the SEC.

LESLIE SEIDMANFASB Chair

There are quite a lot of new things goingon at the FASB, and I thought I’d startout on a very positive note, going throughsome of the changes that have occurredover the recent months and years. BeforeI move forward with describing thosechanges, I really should give credit toBob Herz for starting a lot of these posi-tive developments. It really is an honor tostep into the big shoes that he left. He real-ly had done a terrific job as chairmanover the eight years that he served.

The first thing that I want to focus on isthe new people that we have at the FASB.Our trustees decided to add two boardmembers to our ranks, to restore the size ofthe board back to seven members. We havea new board member who primarily spenthis career in the private-company, small-busi-

ness area—Daryl Buck—and another newboard member—Harold Schroeder—whohas spent his most recent professional years

as an investor. Before that, he was a CFOand also an auditor. It’s terrific to havemore board members at the table, becausethe more perspectives we have during thoseinitial discussions, the better opportunity wehave to have a robust discussion. We alsohave a new technical director, Susan Cosper,who will be speaking later. She has really hitthe ground running, having served as a fel-low for us a few years ago, and she’s doinga terrific job at the beginning of her service.I have very high hopes for the rest of the timeshe spends with us. It’s great to have newpeople involved in the process.

Current FASB Projects We also have a number of new projects.

Recently, we at the FASB and the FAF[Financial Accounting Foundation] undertookthe responsibility for developing the XBRL—or extensible business reporting language—taxonomy, which is the code or definitionsthat we use when we’re attributing labels tothe databases that communicate financial

information. We have an opportunity to stan-dardize those codes so that when investorsare extracting information through those

means, they have someindication that everybodyis doing it the same way.We’ve built that functioninto our process; as we’redeveloping new guid-ance, the team of peopleworking on XBRL areworking side by side todevelop the right codesfor people to use as theyimplement these newstandards.

We have also startedworking on our disclo-sure framework project inearnest in recent months.The purpose of that pro-ject, which I’m veryexcited about, is to devel-

op a framework for the board to use as we’reapproaching disclosure requirements in futurestandards, so that we have a more disciplinedapproach to identifying the key elements thatusers of financial statements want to see withregard to a particular type of item or withregard to the financial statements taken as awhole. It really offers an opportunity for usto take a fresh look at how we approachthe full set of information in a set of finan-cial statements.

I would say the most common concernthat I hear among business professionals,investors, and preparers of financial state-ments is that the disclosure package is toodetailed and cumbersome, to the degreethat it’s not an effective communicationtool. Once we have that frameworkdeveloped, we can take a step back andevaluate which current disclosures are get-ting the job done. We will do some house-keeping to go through and clean up therequirements so that we have a more use-ful package. There’s obviously an overlap

18 AUGUST 2011 / THE CPA JOURNAL

between the GAAP requirements and theSEC and other disclosure regulatoryrequirements. At some point down theroad, we will need to work collaborative-ly with the SEC, and the SEC staff has cer-tainly indicated a willingness to do that. Ithink it’s a real opportunity for a win-winin terms of preparers being able to com-municate more effectively, and investorsbeing able to see the messages more clear-ly and not having to parse through all ofthe detailed disclosures that currently exist.

We’re also working collaboratively withthe EFRAG [European Financial ReportingAdvisory Group]—it advises the EuropeanCommission on whether to adopt anaccounting standard—and we recentlystarted working with the U.K. AccountingStandards Board and the French AccountingStandards Authority [Autorité des NormesComptables; ANC] because we realized wewere all trying to pursue a similar initiative.We also have a new advisory group: Weformed a group primarily of nonprofit pro-fessionals, preparers, donor groups, and audi-tors in that area of practice, to help us takea fresh look at the accounting standardsthat apply to nonprofit organizations. Thosestandards have been in effect for over 20years, and we were starting to hear concernsthat there was a need to review whether thosestandards are providing useful informationto the nonprofit community. We had our firstmeeting recently and identified three work-ing groups to work on particular aspects ofnonprofit accounting, and we’re hopingthat those subcommittees can advise theboard on where to prioritize in order to movethose efforts forward on a timely basis.

Process DevelopmentsWe have new processes at the FASB.

Our oversight organization, the FinancialAccounting Foundation, realized through rec-ommendations that had been made by theSEC’s committee on complexity, or the CiFIR[Committee on Improvements to FinancialReporting] committee, that there was a strongdesire to take a look back at standards thathave been in effect for a period of time and

see whether they are accomplishing theboard’s intended objective. Our trusteeshave set up a function within the foundation—and that’s an important point; it is not afunction within the board itself—to take apost-implementation review of existing stan-dards. The objective is to make sure thestandard is functioning as the board intendedand also to identify opportunities to improvethe process that we use to go through thesetting of our standards. A team of people hasbeen established within the foundation thathas been working on a process that it is cur-rently beta-testing. My understanding is thatthey will be doing public communicationabout the process and the standards that theymay select for review, and you’ll have moreinformation from the foundation about that inthe near future. But I wanted to highlight itas an important positive development in over-sight that will ask: Is everything going accord-ing to plan and are there opportunities forimprovement there?

Another important development is the estab-lishment of a Financial Reporting Series bythe SEC. The FASB will be participating init as another opportunity to have feelers outthere in the community to identify emergingpractice issues on a timely basis, and I’mvery supportive of that effort.

Technological AdvancementsWe have some new technology at the

FASB. We recently began videocasting ourboard meetings so that you can sit in thecomfort of your own office and watchour board meetings, either live or on anarchived basis. An important processchange that we made was also to video-cast the education sessions that we haveleading up to a board meeting. So, if youchoose to, you can watch the process fromsoup to nuts, because every meeting of theboard is conducted in public, and nowwe’ve made it even easier for you toobserve and share your views with us with-out having to come to Norwalk or go toLondon. For some time now, we have beenconducting webinars that include trainingabout our standards and our exposure

drafts. We’ve tried to step up those activ-ities recently, to make it easier for peopleto stay in step with us in terms ofaccounting developments.

But a very positive important develop-ment is that we’re planning to offer CPEcredits for those webinars, particularly theones that relate to technical matters. I wantto encourage people to stay current withstandards and not wait for annual orsemi-annual conferences held by others,but rather to go to the source. We’ll takeownership of that and give you credit forparticipating in the process.

Another important technological develop-ment that we have just introduced is an exper-iment with an online way to provide com-ments on proposals. In connection with a pro-posal having to do with goodwill impairment,we are demoing an opportunity for con-stituents to fill out a few questions to give usan indication of how they’re generally view-ing this proposal. Of course, if you would liketo go into more detail, you can do it right onthe website or send us a letter. The reasonwe’re doing that is to make it easier for peo-ple to participate without having to go throughthe process of developing a comment letter,which some people find very challenging andtime-consuming. We’re hopeful that peoplefind this a more accessible, easy way to par-ticipate in the process.

All of these changes are designed toencourage people to stay up-to-date onthe developments at the FASB with respectto the proposals and the final standards,and encourage them to share their pointsof view with us on a timely basis so thatwe can work those considerations into theproposals before they go final.

Private Company ReportingOne of the heightened areas of focus at

the FASB recently is our focus on privatecompany issues. A special Blue RibbonPanel was formed to address and studyconcerns that have been expressed aboutthe way that the FASB and other partici-pants in the system are handling the uniqueconcerns of private companies. There were

In Focus


concerns about relevance: Were the stan-dards relevant for private companies andthe users of their financial statements? Arethey overly complex for those particulartypes of stakeholders?

There was a set of recommendationsissued by the Blue Ribbon Panel. One ofthe major recommendations is a proposedstructural change so that a separate boardwould be formed to develop accounting stan-dards for private companies. There wereother, more short-term, recommendations, anumber of them aimed at changes in the pro-cess that the FASB goes through to set stan-dards. I strongly support those short-term rec-ommendations having to do with processchanges. In fact, we had already begun toimplement them or are continuing to imple-ment most or all of those changes.

Let me just pause for a second to speakabout that more major recommendationhaving to do with the structural change.That recommendation has gone to the foun-dation, and the trustees are undertaking aprocess to evaluate the recommendationand discuss it with a wide range of stake-holders. They will then form a view onhow to resolve the concern that has beenraised and also any appropriate response toit. It is not something that the FASB itselfwill be undertaking as a project, but some-thing that the foundation is giving seriousconsideration to.

Regardless of the outcome of that struc-tural recommendation, the FASB is movingforward with a number of specific processchanges that are all designed to be moreresponsive to our private company stake-holders, to get a better handle on the uniqueneeds of preparers and users of private com-pany financial statements, and to see if wehave some common ground that we can useto move forward and better address those con-cerns. For example, we have a number of staffmembers whose sole focus is to understandthe concerns that are being expressed by pri-vate companies and the users of their finan-cial statements, and make sure those viewsare brought to the board on a real-time basisfor us to consider as we make decisions aboutvarious technical matters. We’ve also held anumber of roundtables designed specificallyto get at the views of private companies andthe users of their financial statements; we’re

trying to hold those around the country tomake sure that it’s easy for people to partic-ipate. We have standing advisory committees:a Small Business Advisory Committee[SBAC], as well as a Private CompanyFinancial Reporting Committee [PCFRC].We’re also making sure that at each of thosemeetings, we have a separate discussion abouteach major project that’s going on, to givethem another opportunity to express theirviews directly to us and have a discussionabout what the issues are and how we mightbe able to best address them.

A very important development is that ourstaff is developing a white paper that willask: What are the unique needs of privatecompanies and the users of their financialstatements? We’re calling that a “differen-tial framework” to see if there are differ-ences, what are they, and why should theyexist. My strong belief is that unless wehave a common understanding on that keyissue (whether it’s the FASB that movesforward with this responsibility—which Istrongly hope is the case—or a new boardis established to conduct this activity), with-out a common understanding of when dif-ferences should exist and why, I think anyeffort is doomed to fail because there willbe an ongoing expectation gap betweenall the parties involved. Our staff is wellunder way with the development of a dif-ferential framework that is based on dis-cussions with private companies and thepractitioners in that area, and it reflects whatwe’ve heard. We have formed a specialresource group to work with us on theseissues, and they are in the process ofgoing through that initial draft to seewhether it resonates, whether it is complete,and whether they can add any value to thedevelopment of the white paper before westart discussing it with others. Ultimately,I think we’re going to need to expose thisdocument for public comment, so thateverybody has an opportunity to look at itand share their views on it.

I hope that those improvements that I’vedescribed show a strong commitment onbehalf of the FASB to respond to theconcerns that have been expressed in a veryconstructive, positive way. Despite all thesechanges, let me emphasize one thing thathas stayed the same at the FASB, and

that is our strong commitment to the devel-opment of high-quality accounting stan-dards so that the users of financial state-ments can make informed decisions abouthow best to deploy their capital.

ConvergenceOur recent focus has been on our con-

vergence projects with the IASB[International Accounting StandardsBoard]. I thought I’d give you a generaloverview of the status of the Memorandumof Understanding, or MOU, that we havewith the IASB. We have made some sig-nificant progress on the MOU this year andother joint projects with the IASB. Weissued two chapters of the ConceptualFramework that were jointly developed andthat relate to the objectives and qualitativecharacteristics of financial information. Weare also about to issue two new standardsthat are converged, one on fair valuemeasurement, so we now have a standardthat is the same between U.S. GAAP andIFRS [International Financial ReportingStandards] on how to measure fair valuewhen another standard requires or permitsthe use of fair value. We are about to issuea standard on the presentation of othercomprehensive income [OCI], so that any-where around the world, OCI will be pre-sented either as part of a single statementof comprehensive income or in a statementthat immediately follows the statement ofnet income. So there will no longer be apractice of presenting other comprehensiveincome in the statement of changes instockholder’s equity, which is the majorway that that item is presented in U.S.GAAP today.

At about this time last year, we announceda prioritization of the remaining projects onthe MOU and we did defer work on sever-al of the projects in order to focus on whatwe viewed as the most important projects: tomake progress on and improvements inU.S. GAAP and in IFRS, and also to giveour constituents an opportunity to focus onfewer matters so that we could encourageactive participation among everybody on thatsmaller group of projects. Those projectsare the revenue recognition project, the leas-ing project, financial instruments, and then,as we say, “our friend, insurance,” because


it’s not technically on the MOU but it’s cer-tainly viewed as a very important project. Ibelieve that the strategy of winnowingdown the list was effective, if I use thenumber of comment letters that we receivedas an indicator of people’s willingness andability to participate. We did receive veryhigh volumes of comment letters on theseprojects, and I’m very grateful for the timeand effort people spent, because I knowthere’s a lot else going on in the world andit takes a significant amount of effort tounderstand the proposals and share yourviews. So thank you for that.

We also really stepped up our outreachactivities and went out to meet with peoplewho we knew would be affected by the pro-posals to make it easier for people to sharetheir views with us. One particular groupthat we were focusing on in those effortswas investors, because we have found his-torically that investors are less likely to sharetheir views with us in writing.

Generally speaking, all of those priori-ty MOU projects that I mentioned are inactive redeliberations. A number of issueswere raised about each of the projects, andwe are carefully working through all ofthose issues. A common theme amongthe proposals was that there was a levelof complexity that did not seem warrant-ed, and we’re taking that particular con-cern to heart and trying to find ways toprovide useful information without mak-ing the proposals unnecessarily difficultto understand or to apply. We want to dothis without compromising the quality ofthe information that will ultimately be pro-vided to investors. To try and get that bal-ance just right, what we’re doing is con-ducting targeted research outreach withinvestors, preparers, and auditors to imme-diately cross-check whether we’re gettingthat balance right. I should say that we doso on a “targeted basis,” meaning it hasto be a pretty central issue in the projectand something that we think people caredabout deeply in their comments to us.

Another important change with respectto the convergence project is that, at our

April meeting with the IASB in London,we determined—after looking at theremaining issues that needed to beaddressed and important steps in the pro-cess that we felt needed to be conducted—that we were going to need a little moretime before we feel we’ve done what weneed to do to issue a high-quality stan-dard on these matters. The purpose forthe extension of the timetable is entirely toensure that the standards are of the levelof quality that we think is important. Thereis no desire here to indefinitely delay theseprojects or to lose momentum on them, butwe felt it was extremely important to pro-ceed at a pace that allowed people to con-tinue to participate actively, and then allowtime for us to evaluate the proposals as awhole and determine what other stepsmight be necessary from a quality controlstandpoint to make sure the standards wereready to be issued and implemented bypeople widely around the world.

Each of the projects has unique consid-erations, but what we’re hoping to do ishave the major decisions made on each ofthese projects, with insurance being anexception, on or about a June time frame.For those of you who follow us very close-ly, I am not saying that we’re going to bedone or that we’re going to have a draftof some kind done—I’m just saying thatwe’re hoping to complete the board meet-ings around that time frame. Then we havean extensive process to draft the basis forconclusions and move forward with pub-lishing a document.

Before we publish anything, we willtake a look at the decisions as a whole anddetermine whether we need to re-expose thedocument or not. The way we determine thatis to evaluate the changes that we’ve maderelative, first, to current GAAP and, sec-ond, to what we’ve already exposed.Depending on the nature of the changes,we will have a basis to evaluate whetherwe think we need more commentary onthis proposal or not. Regardless of whetherwe decide to expose the documents, whatwe’re planning to do jointly with the IASB

is, when we’re finished with the standards,to draft them and post them on our web-sites for a period of time, to give people anopportunity to look at the standards as awhole and provide any additional commen-tary that they have about whether we’vemissed something, whether there’s a fatalflaw in the proposal. There will be a pausebuilt into the process to give people anoth-er chance to take a look at the document.

We have, importantly, not decided yeton any effective dates for the standards.We issued a special document to solicitcomments on whether these standardsshould be implemented as a group orsequentially, released over time. We gotmixed feedback on that discussion paper,geographically as well as within the vari-ous communities of constituents. We hadvery few responses from investors, and sowhat we have done recently is posted asurvey on our website and done a littleprodding to get people to participate to giveus a little bit more information, especiallynow that we’ve made some changes tothe proposals in our redeliberations. Inmy mind, those are interrelated. Sometimespeople will tell you they need more timeto implement a standard or they want toimplement in a certain way, because of thenature of the accounting change. We’regoing to regroup and get a little moreinput on that before we determine theeffective date or the manner of transitionon any of these individual standards. Butthe clear signal I want to send is that wedo plan to provide ample time for peopleto understand the proposals and then tran-sition to the new requirements in an orderlymatter. This is not going to be a casewhere we release something and makeit effective this year-end or next year-end. We’re looking at a couple ofyears at a minimum before we wouldmove forward.

As you can see, we have made a lot ofprogress within the organization. You haveall been a major contributor to that pro-cess and that progress, and I want to thankyou very much for that. ❑

In Focus


JAMES L. KROEKERSEC Chief Accountant

Last year at this conference, you heardabout a comprehensive assessment of thestaff work plan on IFRS that we werebeginning to develop and execute. Sincethen, we’ve issued a progress report, andI expect to issue updates of our workprogress as it continues. The SEC is ded-icating several resources to the work inpreparing the commission to make a fullyinformed decision about IFRS, a decisionthat must be in the best interest of U.S.investors and the U.S. capital markets.

Financial Reporting SeriesToday I’d really like to focus on several

other accounting and auditing developmentsthat are on our agenda for 2011. As part ofour oversight of the financial reportingsystem, we’re instituting a series of roundta-bles that we’re aptly—I think, at least—referring to as the “Financial ReportingSeries.” The idea is to facilitate a robust andbalanced discussion of existing and emerg-ing risks, trends, issues, and pressures onfinancial reporting. The Financial ReportingSeries will help us at the SEC in our job—and also at the PCAOB [Public CompanyAccounting Oversight Board] and theFASB—in early identification of risks relat-ed to, as well as other areas for potentialimprovement in, the reliability and useful-ness of reported financial results. Theapproach will be one of inviting a cross sec-tion of auditors, preparers, investors, andother individuals to express their views. Thepurpose of the roundtable is to gather a spec-trum of views and to foster informed dis-cussion and dialogue on some of the mostdifficult and challenging financial report-ing topics. The idea is not to create sometype of “blue ribbon” committee that wouldoffer up a set of recommendations.

More particularly, I expect that the serieswould provide the commission staff, as wellas the FASB and the PCAOB, with usefulinformation about emerging issues and chal-lenges in the business environment that affecteach of our respective roles and responsibil-ities. In addition to observers from theFASB and the PCAOB, we expect to invite

others. For example, if the issue relates to anarea that is important to bank regulation, wewould invite bank regulators or other com-mission staff from other offices or divisions.

I anticipate that we would have aroundthree sessions of this Financial ReportingSeries each year, depending on the natureand the number of issues that are encoun-tered. We’ll be looking for participants whoare knowledgeable about the issues at hand,and, consistent with the commission’s otherroundtable activities, the sessions will beopen to the public. They’ll be webcast andarchived. I encourage you to watch for apublic announcement about these sessionsin advance through a press release orthrough a devoted webpage to the FinancialReporting Series that will be available onthe commission’s website. I expect—or atleast I hope—that our first session couldbe held later this summer and that it wouldfocus on a topic such as addressing dis-closure uncertainty and the role of uncer-tain measures in financial reporting. It’s apretty big topic to bite off.

Converging StandardsAnother item on our agenda is conver-

gence of accounting standards. TheFASB and the IASB are committed toenhancing and converging financial report-

ing standards and have been doing so fora number of years. They’re nearing com-pletion on a number of priority projects andare considering how best to transition fromexisting accounting standards to the onesthat will be finalized. I’m pleased that theboards are working on these importantfinancial reporting issues and that they’remaking progress toward resolution. To me,the boards’ issuing of high-quality stan-dards is of the utmost importance. High-quality standards provide investors with relevant, reliable financial information toguide investment decisions. High-qualitystandards can be understood and imple-mented in a consistent way by preparersand audited by auditors. I’m also pleasedthat the boards are committed to followingrigorous due-process procedures, includingpreimplementation testing and outreachso that they’re able to achieve this high-quality desired result. While performingresearch and field testing are important ele-ments of the process, they also take time.I support the continued reprioritization oftheir agendas and the time to achieve high-quality converged standards.

I believe it’s crucial, particularly as itrelates to the MOU projects, that theboards take all reasonable steps to max-imize the prospect of really converged


solutions. For example, currently theboards are not aligned as it relates to theirapproaches to consideration of hedgeaccounting in their financial instrumentsproject. Numerous conceptual, opera-tional, and practical questions have beenraised about proposals issued to datethat I believe should be consideredjointly by both boards. I believe that inthe long run, a measure of added timeto provide for joint redeliberations on aproject as critical and as complex ashedge accounting will prove to be farmore productive than any gains that areperceived by finalizing deliberations indi-vidually. In achieving high-quality con-verged standards, the boards inevitablywill be faced with difficult choicesabout how to proceed. I continue toencourage the boards to reconcile theirdifferences in their proposed standards,and to work to reach converged andapproved solutions. My focus tends to beon ensuring that there is an appropriatebalance between the conceptual under-pinnings of the project and a degree ofpragmatism in the standards so that theycan be consistently applied and audited.

I’ve also spent time understanding thereport and the recommendations put forwardby the Blue Ribbon Panel on private com-panies. My focus has been to consider thenature and the impact of any recommenda-tions for private companies to apply account-ing standards that may differ from those ofpublic companies. It’s prudent, in my view,to carefully consider the impact placed onthe capital formation process if private com-panies have to adopt a more stringent set ofaccounting policies in connection withpreparing for a filing to raise capital. It’simportant to understand why one might sug-gest a different standard for private compa-nies. I support the approach taken by theFAF to carefully consider the advice fromthis panel as they strategically assess thefinancial reporting system for private com-panies. I believe additional research, study,and outreach, particularly to investors, willbe warranted in a number of areas prior to

implementing any significant structuralchange.

Improving Auditing With that, let me turn to auditing. We have

a number of auditing issues on our agenda,several of which arise from or are at leasthighlighted by lessons learned as our nationemerges from the financial crisis. Let mestart with just our work on [Sarbanes-Oxley]section 404(b). As many of you know, com-ing out of the Dodd-Frank legislation, thecommission was directed to study how toreduce the burden of complying with theauditor-attestation requirement. This iswhat people often refer to as section404(b), or the auditor’s opinion, particular-ly as it relates to companies that are on thesmaller end of the spectrum, companies withmarket capitalizations between $75 millionand $250 million. [We were directed] tostudy that, but also study how to reducethat burden and, at the same time, maintainthe investor protection for such issuers thatis a result of section 404(b).

Let me provide you with an update inthis area. We’ve issued our study, whichis available on the commission’s website,and in performing this study we consid-ered the number of actions that had beentaken since the implementation of 404(b)in 2003. First, when 404(b) was imple-mented, it was done on a phased basis.There were several extensions to thecompliance date. The commission alreadyput in place relief for those companies thatare entering into initial public offerings,both for the period of the offering as wellas the next annual period. Further, the com-mission issued interpretive guidance tomanagement and the PCAOB revised itsauditing standard from AS 2 to AS 5 at thesame time, and then in 2009, the commis-sion released a study on 404 and the costsand benefits of its implementation thatforms much of the basis for the commis-sion’s recently issued study.

The information that we compiled in thecontext of the study provided us with afairly clear understanding of a number of

points. First, the cost of complying with theauditor-attestation requirement of 404(b) hasdeclined since the commission first imple-mented those requirements in 2003. Investorsgenerally view the auditor’s report,required under section 404(b), as beneficial,and financial reporting as a whole as morereliable when the auditor is involved in theinternal control of a financial reporting pro-cess. Finally, the evidence that we lookedat in the study does not suggest that 404(b)alone is affecting listing decisions in thestudy. After gathering this information, weconcluded with the two recommendations.First, the commission should maintain theinvestor protections of 404(b) for accelerat-ed filers, that is, those that were the subjectof the study. There’s strong evidence that theauditor’s role in auditing the effectiveness ofinternal controls improves financial report-ing, and I would note that the Dodd-FrankAct exempted approximately 60% of report-ing issuers from section 404 when it exempt-ed companies below $75 million. Therefore,as recommendation one, we don’t suggestany further exemption. The second recom-mendation was that the commission staffencourage activities that have the potentialto improve the efficiency and effectivenessof section 404(b).

That sounds pretty abstract, so I’ll justgive you one example. The staff has rec-ommended that the PCAOB, through itsinspection process, monitor the resultsand publish its observations beyond theobservations that they already published in2009 on the performance of audits. Theobjective in publishing these observationswould be to provide auditors with the ben-efits and lessons learned that the PCAOBsees in their process.

Let me now just turn to the role of theauditor in mitigating financial reportingrisks. We’re also considering whatlessons can be learned from the financialcrisis about the role of the auditor morebroadly than you think about it today. Inexercising their vital function in our capi-tal markets, auditors play a key role withrespect to a particular type of risk, that is,

In Focus


the risk of a material misstatement inreported financial results. In looking specif-ically at the role of the auditor, it’s criti-cal to distinguish between financial report-ing risk and other types of risk, such asbusiness risk or operational risk, that mayaffect the company’s results and impactinvestment decisions. While auditorsmust understand these risks, to the extentthat they impact financial reporting risks,the auditor’s procedures and communica-tions are not designed specifically toaddress risks other than financial report-ing risks, or to make judgments about themerits of a company’s business strategy ormanagement’s decisions in implementingthat strategy. An audit is not designed,nor can it or should it be designed, totake all risk out of investing. An audit isinstead designed to add to the credibilityof financial information reported toinvestors, so that investors can rely onthat information in making their owninformed investment decisions.

Focusing, then, on financial reportingrisk, we’re taking the opportunity to con-sider how the role of the auditor could beimproved. I’d like to underscore what Ibelieve to be a good opportunity for arenewed focus on the auditor’s reportingmodel. I believe the PCAOB projectrelating to the auditor’s reporting modelis a particularly important initiative inunderstanding whether there is informationthat investors are currently not getting fromauditors. Of course, there are fundamentalquestions that I think have to beanswered—questions such as: Whatinformation is needed for investors, or whatadditional information might be useful?Who should provide that information? Inwhat form or in what manner should theinformation be provided? I look forwardto the PCAOB’s continued work on thisproject. Of course, we at the SEC will pro-vide our perspective to the PCAOB onthe details of the project, including ques-tions such as whether the auditor shouldhave a role in auditing presented MD&A[management discussion and analysis]information or other aspects of reportedresults that might rest outside of thefinancial statements.

While there might be an opportunity fornew standards, I hasten to mention thatthere are existing requirements for disclo-sure of risks and uncertainties. To theextent that poorly performed audits havefailed to report substantial doubt about anentity’s ability to continue as a going con-cern, or where audit standards have other-

wise not been complied with, let me justissue a warning that there are existingmechanisms for dealing with that, both atthe PCAOB and at the SEC.

International AuditingBefore I conclude, let me turn to one last

topic, international auditing. In recent years,we’ve seen a spike in private companiesmerging with public shell companies, andwhile there are a number of companiesfrom a particular country that have grabbedheadlines recently, the problems coming tothe forefront are not limited to companiesbased in any geographic region. There area number of different ways for companiesto access the public capital markets, one ofwhich is a reverse merger into a publicshell. Since January 2007, there havebeen more than 600 registrations thathave occurred through this process.

U.S. listing of certain companieslocated overseas has raised some uniqueissues; for example, the PCAOB staffrecently highlighted concerns surroundingthe quality of certain financial statementaudits that they have reviewed. As theynoted, U.S. auditors may be issuingaudit opinions on financials, but notengaging in their own audit work. Instead,the U.S. firms may be issuing audit

opinions based almost entirely on thework performed by other auditors outsideof the U.S. This is significant for a num-ber of reasons, not the least of which isthat the PCAOB has been unable toinspect audits in a number of countries.While the vast majority of these registra-tions via a reverse merger may be legiti-

mate businesses, some of them seem tohave significant accounting deficiencies—even to the point of being frauds. We haverecently seen an uptick in resignationsassociated with these types of issuers. Inlooking at the 8Ks for resignation, the dis-closed reasons have included troublinginformation about auditors being unableto do things like confirm cash and receiv-ables, and in some instances [there havebeen] allegations of falsified documents.We’re looking at these situations veryclosely, and I’d encourage each of youwho has a role in auditing overseas andin these types of listings to be vigilant aswell. Staff in my office, as well asacross the commission, have been work-ing collaboratively with the PCAOB andothers to investigate concerns about finan-cial reporting deficiencies or frauds atU.S.-listed foreign companies, with a par-ticular emphasis on companies engagingin reverse mergers to achieve registration.

We all have an important stake in theaccounting and auditing topics that we’vediscussed so far and that we will contin-ue to discuss today, with the goal of maintaining the trust that investors have—that bedrock of our financial system uponwhich much of our capital market system rests. ❑

“I believe the PCAOB project relating to the auditor’s reporting model

is a particularly important initiative in understanding whether there

is information that investors are currently not getting from auditors.”


The first panel at Baruch College’s10th Annual Financial ReportingConference on May 5, 2011, featuredspeakers discussing current devel-

opments at the SEC, including financialreporting issues, SEC audit investigations,and the Commission’s progress on adopt-ing global standards.

Communication EffortsWayne Carnall, the chief accountant of

the Division of Corporate Finance at the

SEC, began by speaking about the com-mission’s efforts to improve communica-tions with corporations, accountants, andthe public. He pointed to the SEC’s“Dear CFO Letters” program as an exam-ple. Through this project, the SEC putsactual letters it has issued to companieson its website to provide guidance to oth-ers. For example, an October 2010 letterdealt with the topic of foreclosures(www.sec.gov/divisions/corpfin/guidance/cfoforeclosure1010.htm). Carnall also stat-

ed that the SEC teams up with the PublicCompany Accounting Oversight Board(PCAOB) to present seminars around thecountry for auditors of smaller businessesto help address issues unique to them. Thisinformation can also be found on theSEC’s website, where Carnall said thereare “50 pages of detailed information ofunique issues that we have addressed forsmaller reporting companies.” The SEChas also been making strides in commu-nicating with small, community banks,

In Focus

Current Developments at the SECEnforcement, Red Flags, and the IFRS Work Plan

Panelists, from left to right: Wayne Carnall, Howard Scheck, and Paul Beswick


developing guidance documents that areavailable on the website.

Working with the SECSaying that if people don’t work with

the SEC staff on a frequent basis, theycan seem like “a mysterious group ofpeople,” Carnall pointed to an online doc-ument that will help filers learn how tointeract successfully with the staff. “BestPractices for Working with SEC Staff”(www.sec.gov/news/speech/2009/spch120609ac-ms.pdf) outlines when to ask ques-tions, whom to call, and how to performresearch on the SEC website.

Another tool that Carnall recommend-ed is the SEC’s Financial ReportingManual, which is updated quarterly(sec.gov/divisions/corpfin/cffinancialreportingmanual.pdf). “It doesn’t address account-ing guidance; it addresses financialreporting in terms of the SEC’s rules andhow you comply with them,” Carnall said.“It has a lot of valuable information.” Hesaid updates to the manual in the pastyear have included guidance on calculat-ing “significance” for acquired business-es, goodwill impairment, what types of dis-closures should be included in the man-agement discussion and analysis (MD&A),and stock compensation in an IPO.

Carnall also highlighted the importance ofCompliance and Disclosure Interpretations,which primarily address legal issues butcan be, he said, “very relevant to an accoun-tant.” They are updated regularly on theSEC’s website (www.sec.gov/divisions/corpfin/cfguidance.shtml). One recent itemfor which the SEC provided additional guid-ance was a filer’s change of accountants; theguidance addressed the interim periodbetween auditors during the change, going-concern opinions that might have beenissued, and the deregistration of auditors bythe PCAOB. Carnall said that especially inthe latter case, such a situation should be dis-closed in the 8K, because “that is a factthat investors should know.”

Carnall then offered advice on how tohandle issues that may arise with the SEC.Most significantly, he recounted a storyabout an issuing company that providedonly a one-page response to the SEC’s

questions about its financials—before com-ing up with a 35-page submission, oncepressed. Carnall advised: “Don’t try to sub-mit something to us to see if we go away.Make it your best effort, your most com-plete response. It makes the process moreefficient and effective for all of us.”

Issues of Focus for the SECCarnall pointed out two other areas on

which the SEC is focusing: contingenciesand reasonably possible losses. On the for-mer, he said: “If we see a company hashad a large settlement, we look at prior fil-ings to see if there’s any disclosure aboutthat or see how they have accrued for it.”He said one of the concerns the SEC hasis that companies sometimes take a chargeand accrue it over a long period of time—several quarters; the SEC will want to knowthe basis for when a company booked thecharge and how they supported the chargewhen that event took place. “We don’t allowcompanies to smooth charges in this regard,”Carnall said.

Carnall pointed to three ways to complywith the disclosure requirements for rea-sonably possible losses: Disclose theamount or the range of possible reasonablelosses, disclose that any additionalamount would not be material, or disclosethat the amount cannot be estimated. “If acompany makes that assertion, though, theyneed to be able to support it,” he said.

On the topic of disaggregated informa-tion, Carnall said, “Obviously consolidatedfinancial statements are critically important,but sometimes you have to pierce those itemsto understand what’s behind them and tounderstand the company’s financial state-ments.” He used segments as an example ofthe type of information the SEC might beskeptical about. Another area that the SEChas been asking questions about is income taxdisclosures from companies that have manyoffshore operations. He said the SEC some-times sees companies assert that their profitsare permanently invested overseas and theydo not provide taxes on repatriation, even asthese companies have lots of cash and short-term investments. When that occurs, he said,“We will suggest that they segregate in theirMD&A the amount of cash in short-term

investments that are overseas and that theyare not planning on repatriating.”

Lastly, Carnall touched on the area ofreverse acquisitions and non-U.S. compa-nies. He said that when the SEC sees acompany with all its operations overseasusing U.S. GAAP, “We will basically aska very simple question: Who is preparingthe financial statements and what are theirqualifications? Are they a U.S.-trainedCPA? Do they have any U.S. GAAP expe-rience?” As a result, he said that the SEChas seen some registrants elect to deregis-ter and basically delist from the UnitedStates; some acknowledge that they don’thave the capability and indicate that it’s amaterial weakness, while others hire peo-ple to fulfill that role. The third option,Carnall said, is the SEC’s long-term objec-tive: “We want companies to have thecapability to be able to prepare financialstatements that comply with U.S. GAAP.”

How SEC Enforcement WorksHoward Scheck, chief accountant in

the SEC’s Division of Enforcement, spokenext. He explained that his division helpsthe enforcement attorneys who are inves-tigating accounting cases with all aspectsof their day-to-day activities, including“advising on accounting and auditingissues, deciding what documents to requestfrom companies and auditors, reviewingthe documents when they come in, takingand participating in testimony, evaluatingall the evidence, and making recommen-dations to the Commission as to whetheran enforcement action should be made.”

Scheck said his general view is that thevast majority of accountants and other prac-titioners are doing the right thing and arefulfilling their role in detecting and deter-ring fraud. “But we all know that thereare frauds that still occur,” he said. “Andit usually is the CFOs, the controllers, andthe audit partners who are involved in thosefrauds, so we all have to remain vigilant.”

He then highlighted the federal securitieslaws that apply in the cases his divisioninvestigates. “We’re always going to be eval-uating intent—if there’s an accounting error,why did it happen, how did it happen, whowas involved,” he said. “We’re going to try


to look behind whether it’s just a GAAPerror and why it happened.”

Sheck also pointed out the “nonfraud vio-lations that we have in our arsenal fromenforcement.” He specifically wanted audi-ence members to be aware of reportingviolations (section 13[a] of the SecuritiesExchange Act of 1934), books and recordsviolations (section 13[b][2][A]), and internalcontrols violations (sections 13[b]2[B] and13[b][5]). “Those are all nonfraud violationsin the sense that the Commission doesn’thave to prove fraudulent intent to bring thoseviolations,” he said.

Enforcement Areas of FocusHe also outlined the accounting areas of

focus for the enforcement division, whichinclude reverse mergers, disclosure, rev-enue recognition, loan losses, valuations,impairments, expense recognition, andrelated-party transactions. He said reversemergers is an area where the SEC hasbecome increasingly proactive in the pastyear. “In the last couple of months alone,there have been over two dozen compa-nies that have filed a case that disclosedauditor resignations or accounting issues,and the SEC has recently suspended trad-ing in various reverse merger compa-nies,” he said.

As for red flags, Scheck said the SECis not seeing any significant new items. Hesaid it continues to examine aggressiveaccounting policies, changes to accountingpolicies, or methods of applying those poli-cies without disclosure. He added:“That’s one of my particular pet peeves,when changes are being made and theremight be a material impact but there’s nodisclosure to investors.”

He said the SEC continues to focus ongatekeepers and other relevant individuals,such as audit committee members, CEOs,CFOs and controllers, and transactionpersonnel. In addition, he explained, “we’realways going to be getting the auditworkpapers, to see what the auditors did,to evaluate whether they were lied to ormisled, or whether there was some sort of

audit failure, and we’re going to be look-ing at what the lawyers were recommend-ing regarding disclosure and what the coun-terparties did.”

Scheck gave some advice as to howthose involved in auditing should conductthemselves. “When you’re on the privateside, if you’re involved in an audit or aninvestigation, you have to ask yourself:How is this going to look?” he said. “Whatare the facts and circumstances going tolook like? What is the analysis going tolook like if the enforcement divisionlooks at it?”

He said that, in assessing audit board con-duct, the biggest issue is what happens whenthe board finds something: What did theydo to resolve it, and what did they do toensure that the financial reporting was right?He said that questions his division wouldask might include: “Was there an investi-gation being done? Who conducted theinvestigation? Did they use inside counsel?Did they use outside counsel? Did theyuse the internal audit folks? What is thescope of the investigation?” Scheck said theSEC would use similar queries in assess-ing independent auditors; in assessing thirdparties, it would look at counterparties todetermine whether they provided any sub-stantial assistance in causing a violation. Headded that the Dodd-Frank Act has clarifiedthat recklessness is, in fact, sufficient as faras aiding and abetting.

Scheck ended by stating that section 106of the Sarbanes-Oxley Act, which dealswith the ability of the SEC and PCAOBto obtain foreign audit workpapers, wasupdated in the Dodd-Frank Act. He antic-ipates that the SEC will “be using 106going forward.”

SEC Work Plan UpdatePaul Beswick, SEC deputy chief accoun-

tant, spoke last on the panel, focusing onthe topic of the SEC’s work plan regard-ing conversion to or convergence withIFRS, which was issued in February 2010(“Commission Statement in Support ofConvergence and Global Accounting

Standards”). He said the goal of the workplan is to provide information to the SECso it can make the most informed deci-sion possible. A progress report was issuedin October 2010; Beswick said that, as ofthe May 2011 conference, the SEC wasstill in the process of gathering informa-tion and not yet “trying to understand whatthat information means.”

Areas of Focus on IFRSBeswick said there are three areas of

focus on which the SEC might release staffreports: the potential incorporation frame-work, a comparison of U.S. GAAP andIFRS, and a review of financial statementsprepared under IFRS. With regard to aframework for the incorporation of globalstandards, he said that the SEC has learnedin its outreach that “people initially thoughtthat going to IFRS was a binary decision—we either had to go or we didn’t go.” Buthe said the SEC saw that there were otherways that countries had incorporated IFRS into their financial reporting sys-tem, including a model of endorsement:The International Accounting StandardsBoard (IASB) would issue a standard,and then the local standards setter wouldendorse that standard into the nationalGAAP. “One of the key questions, though,if you’re going to do an endorsementmodel, is what is the threshold for endorse-ment?” he said. “I’m not sure if we everwant to have a mechanism where wehave a perfunctory endorsement.”

He added that another area to consideris what to do with existing national stan-dards. “If you go to a scenario where some-one would endorse new standards, whatwould you do with existing GAAP?” heasked. “One of the things we’re trying toflesh out in that paper is: What would bea good model for dealing with existing dif-ferences?”

In order to make progress on that ques-tion, Beswick said the SEC is preparing astaff report that would compare U.S.GAAP and IFRS. “We started with iden-tifying every difference possible, down to

In Focus


almost the comma,” he said. “Now, we’retrying to take those differences and makeit in a format that’s more understandablefor people.” In doing so, the SEC is try-ing to focus on where there is a differ-ence in the objective, as compared to theapplication guidance. He said that, so far,the SEC has highlighted different objec-tives in the areas of “LIFO [last-in, firstout inventory method], contingencies,R&D, and rate-regulated assets.”

The last area of focus for a potential staffreport is reviewing financial statements pre-pared under IFRS. He said the Division ofCorporation Finance selected a sample ofaround 200 SEC registrants and reviewedtheir financial statements in order to under-stand what companies are really doing withstandards. The SEC is currently in the pro-cess of summarizing the results of that review.

SEC Decision on IFRSLast year, the SEC stated that it would

make a determination in 2011 on whetherto require companies to report using IFRS.Beswick said this decision has generateda lot of interest from the accounting andinvesting communities, but the SEC is stillgathering the information it needs tomake a decision. He said that if the SECdoes decide to incorporate internationalstandards, “some of the various waysthey can do that are IFRS as issued bythe IASB, convergence, or an endorsementmechanism”; the SEC is making sure thatit has considered each of these optionscarefully and determined whether there areothers.

He outlined the key questions forconsideration, including the role of theSEC in accounting oversight and the role

of FASB in standards setting. “I can’timagine we have a scenario where theFASB doesn’t have a very substantiverole,” he said. “I think it would be veryimportant for FASB to be the represen-tative of U.S. interests in the globalaccounting standards setting.” Some ofthe other key considerations are oversightof the IASB and the IFRS Foundation,funding of the IASB, and options for U.S.issuers.

Beswick ended with a list of things theprofession can do to build investor confi-dence, the most important being to remem-ber that no issue is worth risking a person-al reputation over. “You can’t get it back.Once you lose it, it’s almost impossible torebuild,” he said. “So you just really needto try to operate and conduct yourself withas much personal integrity as you can.” ❑

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The second morning panel at BaruchCollege’s 10th Annual FinancialReporting Conference on May 5,2011, focused on the topic of finan-

cial instruments, and brought togetherregulators, preparers, and users to discussrecent and proposed changes in the field,as well as the progress of the ongoing con-vergence project between FASB and theInternational Accounting Standards Board(IASB). Norman Strauss, Ernst & YoungProfessor-in-Residence at Baruch, moder-ated the panel.

Converging Standards Leslie Seidman, FASB chairman, began

by explaining why FASB and the IASBare working on the project to convergestandards. “Current U.S. standards forfinancial instruments have been set overtime on an ad hoc basis, as a problembecame clear for a particular instrument ora particular activity,” she said. “So whatwe have is a piecemeal accumulation ofstandards that sometimes account for sim-ilar things differently. And that hascaused a great deal of confusion.”

Greg Jonas, managing director inMorgan Stanley’s equity group, stated that,from a user’s perspective, changes in thisarea are necessary. “We’ve long arguedthat the current model is, in certain respects,broken,” he said. “It’s too complex. Thesame instrument can be accounted for infive different ways. It’s not intuitive.”

Enrique Tejerina, a partner in KPMG’sdepartment of professional practice and amember of FASB’s DerivativesImplementation Group, explained howFASB’s initial proposal was intended to

In Focus

Accounting for Financial InstrumentsA Status Report

Panelists, from left to right: Enrique Tejerina, Greg Jonas, Robert Laux, Leslie Seidman, and Paul Beswick


improve the accounting for financial instru-ments. “FASB issued one comprehensiveexposure draft, covering classification andmeasurement, impairment, and hedgeaccounting. In addition, that exposure draftaddressed all financial assets and liabili-ties,” he said. “The accounting would bethe same for all instruments, as opposed tohaving different accounting for debt secu-rities, loans, and other things.”

Classification and MeasurementsTejerina then delved into more specifics,

starting with classifications and measure-ments, which, he said, FASB is in the pro-cess of redeliberating. “One significantchange is that for financial assets, theexposure draft had fair value on the balancesheet and then changes in either netincome or OCI [other comprehensiveincome],” he said. He described that, in thecurrent proposal, “instead of two buckets,we have three buckets.” The new third buck-et, added to fair value through OCI andfair value through net income, would beamortized cost, limited to “plain vanilla”borrowings.

Strauss asked Seidman what it was thatgave rise to FASB’s thinking to allow formore historical cost. She said: “It did seemas though people cared very much whichof those measurement attributes was goingto form the basis for the footings in the bal-ance sheet. In other words, people caredwhether loan deposits and your own debtwere going to be carried at cost on the bal-ance sheet or at fair value.”

Seidman continued: “There was generalagreement that the impairment model is toocomplicated, too diverse, and didn’t serve uswell during the financial crisis—therefore,we should move forward with an improve-ment that would cause more timely recog-nition of losses on debt instruments.”

She added: “There was widespread sup-port for reporting plain-vanilla debtinstruments—loans, deposits, and your owndebt—that are plain vanilla at cost in thebalance sheet with a more robust impair-ment approach and more extensive dis-closures than what we have today.”

Robert Laux, director of financial report-ing at Microsoft, gave his thoughts on thesechanges from a preparer standpoint. “I

think the preparer community is generallysupportive of the changes, and I actuallythink there’s a very strong argument for cer-tain securities being held at amortized costif their purpose is collecting cash,” he said.

Laux added: “I don’t believe preparersthink fair value information is all-relevant,and most are supportive of disclosing theinformation, but when it comes to givingan indication of future cash flows for a secu-rity that’s going to be held to maturity, thebest predictor of that future cash flow is, inmy opinion, amortized cost.”

Jonas said the three-bucket approach willfeel familiar to users and that the approachis simpler than current practice. Headded, however: “On the potentially neg-ative side, I think this loan participationissue is going to be a problem. … Banksget all worked up about not having loansat amortized cost, and I think they’d beequally worked up at not having loan par-ticipations at amortized cost.”

Jonas continued: “I think a lot of userswould say, ‘Gee, I don’t see a big differ-ence between a loan that I originate and aloan participation that I have, so why do Ihave radically different accounting forthose two?’”

Strauss asked Laux if he thought thatpreparers would find these new classifica-tions objective enough to be able to tellwhat a company’s business strategy is. “Ithink it is functional,” Laux said. “It maybe difficult to audit, and we need to beforthright in our application of it, but it’sthe way we run the businesses, and I don’tsee a difficult problem in actually incor-porating that into our processes.”

Jonas said the business strategy notionis superior to management intent. “Nothingis worse than management intent, notbecause management is evil, but becauseaccounting and audit differ based on under-lying economics,” he said. “Managementintent not only seems to me to be very dif-ficult or impossible to audit, but it makesdifferences in accounting happen, which isproblematic.”

Paul Beswick, deputy chief accountantat the SEC, said he thinks the SEC “canabsolutely get behind the notion of abusiness model.” He added: “I thinksome of it is going to put a little pressure

on how FASB articulates what a businessmodel is and what the principle is. Weare—at least I think I am—perfectlycomfortable accepting preparers and audi-tors making good judgments in terms ofapplication of GAAP.”

Recognizing Impairment: A Compromise

Tejerina then spoke about another aspectof the financial instrument project—howto recognize impairment, principally, theimpact on financial institutions with long-term loans like mortgages. He character-ized the issue as “too little too late.” Heexplained the background of the proposedcompromise between FASB and the IASB,saying that “FASB proposed a modelwhere you would get rid of the probabili-ty, so you would recognize a loss on dayone, based on current and past events. …On the other hand, the IASB’s proposalwas that you have the same expected lossmodel; however, on day one, you look atthe expected loss on that particular assetover its life, and you would amortize it,or put that into the yield of the asset andrecognize it over the life of the asset.”

Tejerina said the boards have started toredeliberate together and have issued a dis-cussion document that is clearly a com-promise, in other words, not necessarilywhat either board would have liked. Hementioned that one aspect of the compro-mise is a “combination of the IASB’s viewof amortizing a loss and the FASB’s viewof taking a loss when you actually thinkyou have an expected loss.”

Seidman explained the thinking behindthe compromise proposal. “There’s a philo-sophical divide here,” she said. “I wouldsay that FASB and most U.S. constituents… see this as an asset impairment issue.In other words: What should these loansand debt securities be reported at when youdon’t expect to see all the cash flows? TheIASB believes that when you make aloan or invest in an asset, there is a cer-tain amount of uncollectibility that you canforesee or that you price into the loan.”

She added: “The world wants us tocome to a converged solution here.”

Laux said most preparers probably donot support this proposal. “What I think


In Focus

most preparers in the U.S. take exceptionto is just how complex these two thoughtprocesses are, and I am skeptical it canwork, from a practicality standpoint.”

Jonas said users might not be happy withthe solution, either. “We basically took a gunsapproach and combined it with a butterapproach—and we ended up with a gutterapproach,” he said. “I was a big fan of the

IASB’s approach, of the yield adjustmentapproach, and I thought I could understandit. I thought I could explain it. Then I becamea fan of the FASB’s approach. There arebig negatives any way we go.”

Jonas suggested, “Maybe we go back toan incurred loss framework—but onsteroids. Let’s go back to thinking aboutincurred loss but encourage companies torecord losses earlier than we do today,which has been a key problem with users.And we could do it in two ways: One iswe could lower the threshold for lossrecognition from ‘probable’ to somethingless, like ‘more likely than not.’ Or, wecould emphasize incurred but not report-ed consideration and demonstrate tech-niques to do that in a more robust way.”

Seidman said the boards are consideringalternative approaches. “We are determinedto work this one to the ground and comeforward with an improvement over whatwe exposed, because it was not wellreceived, and we will end up with animproved impairment model that is thesame around the world.”

Hedging Needs FixingStrauss said FASB and the IASB are

also working on the issue of hedging andderivatives. “Everybody seems to agree that[SFAS] 133 is too hard, too many com-panies do it incorrectly, and it needs somefixing,” he said.

Seidman said FASB reviewed its hedg-ing standard because of the practiceissues that were emerging with compliancein interpretive matters. “In the meantime,the IASB moved forward with a funda-mental reconsideration of hedge account-ing, even though the standard they werestarting with is quite similar to [SFAS]133,” she said. “And so we have gottenout of step.”

She said FASB took the IASB’s expo-sure draft and issued it for comment inthe United States in order to see if it wasa “superior starting point for us to devel-op a converged standard.” She added thatthe comment period had just closed, andFASB was beginning to look at the com-ment letters.

Laux agreed that preparers think hedgeaccounting needs fixing, “not just tomake it easier, but to make it so it’s morerepresentative of an entity’s risk manage-ment for these changes in value.”

Jonas said users have struggled, not somuch with the U.S. accounting model forderivatives and hedging, but rather, withthe company’s story about “What risksexist? Which of those risks do we try tohedge? How do we go about economical-ly hedging them? And how do we accountfor those activities?”

Tejerina pointed out some of the changesto hedge accounting in the exposure draft.“Right now, we have to conclude thatyou can have a hedge because it’s ‘high-ly effective.’ … The exposure draftwould change that to a ‘reasonably effec-tive’ threshold,” he said.

Another change, he said is, “today, youhave to have very detailed calculations ofyour assessment of effectiveness at incep-tion and on an ongoing basis. The expo-sure draft would allow a qualitative assess-ment to be performed, both at inception

and going forward. And it would onlyrequire actual reassessment if there was evi-dence that the relationship wasn’t goingto function the way that you thought whenyou set it up.”

Tejerina said one big issue that peopledisagreed with was that the exposuredraft proposed that hedges could not be de-designated once established if they con-tinued to qualify as hedges. “In otherwords, once you set it up you have to keepit,” he said “There was some ability toterminate the hedge by buying an offset-ting derivative, but it got convoluted.Bottom line, it’s going to be very difficultto de-designate a hedge, which people didn’t necessarily appreciate.”

In comparing the exposure draft thatFASB issued with the IASB’s exposuredraft, there are also major changes,Tejerina said. “Number one, the IASB is suggesting that hedge accounting bealigned with an entity’s risk-manage-ment activities.” Other changes he outlined include: The assessment of effec-tiveness would be much more qualitative,the IASB would allow nonderivativefinancial instruments carried at fair valuethrough net income to actually be hedg-ing instruments, and hedged items couldbe combined into a portfolio.

Beswick said the SEC would be work-ing with both the IASB and FASB on thistopic. “I think both boards need to meetand come up with, ‘What are we really goingto do here?’” he said. “Are we going to tryto make some small changes to improvethe ability of preparers to comply with thestandards, or are we going to holisticallyrethink how we’re doing hedging?”

Seidman said that this is what sheintends to see happen. “My personal pref-erence would be for us to try and completeour discussions on classification and mea-surement and impairment, pause, sitdown with the IASB and say, ‘What arethe remaining differences?’” she said.“Let’s get in the room again and figure outhow we want to move forward with a con-verged standard here. I would have hedg-ing follow that discussion.” ❑

“The IASB is suggesting that hedge

accounting be aligned with an

entity’s risk-management

activities,” Tejerina said.


The Reliability, Role, and Relevance ofthe Audit: A Turning Point

Keynote Address: JAMES R. DOTY

John A. Elliott, dean of Baruch’s Zicklin School of Business: It’s my pleasure to introduce James Doty. He

was appointed PCAOB [Public Company Accounting Oversight Board] chairman in January of this year and

he took that responsibility over on February 1, 2011. He was born and raised in Texas and began his educa-

tion at Rice University, where he earned a BA in history. Subsequently, he served as a Rhodes Scholar at Oxford

University in England. He then moved to an MA in history at Harvard, followed by an LLB from Yale Law School.

His education is extraordinary, and it launched him on a career in the law firm of Baker Botts LLP. He joined that

firm in 1969 and served with distinction most of the rest of his career. He was mostly an attorney but he did spend

a two-year stint at the SEC as general counsel, and that experience gave him significant insight into the process of

drafting regulations—insight that will, no doubt, be very helpful in his new role as chair of the PCAOB.


One of the legal cases that he success-fully brought to a conclusion was FreeEnterprise Fund vs. PCAOB. They wereattacking the constitutionality of thePCAOB, and he successfully defended thatclaim, since the organization continues withhim at its helm. That background posi-tions him extraordinarily well to serve theorganization. He has a strong relationshipwith Mary Schapiro, and that relationshipwill help support interaction with the SECin the years to come, while the PCAOB’sagenda will provide him many opportuni-ties to bring that background to work. Ifound the following quote from ChairmanDoty in an article about his role at thePCAOB: “I’ve had a very satisfactory,interesting legal career, but I’m not in aposition where I need to be thinking aboutwhat my next job will be. This is my lastjob, and I want to do it justice.”

A Turning PointJames R. Doty, PCAOB chairman:

Accounting and auditing are more impor-tant to American society than ever.Auditors may look back on this time as themoment when they turned to seize thefuture. This may seem odd, given theextent to which they have been questionedsince the financial crisis. I am thankfulfor the opportunity to explain.

I intend to focus my remarks today onauditing. There are obviously importantaccounting issues to discuss and debate aswell. But since February 1, when I becamechairman of the PCAOB, auditing has pre-occupied me. The public policy questionsrelating to the role of the auditor and thesocietal value of the audit deserve ampleattention. I do have to say that the ideas Iexpress today are my own and should notbe attributed to the PCAOB as a whole orto any other members or staff.

BackgroundAs was the case nine years ago, before

the PCAOB was created, auditors find them-selves at a point where their role and rele-vance are being debated. Reliable financial

and economic data are one of the funda-mental assumptions of American society thatset us apart. We value a culture of honestrepresentation and must continue to do soto promote our economic success.

Our system of capital formation reliesupon the confidence of millions of saversto invest in companies they trust. The audi-tor’s opinion is critical to that trust. Thereare, of course, formidable forces that workagainst that trust.

First, the payment model: The auditor ishired and fired by the company itself. TheSarbanes-Oxley Act’s reform to shift hiringand oversight of the auditor from manage-ment to the audit committee may, in prac-tice, have proved insufficient to counteractthat conflict and others facing auditors. Aswith management, audit committees may seetheir job as negotiating the lowest audit fee,not championing auditor objectivity and inde-pendence from management.

In this environment, not surprisingly, thescope of the audit has not grown, even ifsociety’s expectations have. As theguardian of a cultural value, the audit isarguably as important as electricity orwater. But if it is to retain that lofty sta-tus, auditors and the PCAOB need to dotheir best to make sure the audit is useful.

This is not a new challenge. The lateSandy Burton was a respected SEC chiefaccountant, thereafter deputy mayor ofNew York City brought in to fix thecity’s finances when it was on the vergeof bankruptcy, and dean of ColumbiaBusiness School. In his time, Sandy putthe same challenge to the profession.Burton was an effective advocate for usingaccounting and auditing to promote thepublic interest. He challenged auditors todo more for the public, but as he lament-ed in a characteristic op-ed piece in April1980, auditors devote “[a] great deal ofeffort … to limiting responsibility ratherthan enlarging it.” His advice was clear:“The concept of audit” had to be expand-ed, and the auditor “must see his role asencompassing the evaluation of effective-ness in meeting goals and efficiency in

operations as well as simply expressingan opinion on financial statements”[“Where Are the Angry Young CPAs?”New York Times, April 13, 1980].

Second, to protect the investing public,all public companies are required by lawto obtain an audit. This statutory franchiseprotects the profession as a whole from therisk of obsolescence, thereby reducing audi-tors’ need to adapt to investor needs. As aresult, auditors don’t have a natural incen-tive to evolve their reports into whatinvestors want.

Third, there are other external conflicts ofinterest for the audit to overcome. Conflictsare rife in the fundamental issues auditorsface in evaluating whether a company’sgoing-concern assumption is valid. Theyinhere in the judgments of people who pre-pare and market valuations while activelytrading. Conflicts also emerge in audit com-mittees compensated substantially in stock.

These forces—the payment model, thestatutory franchise, and the incentives ofothers in the environment auditors operatein—constitute formidable discouragement.They deter the profession itself frominnovating the audit to meet publicexpectations the way, say, a technologycompany or a properly incentivized servicecompany would.

There is no silver bullet to address thesechallenges. There are as many or moreproblems with structural alternatives, suchas a third-party payer or insurance-basedsystem, and, in a dispersed ownership soci-ety, eliminating the audit requirementwould be impractical and outright reckless.Therefore, our initiatives should go toreducing risks that follow from these con-flicts and challenging incentives that weak-en investor protection by applying acounterweight.

Public expectations demonstrate that theaudit embodies a core societal value andrelevance. But we obviously need towork on resolving the debate over therole auditors should be expected to play.In this, we will continue to benefit fromthe thoughtful involvement and support

In Focus


of Chairman Schapiro, her fellow com-missioners and staff, and especially ChiefAccountant Jim Kroeker.

The Regulatory Interest in the Audit We are not alone in our reevaluation of

the role and relevance of the audit, inlight of lessons learned from the financialcrisis. The cacophony of ideas currentlyin play makes for an exciting—but at timesconfusing—debate. Making sense of thedebate requires careful consideration of therelationship between potential reforms andthe goals we want to achieve.

European policy makers have contribut-ed substantially to the debate. Many ofthe problems they have identified are thesame that we experienced in the UnitedStates. But they attribute the cause of theproblems, in large part, to market concen-tration. The reforms they propose wouldgo to reducing market concentration—thepaucity of choice among global audit firms.

Thus, for example, the EuropeanCommission has sought “views on whetherthe consolidation of the past decades shouldbe reversed” by breaking up the Big Four(green paper on Audit Policy: Lessons fromthe Crisis, October 13, 2010, p. 17). TheFinancial Reporting Council (FRC) in theUnited Kingdom has championed “livingwills” to plan for the contingency that a largefirm will fail and thus concentrate the auditmarket even further (Response to GreenPaper on Audit Policy: Lessons from theCrisis, December 2010). In the same vein, itsupports initiatives to “reduce the level ofconcentration.” The FRC also proposesencouraging banks and other systemicallyimportant institutions to use non–Big Fourfirms and prohibiting the use of “Big Fouronly” clauses in banking and loan covenants.

In a rather unprecedented measure, theUnited Kingdom’s House of Lords’ SelectCommittee on Economic Affairs has alsoweighed in on these issues. The Lordsfocused on the ramifications, during thefinancial crisis, of the “narrowness of theassurance” auditors gave on systemicallyimportant financial institutions, and audi-tors’ “failure to give warning of trouble inthe run-up to the financial crash.” But theywent on to conclude that “There is

inevitably a connection between the assess-ment of the Big Four’s performance andthe question … of market concentration”(Auditors: Market Concentration and TheirRole, HL Paper 119-1, March 30, 2011).

I question how directly these proposalsadvance the public’s call for more relevantinformation, including “early warnings,”from auditors. I do not believe that theglobal audit firm networks themselves posesystemic risk to our economy. But initia-tives to shrink the global firms would like-ly further weaken their ability to audit thelarge, multinational companies that maythemselves be systemically important.

The global audit firm is not too big to fail:It is too important to leave unregulated. Toprotect investors, governments should regu-late such firms, not cripple them.

There’s no reason to think that if therewere more major firms, they’d be morelikely to stand up to their clients. Auditfirms today compete fiercely on the basisof price and client service. They don’t com-pete on the basis of investor protection, andthey question whether their corporateclients value audit quality.

This position offers no support for anti-competitive, price-fixing practices. But com-petition issues are the bailiwick of competi-tion authorities. And I would be concernedabout measures to promote competitionthat would—proposed in the name of auditreform and expressed in the rhetoric of mar-ket transparency—have a negative effecton audit quality in application.

PCAOB Protections Turning away from reforms aimed at

competition, there is still much to be doneto meet the public’s demand for more andbetter information from auditors. ThePCAOB is engaged in a broad dialoguewith investors, auditors, audit committees,preparers, and others to consider how theauditor’s report can be changed to pro-vide more useful, relevant, and timelyinformation. The central questions emerg-ing in our dialogue are: What shouldauditors’ responsibilities to the investingpublic be? What can auditors be expectedto do? And how do we close the expecta-tion gap in a meaningful way?

We expect to issue a concept release inthe early summer summarizing and ana-lyzing the input we’ve received. Thatconcept release may result in the firstsubstantial changes to the reporting modelin more than half a century. The releasewill explore various possibilities and seekspecific feedback.

We are also engaged in efforts to holdauditors to the high standards necessaryto protect investors. The financial crisisrevealed weaknesses in auditor practices,and we are pursuing them.

Confidentiality and process. Both ourinvestigations and any contested disci-plinary proceedings we bring are, by lawunder Sarbanes-Oxley, nonpublic, unlessthe respondents consent to publication ofour complaints and decisions. We haveasked Congress to change this.

In the years since Sarbanes-Oxley passed,the PCAOB has built an active enforce-ment program, but unfortunately forinvestors, audit committees, and the auditprofession itself, it takes place largely behindthe scenes. For example, in the last 18months, the division has handled three dis-ciplinary hearings against partners of largeaccounting firms for audit failures, in addi-tion to a caseload of other litigated matters.If, after investigation, the board determinesto file a complaint, it will not be public.Nor will any decision by the hearing offi-cer or the board to impose a sanction, untilany appeal to the SEC is exhausted.

The confidentiality of the enforcementprocess erodes public confidence in ouroversight. Moreover, the public is deniedany benefit from the deterrent effect that thefiling of public complaints would have onother auditors. And other auditors and theircounsel are denied the benefit of timelyaccess to the board’s precedents.

Current initiatives. Public proceedingsare important for public trust. But theyare by no means the salve for all of therisks to investor protection that wererevealed in the financial crisis. ThePCAOB has important initiatives under-way relating to improving audits of fairvalue measurements, improving com-munications among affiliated firms inglobal networks engaged in multination-


al audits as well as related global quali-ty controls, and improving auditors’ com-munications with audit committees. Ourimprovements in standards are not intend-ed to be traps or trip wires for auditors.We write standards so that expectationsare clear.

We are also looking for ways to makeour own oversight more effective and rele-vant. Our inspection process is a key earlywarning tool. I’m therefore troubled aboutreports that some auditors have downplayedthe significance of our findings to theirclients. Audit committees should be skepti-cal of auditors’ efforts to do so.

Many aspects of inspection findings are,by law, confidential other than to theinspected firm. But we are looking forways to improve audit committee aware-ness of the risk of accepting overly rosycharacterizations of our reports, as well asto discourage firms from making them.

I am also concerned about possible dis-parities between firms’ routine represen-tations—in public responses to PCAOBinspection reports—that they have com-plied with applicable standards on address-ing deficiencies, and the inspection staff’sview that that is frequently not the case(see AU 390, “Consideration of OmittedProcedures After the Report Date,” and AU561, “Subsequent Discovery of FactsExisting at the Date of the Auditor’sReport”). We intend to increase our scruti-ny of firms’ follow-up efforts to correctdeficiencies and will consider enforcementactions where appropriate.

Oversight of Multinational Audits I’ve touched on the global networks a

couple of times today. While I don’tthink they are too big, let me talk aboutwhat does concern me.

My first concern is investor and publicawareness. I have been surprised toencounter many savvy businesspeople andsenior policy makers who are unaware ofthe fact that an audit report that is signedby a large U.S. firm may be based, in largepart, on the work of affiliated firms that

are completely separate legal entities inother countries. For many large, multina-tional companies, a significant portion ofthe audit may be conducted abroad—even half of the total audit hours. In theo-ry, when a networked firm signs the opin-ion, the audit is supposed to be seamlessand of consistently high quality. In prac-tice, that is often not the case.

This gets to my second concern. Basedon our inspections, I can say that thechallenges of managing a multinationalaudit are great. As our international inspec-tions program matures, we have begun toevaluate the various pieces of the audit per-formed by different registered firms in mul-tiple jurisdictions. Our inspectors often seemore than the principal auditor or signingfirm does. In many cases, principal audi-tors rely on high-level reports from sub-sidiary auditors. They often don’t reviewthe workpapers of the other auditors. Ourinspectors do. And they often find prob-lems in that work. (It is worth noting thatthe European Commission’s green paperAudit Policy: Lessons from the Crisisexpressed the view that “Group auditorsshould have access to the reports and otherdocumentation of all auditors reviewingsub-entities of the group. Group auditorsshould be involved in and have a clearoverview of the complete audit process tobe able to support and defend the groupaudit opinion.”)

Inspectors have found obvious errors thatcould have—and should have—beenpicked up by the principal auditor if com-munication between the two auditors hadbeen more robust. Inspectors have foundunresolved audit issues between affiliates.One inspection team found a situationwhere the affiliate’s audit team pervasive-ly failed to perform audit procedures, unbe-knownst to the principal auditor until weconducted our review. Once the problemcame to light, the firm arranged for theteam to be removed. But it fell to thePCAOB to find the problem. In severalcases, inspectors discovered that an affili-ate had failed to appropriately audit rev-

enue, even though the affiliate reported tothe principal auditor that it had. There’smore, but you get the picture.

We intend to enhance our scrutiny ofhow principal auditors react to deficienciesin the work they refer to other auditors.Findings like those I’ve described shoulddrive auditors to improve their communi-cations with the affiliates they use, aswell as improve preventative global qual-ity controls.

These findings demonstrate why it’s soimportant that we look at the parts of theaudit not performed by the principal audi-tor, whether the principal auditor was inthe United States or elsewhere. (Indeed,some of these examples were in situationswhere the principal auditor was outside theUnited States, but the subsidiary auditorwas in the United States.) This month, weare commencing joint inspections withU.K. and Swiss authorities. In addition tothe work we perform to protect U.S.investors both here and in those jurisdic-tions, as appropriate, we will share any rel-evant information we obtain on the U.S.portion of multinational audits of impor-tance to those authorities.

We are working diligently to reach sim-ilar arrangements with other Europeanauthorities. In addition, the PCAOB con-tinues to be engaged in discussions withthe Chinese authorities and hopes that—over the course of the next severalmonths—significant progress will be made.This is especially important given thegrowth in the number and size of Chinesecompanies seeking access to capital in U.S.securities markets.

I believe Chinese authorities understandthat they have a real interest in solving ourimpasse. For those who argue that the bigChinese companies don’t find the U.S. mar-kets attractive, think again. The ChineseInternet social networking giant, Renren—sometimes referred to as the “Facebook ofChina”—went public earlier this week, rais-ing in excess of $700 million in its IPO. Ithas an estimated market value of approxi-mately $7 billion.

In Focus


U.S. markets continue to be attractivefor companies that have their major oper-ations in China. It is critical that investorsin these companies are afforded theinvestor protections that attach to U.S. mar-kets. But as long as we are unable toinspect a registered firm’s work, investorsare deprived of the benefits of our identi-fying or correcting audit problems likethose I’ve described. In the case of multi-national U.S. companies, investors mayeven mistakenly assume their interests havebeen protected by an audit inspection. Thisundermines a key component of ourinvestor protection system.

Our markets are the strongest in theworld. They provide for the formation ofcapital, and ownership by U.S. and non-U.S. companies and investors alike. I knowmy predecessors have pointed this outbefore, but let me reiterate: Investors arewilling to pay a premium for shares pur-chased in U.S. markets and protected bystrong securities regulation and enforce-ment. Foreign companies can even get apremium in their home market if they arealso listed in the United States (see ReneM. Stulz, Craig Doidge, and AndrewKarolyi, “Why Do Countries Matter SoMuch for Corporate Governance?,”Journal of Financial Economics, vol. 86,no. 1, October 2007, pp. 1–39; and LuziHail and Christian Leuz, “Cost of CapitalEffects and Changes in GrowthExpectations Around U.S. Cross-Listings,”Journal of Financial Economics, vol. 93,no. 3, August 2009, p. 428–454).

The premium will only survive, though,if investors believe U.S. investor protec-tions are actually enforced. The laws onthe books, including oversight of auditors,won’t continue to make a difference fornon-U.S. companies if they don’t comply.

As painful as the recent past has been forinvestors and financial markets, and as com-plicated and expensive as the future appears,we in the United States can take heart inthis: When we acknowledge and focus onissues such as those raised by the recentfinancial crisis, our system of governmentand regulation is capable of making cor-rective—and appropriate—changes. I ampleased to be part of that system.

Questions from the AudienceAudience member: How does that super-

visory-driven inspection meet the [Sarbanes-Oxley] Act of 2002, which says that over-sight is to determine compliance? It contin-ues to be a supervisory-driven inspection,and the inspection report says you can’tmake any judgment about the rest of thiscompany and there’s no way to compare thisyear’s with last year’s, or all of them as agroup in a given year, because they’re doingdifferent things at each inspection. Does thissupervisory approach meet the complianceimplication? I have never been able to getan answer to this question.

Doty: You have touched on one of myfavorite subjects in this area; it’s a goodquestion. I believe that the entire discus-sion over supervisory roles has been a con-fusion over nomenclature. We are not theFederal Reserve; we do not have money tohand out. We do not perform a support role.We are inspectors. We are there to pro-mulgate standards that add clarity and effec-tiveness to the performance of the audit. Weinspect to determine whether those standardsare being met in the audits that we inspectand insist on remediation where we thinkthey are not. If a firm is not cooperating inour process of inspection, or our investiga-tion of audit deficiencies, or our remedia-tion, we bring complaints. Those are thefunctions that we have.

I think supervisory roles add confusionto what is a straightforward regulatory role.We administer statutes—we are requiredto promulgate audit standards, to improveaudit standards where they need to beimproved. Some of the ones I’ve men-

tioned today, such as the supervision of thework of a foreign audit firm, a non-U.S.audit firm, a participating audit firm, areareas where we think the standards willbe improved and should be improved.But to the extent we demand or ask forremediation and then determine whetherremediation has occurred, we do that understatutory mandate. I don’t think it’s usefulto lump all of that into a term like “super-visory” and assume that it means some-thing other than what the statute and theregulatory system calls for.

Audience member: Are the board mem-bers sufficiently skilled for the responsi-bilities that they undertake? And a secondquestion: Many board members have mul-tiple board obligations. When you get tofour, five, six memberships for a singleindividual, what impact do you think thathas, and what is your view on the com-mitment level?

Doty: First of all, let me say I don’t thinkthe chairman of the PCAOB has any par-ticular standing on this question. I think Ihave standing based on 35 years of lawpractice and having seen boards of all kinds.I will tell you that I am firmly of the opin-ion the quality of directors varies a greatdeal, has generally improved in the courseof my time as a practicing lawyer, and stillhas a way to go in some areas.

Second, I think the bar—and theefforts of a lot of people, such as the onesin this room—has done a great deal tofocus directors on the problems of beingon too many boards. And I do thinkthat’s one of the areas where I, a practic-ing lawyer, have seen much more self-con-sciousness.

I don’t think directors think that they canbe on six, eight boards anymore. I hear alot of the people I regard as the better direc-tors saying that you can’t handle more thanthree, that if you’re on an audit commit-tee or a compensation committee, one ofthe high-work, skills-based committees,that cuts down the number of boards thatyou should undertake. This is an areawhere, if I may say so, I think that lawyershave actually elevated the level of con-sciousness and awareness. The standardsthat were enacted in Sarbanes-Oxley, min-

“As long as we are unable to

inspect a registered firm’s work,

investors are deprived of the

benefits of our identifying or

correcting audit problems.”


imum standards of independence of com-mittees and boards, and that were embod-ied in the New York Stock Exchangerules—these all became best practices bythe time they became part of law. So Ithink that board quality, board skill, andboard acumen is something that directorshave to continue to work on.

Our standard on communications withaudit committees will have that governancefocus. It will be intended to make sure thatwe have enhanced the awareness of aboard of directors or an audit committeeabout the nature of the audit and the ade-quacy of the audit practice and the auditfunction. There’s a governance role for thePCAOB there, and it’s broader.

Norman N. Strauss, Ernst & YoungExecutive Professor-in-Residence, BaruchCollege: May I ask a quick question aboutwhat you had said about the possibility ofchanging the auditor’s report to a qualita-tive report introducing a lot of subjectiveinformation? I imagine auditors who areused to having the standard language forall these decades might be a bit reluctantto get into this new, possibly subjectivedirection. Do you expect that type offeedback from the auditing profession?

Doty: We’re getting it. We’ve had it.The concept release will recite concerns by the audit profession that, first, theyshouldn’t be preparers of financial infor-mation. The responsibility for preparing theinformation that’s in a financial documentshould stay clearly with management; tothe extent that the auditor expands someof these areas that are covered, there’s adanger of that. Auditors are keenly awareof the fact that there are some things thatcan be audited and some things that can’t.The concept release offers a wide rangeof areas in which the audit report couldbe modified to make it more meaningfuland relevant. We hope that when we’rethrough with this, we will have had a lotof comments from the audit profession andthe investor constituencies that willenable us to focus on those changes ofthe best ones. There is, for example, a view

that we should have an “auditor’s discus-sion and analysis” in which they do addresssome of the non–financial statementitems in the report of an issuer—there’s apractical question which the profession rais-es as to how you get control of that. As amajor firm with 20,000 to 30,000 peopleout there preparing a year-end audit, how

do you avoid free riding, which results inno control by the firm?

You asked what the audit profession isconcerned about, and I’ve summarized that.There’s an equally wide range of concernsby investors and by users of financial state-ments that somehow we avoid a simplebinary formulation, which gives an investorlittle sense of how far the audit has gone,how searching some of the processeshave been, and whether they’ve donetheir work, for example, in determininganything about the adequacy of manage-ment’s estimates. There’s a big menu inthat concept release that will attract a lotof interest.

Audience member: I respect your sup-port for the idea that important actions bythe PCAOB should be public during theproceedings. What would be the line ofdemarcation according to which someissues should be made public?

Doty: It’s when the division of enforce-ment has brought to the board a proposedcomplaint with charges and the division ofinspection tells the board that they are pre-

pared to prove these charges so that itachieves the specificity of a file complaint.This is very important in my thinking. Inother words, I think we want to avoid spec-ulation and rumor about what enforcementauthorities are doing with respect to anyparticular highly public issuer failure, issuerproblem, and it seems to me that one ofthe advantages is that if that which ispublicized is a filed complaint which hascrisp, clear, concrete allegations in it whichwe approve and prepare to have tested inthe appellate process, that’s what shouldbe made public. Not the negotiations, notthe rest of the process of the investiga-tion. Investigations at the SEC are confi-dential, as you know, and it’s appropriatethat they be highly confidential.

Audience member: Thinking aboutParmalat and Satyam, if you ask for morecontrol of international affiliates, are yougoing to be increasing the accountingfirm’s liability?

Doty: We have a basis on which muchof our activities proceed in which we thinkit is important for us not to proceed with aview to increasing liability or increasing therisk of private civil litigation. We want tomake sure that what we’re doing has aregulatory basis, a regulatory purpose. Withthe SEC rules, one of the examples I use isthat I’m not aware of a single majoraccounting firm that has been brought downby civil private litigation that resulted froman SEC civil enforcement action. ArthurAndersen failed because of a criminal indict-ment which, in retrospect, was very ques-tionable. There are firms that have had theirtroubles with the SEC, but, in general, theadministrative process has proved to be avery flexible tool for dealing with theseissues. There are civil complaints filed onSatyam now, and I assume that as long asthe plaintiff’s bar is working on these issues,there will be complaints filed, and thesecome out of civil enforcement actions. Butwe should not be doing what we’re doing,or refraining from what we’re doing, basedon the issue of what private civil litigantsmay do. ❑

In Focus

“There are firms that have had

their troubles with the SEC, but, in

general, the administrative process

has proved to be a very flexible

tool for dealing with these issues.”


The first panel of the afternoon sessionat Baruch College’s 10th AnnualFinancial Reporting Conference onMay 5, 2011, dealt with standards-set-

ting developments in the private sector.The panelists provided updates on standards-setting efforts by a number of bodies, includ-ing the FASB, as well as the EmergingIssues Task Force (EITF) and FinancialReporting Executive Committee (FinREC).

FASB’s AgendaFASB Technical Director Susan Cosper,

a former PricewaterhouseCoopers partner,

began the session by addressing a varietyof less controversial issues (i.e., revenuerecognition, leasing, and financial instru-ments) recently covered by the board ortopics on its agenda.

“If you have a troubled debt restructur-ing, there’s a lot of additional disclosureand a different impairment model thatone needs to follow. We undertook thisproject to clarify the notion of concessionand financial difficulty,” Cosper said. Theguidance in ASU 2011-12 clarifies whena restructuring occurs and when a debtoris actually experiencing financial difficul-

ties. In practice, Cosper said, “there willprobably be more troubled debt restruc-turings than in the past.”

Cosper then briefly discussed the recent-ly completed ASU 2011-03 (Topic 860).The guidance recommends that an entitylook at whether effective control existswhen determining if a repurchase agree-ment should be classified as a sale or asecured borrowing.

“The credit crisis highlighted the need foradditional disclosures, particularly as itrelates to financing receivables,” Cospersaid. The objective of ASU 2010-20 is

Current Developments in the Private SectorFocus on Transparency and Comparability

Panelists, from left to right: Norman Strauss, Robert Laux, Susan Cosper, Carlo Pippolo, and Richard Paul


“greater transparency to users of the finan-cial statements to understand the changesthat have occurred with respect toallowances and the evaluation that man-agement has performed.” The disclosures“put a little bit more pressure to have com-panies consistently identify troubled debtrestructurings,” according to Cosper. “Theinitial feedback is that users have seen alot more consistency among disclosures andamong companies in this regard,” she added.

Cosper then turned to active projectson FASB’s agenda, starting with multi-employer plans. “The premise behind theproject was to increase the transparencyassociated with an employer’s involve-ment,” Cosper said. What began as a disclosure-only project resulted in a con-troversial proposal that would requireemployers to estimate their proportion ofthe unfunded status of the plan. Becauseof the overwhelmingly negative responsethe proposal received, FASB is “goingback to the drawing board,” and “explor-ing ideas with respect to the informationthat’s already available,” Cosper said.

Debate over Goodwill ImpairmentCosper said that feedback from private

companies led to the current project on good-will impairment. “Is there a way,” she asked,“that we can achieve the same outcome butreduce the cost for private companies?”The proposal would introduce a qualitativescreen in which accountants would “look ata number of factors to see if there’s amore-likely-than-not determination ofwhether the fair value of the reporting unitis less than the carrying amount. If it’smore likely than not that it is, then you pro-ceed—but if it isn’t, then you stop.”

“We’re still looking at it and actuallystruggling with going on record of beingopposed to a simplification,” respondedRobert Laux, senior director of financialaccounting and reporting at Microsoft. Hesaid that there are huge assumptions thatgo into determining the fair value of areporting unit, notably its terminal valueand the weighted average cost of capital.

“I don’t know personally if this is theway to go,” he said. “For the auditing com-munity it seems like: How do you makethat qualitative assessment unless it’s noteven close? But if it is close, it seems likeyou want to see some numbers. It justseemed like a low threshold to me.”

“I think you’re also hitting on a coupleof important issues, which is some of thesubjective nature of the inputs into a fairvalue measurement,” added Richard Paul,partner at Deloitte & Touche LLP.“When is that point where the fair valuemeasurement from some period in the pastis no longer a good piece of informationon which to make this assertion?” Headded, “The user community has typical-ly responded negatively to optionalaccounting treatment … from a compara-bility standpoint.”

“From a user’s standpoint, I’m not surethat this is going to be a huge deal,” saidCarlo Pippolo, partner at Ernst & YoungLLP. “From an auditor’s standpoint, the moresubjectivity you have in a test, the more dis-comfort we have. It’s probably not going tohelp a lot on close calls, but the ones thatwe wouldn’t have been concerned aboutbefore, will be easier to put behind us.”

FASB ProposalsCosper then turned to the proposed

guidance on consolidation, notably theagent-principal classification. The pro-posed guidance would eliminate the defer-ral of SFAS 167 for interests in certain enti-ties and align the variable interest modelmore with the voting interest model.Another consolidation issue that FASB isworking on involves investment companies.“The tentative decision is that, if you’re aninvestment company, you measure all yourinvestments at fair value.” This guidance isexpected to be released alongside similarguidance for investment properties. The project was added to the agenda to “fill avoid” in FASB’s guidance as compared toInternational Financial Reporting Standards(IFRS), brought to light by tentative deci-sions reached in the leasing project.

Cosper also noted forthcoming guidancein fair value measurement, clarifications of“highest and best use,” that should not be sig-nificant for U.S. GAAP filers. Finally, minorchanges to the presentation of other com-prehensive income are also forthcoming.

Norman Strauss, the Ernst & YoungExecutive Professor in Residence at BaruchCollege and panel moderator, followedup with a question: “Right now, there isn’tany real concept for what goes into OCI[other comprehensive income]; it’s basi-cally whatever the board selected in dif-ferent standards. … When a reader picksup the income statement and sees a majoradjustment for changes in exchange ratesfrom the translation adjustment, will therebe some potential for that to detract fromthe ability to read the old-fashioned incomestatement as a stand-alone statement?”

“I think it will have some favorablereactions from users,” Cosper replied,“and it may cause a little consternationto some preparers; but I think the infor-mation was previously there, but perhapsnot as prominent.”

The EITF’s Efforts“With the SEC and Dodd-Frank and

everything else going on, I have some goodnews for you: The EITF has absolutelyslacked off over the last year,” Pippolo, amember of the EITF, began his presenta-tion on the group’s recent efforts. Pippoloattributed the EITF’s lack of recent pro-nouncements to FASB’s own full agenda.The EITF’s recent projects have tended tobe industry-specific.

“Hospitals are required to disclose howmuch charity care they provide,” notedPippolo. “The only problem is, there’s noguidance about how to calculate that num-ber. Some entities were using revenue,some were using stated revenues, someprice lists, some reduced prices, some cost.So the EITF decided, let’s make it cost”(EITF Update 2010-23). In another health-care industry issue, Pippolo said the EITFdecided that “when you have a contingentliability, like a malpractice liability, and

In Focus


you have a probable insurance recovery,rather than netting those on the balancesheet, those have to be grossed up” (EITFUpdate 2010-24).

With regard to reporting loans to par-ticipants in defined benefit plans, the EITFclarified a problem in the literature byadvising entities to account for them atamortized cost (EITF Update 2010-25).

A more controversial decision (EITFUpdate 2010-26) involved the costs asso-ciated with acquiring life insurance con-tracts. “A lot of life insurers were basical-ly capitalizing the loss incurred by under-writers whether or not they successfullyissued an insurance contract. And that’ssomething that really caught the attentionof some people,” Pippolo said. Theresulting guidance, a significant change inGAAP, “narrows practice considerablywith respect to deferred acquisition costsin the insurance industry.” The guidance isalso stricter than that from the InternationalAccounting Standards Board (IASB), so Cosper said it will come up for furtherdiscussion.

EITF Update 2010-27 deals with thefees that pharmaceutical companies haveto pay to the government, starting this yearunder the Affordable Care Act (ACA).“Even though it’s based on prior yearrevenues, this is simply a tax,” Pippolosummarized the decision. “We kind oftwisted the interim reporting rules to get toan answer that allowed for amortizationof that liability over the course of the year.”

“Goodwill rears its ugly head again,” notedPippolo in discussing EITF Update 2010-28,“When to Perform Step 2 of the GoodwillImpairment Test for Reporting Units withZero or Negative Carrying Amounts.” Insituations where an entity had negative car-rying value, “entities appeared to skatethrough the goodwill impairment test, eventhough there were situations where good-will looked impaired.” Although the EITFpassed on the issue of whether units shouldbe measured under an equity premise or anenterprise premise, it did say that theimpairment test shouldn’t stop just becausebook value is negative. “Look at the quali-tative indicators that were already in the guid-ance around goodwill impairments and see

if it looks like it’s more likely than not thatyou have a goodwill impairment,” Pippolosaid. “If so, proceed to step two [of theimpairment test].”

The final pronouncement discussed byPippolo, EITF Update 2010-29, madeaccounting rules consistent with SEC rules.“You effectively had this purchase account-ing adjustment amortization comingthrough twice in two different years,”explained Pippolo. The guidance called forusers to “prepare your disclosures as if abusiness combination occurred at thebeginning of the preceding year, not as ifit occurred in two different periods.”

The EITF AgendaPippolo then discussed pending projects

on the EITF’s agenda. Issue 09-H dealswith the netting of patient service revenuesand the associated allowances for bad debt,a widespread issue given healthcare insti-tutions’ obligations to provide care in manysituations where patients’ ability to paymight be in doubt. The consensus out forexposure would start with revenues, clas-sify bad debt expense as contra revenues,and effectively reach a net revenue amount.

“Issue 10-E [Accounting for Decon-solidation of a Subsidiary that Is In-SubstanceReal Estate] is one of those issues where wehave different models that have differentrecognition, or derecognition, cuts,” Pippolosaid. “You wind up getting different answersdepending on which piece of literature youapply.” The EITF was unable to reach a con-sensus, so further attention from FASB isexpected. Finally, Pippolo noted a consensusout for exposure on fees that will be assessedon healthcare institutions under the ACAstarting in 2014, a similar issue to the onefacing pharmaceutical companies.

“Is there any concern that there’s a lagof practice issues that are substantive thatare not getting to the EITF?” Laux askedPippolo. He responded that more issues arenot being dealt with behind the scenes:“Now that we have to go through essen-tially the same type of due process that theFASB does … the EITF process isn’t soquick anymore.” He also thought conver-gence issues might be pushing other issuesinto the background.

FinREC UpdatePaul reviewed recent developments at the

Financial Reporting Executive Committee(FinREC; formerly the AccountingStandards Executive Committee, AcSEC),which he chairs.

“There’s an evolution of accounting stan-dards,” Paul said. “A lot of industry guidanceis getting removed and Revenue Recognition[the joint FASB-IASB project] is the perfectexample.” He said FinREC tries to “providesome examples, but not cross the line andprovide guidance.”

Paul described FinREC’s accountingguides as more robust than the guidance inthe Accounting Standards Codification.“There’s a lot more discussion about theregulatory environment, about state andlocal laws, about some typical types oftransactions that are relevant to that par-ticular industry, and there’s a lot moreexamples. … It’s intended to be a docu-ment that you can pick up and read coverto cover, and you could be knowledge-able about the particular industry.”

Paul described FinREC’s practice aids as“intended to provide examples, to providesome valuation techniques that go beyondwhat the accounting literature says and alignthat with some of the accounting guidanceso that you could really get a full flavor forwhat’s going on with a particular industry.”He mentioned that the group recently fin-ished a draft practice aid on valuing the equi-ty securities of a privately held company andis working on another about impairment test-ing for goodwill, intangible assets, and otherlong-lived assets.

Paul concluded by discussing a pend-ing guide on in-process research and devel-opment. Laux, who is working on theguide, described the challenges presentedby a literal reading of the existing guid-ance. “All intangible assets acquired in abusiness combination to be used in researchand development activities should havean indefinite life,” he said. “The problemis that some of the intangible assets youacquire could be patents and to put anindefinite life on a patent that has a finitelife just does not make sense, so we’re try-ing to step around the literal reading andinterpret it.” ❑


The final panel at Baruch College’s10th Annual Financial ReportingConference on May 5, 2011, was afree-flowing discussion about rev-

enue recognition and leases. These twomajor projects are nearing completionand the panelists, representing a wide rangeof perspectives, debated the pros and consof the approach being deliberated by FASBand the International Accounting StandardsBoard (IASB).

Simplifying Revenue RecognitionNorman Strauss, the Ernst & Young

Executive Professor-in-Residence at

Baruch College, opened the discussion byasking why FASB and the IASB decidedthat a new model for revenue recognitionwas needed.

He was answered by FASB TechnicalDirector Susan Cosper. “There are a lotof rules that are industry-specific and alot of concerns around economically sim-ilar transactions that perhaps aren’t beingrecognized in the same way,” she said.“Simplification is needed, and a principles-based model that spans across all indus-tries is needed.”

James Barge, Viacom CFO, said, “Idon’t think it’s the number of standards,

whether it’s one or 180. I think it’s the abil-ity to implement standards and the rea-sonableness of the standards.” Though helikes the concept of one standard, Bargesaid it is difficult to craft guidance that canbe applied across different industries withdifferent business models.

Greg Jonas, managing director atMorgan Stanley, added, “The concerns ofthe current status quo are that there are toomany models, inconsistent models, insuf-ficient disclosure about revenue streams,and problems with revenues that seem tobe back-ended. In other words, you findthe good news up front and then as con-

In Focus

Revenue Recognition and LeasesControversial Changes Drive the Discussion

Panelists, from left to right: Greg Jonas, James Kroeker, Susan Cosper, James Barge, and Jan Hauser


tracts wear on, the bad news comes out.”He thinks a single, integrated standardcould lead to better understanding byinvestor users. “The two big risks of anintegrated project is it introduces a lot ofjudgment—or could—into the process, andit opens the door for potential aggressivebehavior by removing conservative indus-try accounting that frankly was put in placeover the years because of abuse.”

Jan Hauser, a partner at Pricewater-houseCoopers, said that although simpli-fication would make things simpler forusers and auditors, the devil would be inthe details. “There were a number of thingsin the original exposure draft that willcreate a lot of judgments and estimates thatneed to be used by preparers and thenaudited,” she said.

SEC Chief Accountant James L. Kroekersaid the guidance should address the recog-nition issues raised in Staff AccountingBulletin (SAB) 104. “A good exercisewould be … to go through SAB 104 andsay, ‘How would the model they’re devel-oping address the particular question?’ Thatdoesn’t mean the outcome has to be the sameas SAB 104, but if the question isn’taddressed, then you wonder: Do we still needsome incremental guidance?”

Satisfying Performance ObligationsCosper said that the overall premise of the

proposal is to develop a core principle thatcan overlay all industries: A company wouldrecognize revenue when it satisfies a per-formance obligation by transferring apromised good or service to a customer whothus obtains control. “The challenge of thatprinciple is all of the steps that you need togo through,” she said, “such as identifyingand separating performance obligations,which are sort of similar to what we usedto called deliverables, determining what yourtransaction price is, determining how it’s allo-cated, and so on.”

Hauser said, “Even though there willbe changes in the terminology, I think inmany respects a lot of revenue recogni-tion is not going to change.” She noted thatthe focus now is on the performance obli-gation and what assets and liabilities arecreated as a result. “I think many of the

same types of things that drive the eco-nomics will continue to drive the account-ing,” she said.

Strauss asked, if companies credit theperformance obligation instead of deferredrevenue, would it be clearer to users that itrepresents a liability rather than a deferreditem? Jonas thought it would: “There aremany places in the literature over the yearswhere the board has requested the disciplineof every balance sheet date, taking stock, lit-erally, of where you’re at. Some people havereferred to that as a balance sheet focus. Idon’t think that’s what it is. I think it just addsdiscipline in thinking about defining flows interms of changes in stocks over time.”

Hauser admitted: “When you thinkabout control and transfer of controls as itrelates to services, it’s not exactly an intu-itive concept.” She said the boards are stilldeveloping the details for the final standard,coming up with relevant criteria that wouldaddress services provided continuouslyover time. She said the boards are also talk-ing about the impact on this continuousrecognition of revenue if the service isstopped midstream and if valuable servicesare provided prior to an ultimate deliverable.

Variable Consideration“The boards have tentatively made a

decision that there are two approachesone can use to determine how much vari-able consideration should be included inthe overall transaction price,” Cospersaid. “The overall objective is to estimatethe total amount of consideration that thecompany expects to receive or what theypredict that they might be entitled to.” Thetwo approaches are referred to as proba-bility-weighted and best-estimate.

Strauss walked through how he thoughtthe probability-weighted approach wouldbe applied in a hypothetical situation, butBarge disagreed with the outcome. “To me,this should be relegated to a theoreticaltextbook. It doesn’t work in practice,” hesaid. He favored the best-estimateapproach: “I think real life is far too com-plex to be going down a probability-typemeasure across all points. It’s very diffi-cult in practice, and I would simply removeit from the standard.”

Barge continued: “I think there’s still somework to be done on what ‘reasonably assured’means, to prevent front-end revenue recog-nition that doesn’t serve anybody well.” Heexpressed some concern that one could stillfind examples that would lead to very dif-ferent accounting treatments depending uponthe approach and parameters used.

Hauser admitted that several questionsremain about the “reasonably assured”benchmark. “I think the industry input onthis variable consideration is definitelygoing to be key,” she said. “The board cer-tainly doesn’t want to end up with unin-tended consequences.”

Kroeker added, “I’m not sure how rea-sonably assured and probability-weightedwork together. I’m certainly troubled by theidea that you could choose to do either prob-ability-weighted or best-estimate. … I happento be more of a fan of a best-estimate, withsome higher threshold, if we’re going to getinto recognizing contingent revenue.”

CollectibilityCosper said that feedback to the initial

proposal led FASB to reconsider its stanceon customer credit risk, so that now it isnot considered in the overall transactionprice. Hauser preferred the approachultimately chosen, because the proposalwould have been “very complex in orderto bake the collectibility into the transac-tion price.”

“We want to see all the bad debt and wedon’t care whether we see it upstairs as aseparate line item under revenue or whetherwe see it downstairs as an expense,” saidJonas, noting that the board ultimately didn’t allow companies to bury bad debtsin revenues. “I commend the board forbeing responsive to what they heard.”

Barge disagreed that a separate line itemwas necessary. “I think it’s tough when youtake something that could be small in alot of cases and dictate it as a separateline item on the income statement.”

Other Revenue IssuesHauser said that the board revised the

“onerous test” for contract losses inresponse to comments, but noted that theissue might be revisited.


Cosper explained: “There are two typesof warranties—warranties for latent defects… and a second warranty that perhaps youpurchase for fault down the line. Under thecurrent proposal, the notion of latent defectswouldn’t necessarily rise to a separate per-formance obligation; you’d largely accountfor it the same way you account for war-ranties today. But to the extent you actu-ally do purchase that separate warranty… that would likely give rise to a sepa-rate performance obligation.”

Cosper said the implementation of theguidance will likely be retrospective, per-haps with a limited alternative. When itcomes to reconstructing past numbers,Barge advocated some flexibility, given thetime and costs that will be involved in thetransition. “We should be prepared to makefurther changes to the standards, becauseI think when we start running two yearsparallel before we’ve adopted, that’s where

all of the flaws, unintended as they are, willstart to surface.”

Strauss asked the panel if they thoughtthe revenue recognition was ready to befinalized or needed to be reexposed. “Ithink that there’s some potential fatal flawsin the document as it is now, which hasmoved considerably in a very good direc-tion,” responded Barge. “I think it’s wor-thy of a reexposure to go to that secondlevel … to make what would be anotherset of hopefully good corrective efforts.”

LeasesStrauss turned the discussion to the

proposed accounting for leases. In explain-ing the reasoning behind the changes,Hauser said that “the focus was certainlyto treat leases consistently and get them onbalance sheet, recognizing that there is anelement of an asset.” She noted that thefocus of this project has been on lesseeaccounting.

“I think the model that the FASB pro-posed certainly sounded, on its face, notall that difficult,” Hauser commented. “Butit became much more complex in termsof implementation.”

Jonas opined: “It turns out that users areof two camps on this whole issue. In the onecamp, we have those who think it’s an oper-ating activity, and for them this is not aboutfinance. [The leases of those in this first camp]are operating activities, and lease liabilities arenot debt-like, they are operating-like liabili-ties. … As such, that liability is not verylikely to alter users’ impressions of companyvalue.” He considers himself in the secondcamp, which “view leasing as fundamental-ly a financing activity. And we see lease-relat-ed debt on the balance sheet.” According toJonas, the two camps see leases differently onthe income statement and balance sheet, andthe camps have been giving the boards verydifferent counsel on how to proceed.“Everybody agrees there’s a liability, but wetreat that liability very differently, dependingon your camp.”

From the lessor’s perspective, Hausersaid there are “two different models,

depending upon whether or not the lessorretains exposure to a significant portionof the risks or benefit.” If the lessor retainsexposure to significant risks and benefits,it would use the performance obligationapproach: “The asset would stay on thebalance sheet and then you wouldaccount for the receivable and then havethe offsetting performance obligation.”Otherwise, it would use a derecognitionapproach, where “you would effectivelyhave the right to use an asset removed fromyour balance sheet and have differentaccounting, but not a performance obliga-tion.” According to Cosper, factors to beconsidered in determining whether thelessor has retained exposure to the risksand benefits include the asset’s usefullife, its value, and how that value may havedeclined over the lease term.

Strauss asked how leases, now thatthey were on the balance sheet, would beremoved. Cosper said that the issues arestill being deliberated, but a finance leasecould be amortized based on a pattern ofconsumption, whereas other leases coulduse a straight-line method. This led to adiscussion about the new guidance thatwould distinguish between the two leases,analogous to those formerly termed capi-tal and operating, respectively.

“Once we have the guidance, we’llknow how easy or difficult it will be toimplement,” Barge said. He discussed anexample that would look like a financelease under the proposed guidance and con-sidered the implications on his cash flowand balance sheet.

“I can promise you we’ve seen our lastfinance lease,” declared Jonas. He harkenedback to the two camps of users: Those whothink leases are an operating item areapplauding the proposed guidance, butthose who think every lease is a financingactivity are disappointed. “We think there’sno such thing as lease expense,” he said.“We see amortization of an acquired assetin interest.” He credited the boards for lis-tening to users, but criticized them for lis-tening only to those users in the first camp.

In Focus

“I think the model that the FASB

proposed certainly sounded, on

its face, not all that difficult,”

Hauser commented. “But it

became much more complex

in terms of implementation.”


“I think we need to resolve: Is there afinancing component to leases or not?”Kroeker added. “I think they’re financingand we ought to recognize them as financ-ing. We’re making added complexity bytrying to split them. If it’s financing, putthe asset on the books and recognize it.”Cosper noted that the boards are still delib-erating this contested issue, and thus thedetails are still to be determined.

Renewals and Contingent RentsThe issue of lease renewal was also

controversial. “Today, people in campone are not adjusting financial statementsfor leasing. Camp two are the ones whoare adjusting financial statements for leas-ing,” Jonas said. “We think that leaserenewals that are likely ought to be fac-tored into the thinking. We think contin-gent rent ought to be factored into the

thinking. We’re getting numbers … thatare much larger than the board is goingto give us capitalizing minimum rent.”Jonas questioned the usefulness of theapproach: “The risk here is the board’sgoing to hand us a number we’re goingto look at and say, ‘Well, that numberisn’t helpful,’ and we’re going to adjustthese statements on the back of the nap-kin just like we always have.” He addedthat those in camp one would just disre-gard the number.

“In the original proposal, contingentrents would be included based upon a prob-ability-weighted assessment,” Hauser said.“Once again, that proposal was very con-troversial.” She said that “the boards lis-tened and effectively scaled that back dra-matically,” such that contingent rentswould not be included unless they wereeffectively disguised fixed payments.

Making Progress and Making Judgments“We believe that the revenue project and

the leasing project have progressed at afaster pace than the financial instrumentsproject,” Cosper said. “I think the teamshave consistently endeavored to reach outon all of the decisions that are beingmade as they go along, as well as to tryand solicit feedback after we finish delib-erations on the overall models.”

In response to a question from theaudience about how auditors are going tobe able to support the revenue recognitiondecisions made by management, Cospernoted that such judgments are alreadybeing made today. “As we gain experiencewith this, I think we will be able to makethose judgments,” she said. “I do thinkthe results, in many occasions, are goingto be a better economic representation ofthe revenue stream.” ❑

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As the SEC continues working onits final road map to transitionU.S. publicly traded companies toInternational Financial Reporting

Standards (IFRS), advance planning is thebest way for companies to prepare forthis seemingly inevitable change. It alsopresents companies with a unique oppor-tunity to comprehensively reassess theirfinancial reporting policies. Doing so mayprovide management with the occasion toreconsider whether their accounting poli-cies reflect mainstream practices in theirrespective industries, provide users with theclearest understanding of the underlyingeconomics of the business, and convey thedesired degree of management prudenceand transparency in financial reporting.

Key steps in adopting IFRS include theselection of accounting policies based onIFRS in effect at the end of the first IFRSreporting period, and the preparation of atleast two years’ worth of financial state-ments and the opening balance sheet (state-ment of financial position) at the date oftransition to IFRS, using those selectedaccounting policies.

Selecting and Applying IFRS Accounting Policies

In accordance with InternationalAccounting Standard (IAS) 8, AccountingPolicies, Changes in Accounting Estimatesand Errors, accounting policies are “spe-cific principles, bases, conventions, rules,and practices applied by an entity in prepar-ing and presenting financial statements.”Accounting policies include principles forrecognizing and measuring assets, liabili-ties, income, and expenses, as well as theprinciples and practices for presenting theseitems in the financial statements. Entities

presenting their financial statements inaccordance with IFRS must followaccounting policies addressed in the stan-dards issued by the InternationalAccounting Standards Board (IASB).

IFRS, which are accounting standards

adopted or issued by the IASB, consists ofthe following:■ IFRS, issued by the IASB;■ IAS, issued by the predecessorInternational Accounting StandardsCommittee (IASC), as amended; and

Accounting Policy Options in IFRS

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

i n t e r n a t i o n a l a c c o u n t i n g


By Eva K. Jermakowicz and Barry Jay Epstein

Weighing the Choices Upon First-Time Adoption


■ Interpretations developed by the IFRSInterpretations Committee, formerly calledthe IFRIC (International Financial ReportingInterpretations Committee), or its predeces-sor, the Standing Interpretations Committee.

IASB standards and interpretations oftenhave guidance designed to assist entities inapplying IFRS. Such guidance is manda-tory only if it clearly states that it is an inte-gral part of IFRS. Guidance that is not anintegral part of IFRS does not providerequirements for financial statements.

If an IFRS specifically addresses a trans-action, other event, or condition, an entitymust generally follow the prescribed account-ing. An entity may choose to not follow aspecific requirement addressed in IFRS,however, if the effect of not doing sowould be immaterial. IAS 8 explains thatomissions or misstatements of items arematerial if they could, individually or col-lectively, influence the economic decisionsof users made on the basis of the financialstatements. Nevertheless, it is inappropriateto make—or leave uncorrected—immateri-al departures from IFRS to achieve a par-ticular financial statement presentation.

Under IAS 8, when there is not a spe-cific IFRS that applies to a particular trans-action, other event, or condition, an enti-ty’s management must use its judgmentin developing and applying an accountingpolicy. This should result in informationthat is both of the following:■ Relevant to the decision-makingneeds of users; and■ Reliable, meaning that the information—

■ represents faithfully the financial posi-tion, financial performance, and cashflows of the entity;■ reflects the economic substance oftransactions, other events, and condi-tions, and not merely their legal form;■ is neutral (i.e., free from bias);■ has been prudently developed and pre-sented; and■ is complete in all material respects. In making such judgments, manage-

ment should first attempt to directly applythe requirements in IFRS dealing withsimilar and related issues, and secondar-ily, as needed, make reference to the def-initions, recognition criteria, and mea-surement concepts for assets, liabilities,income, and expenses set out in the IFRSConceptual Framework for FinancialReporting.

Furthermore, when making its judg-ments, an entity’s management may alsoconsider the most recent pronouncementsof other standards-setting bodies thatemploy a conceptual structure similar tothe Framework to develop accounting stan-dards, other accounting literature, andaccepted industry practices, to the extentthat these do not conflict with IFRS (stan-dards, interpretations, and the Framework).

An entity adopting IFRS for the firsttime may have a choice among account-ing policies as a result of options withinaccounting standards (newly issued IFRS),options among alternate accounting poli-cies that are set forth within accountingstandards, and exemptions in IFRS 1, First-time Adoption of International FinancialReporting Standards.

Retrospective Application of IFRSGuidance regarding initial implementa-

tion of IFRS is found in IFRS 1, whichstipulates that an entity should apply themost current version of IFRS throughoutall periods presented in its first set of IFRSfinancial statements, and also in its open-ing IFRS statement of financial position.Therefore, the standard requires retro-spective application of each IFRS effectiveat the reporting date of an entity’s first setof IFRS-compliant financial statements.

For example, if a U.S. entity decides toadopt IFRS in 2012 and to present com-parative information for one year only,the entity has to prepare the financial state-ments for 2012 and 2011 based on IFRSin effect at December 31, 2012, its firstIFRS reporting date. In addition, the open-ing statement of financial position, preparedat the date of transition to IFRS (January1, 2011, the beginning of the earliestcomparative period) must also comply withIFRS in effect at December 31, 2012.Exhibit 1 illustrates these dates.

If a new IFRS has been issued prior tothe first IFRS reporting date, but applica-

tion is not yet mandatory, and if reportingentities have been allowed to apply itbefore the effective date, the first-timeadopter is permitted, but not required, toapply the new standard as well. In suchinstances, retrospective application to thecomparative and transition date financialstatements, as described above, would alsobe necessary. An entity must apply allIFRSs that are relevant.

IFRS 1 contains five mandatory excep-tions to the general rule of retrospectiveapplication, in recognition of the fact thatthe effect of the change in accounting poli-cies for those items cannot be measuredwith sufficient reliability (e.g., retrospec-tive application would require judgmentsabout the past, and the outcome would beknown on first-time adoption). Theseexceptions include accounting estimates,derecognition of nonderivative financialassets and nonderivative financial liabili-ties, hedge accounting, measurement ofnoncontrolling interests, and classificationand measurement of financial assets.

In addition, the standard provides a num-ber of optional exemptions from somerequirements of other IFRSs in areas wherethe costs of applying IFRS retrospectivelymay exceed the benefits to financial state-ment users, or where retrospective applica-tion may be impracticable. An entity will thushave a number of choices between differentoptions of accounting policies within IFRS1, as well as within other accounting stan-dards that need to be resolved in preparingits first IFRS financial statements.

Accounting Policy Options Dictated by Circumstances

The first—and most important—step inmaking the transition to IFRS is theselection of accounting policies. Manyaccounting policy options will, in fact, sim-ply be dictated by an entity’s specific cir-cumstances, for example, the method ofaccounting for long-term construction

Transition Last U.S. GAAP Reporting First IFRS Reporting Date Date Date

I--------------------------------------------I-------------------------------------------IJan. 1, 2011 Dec. 31, 2011 Dec. 31, 2012

EXHIBIT 1Examples of Reporting Dates Under IFRS 1


projects or the method of accounting fordevelopment costs. Exhibit 2 presentsexamples of accounting policy options thatare dictated by an entity’s specific cir-cumstances. These options are discussed inmore detail below.

Inventory methods (IAS 2). The specif-ic identification method is used to cost itemsthat are segregated for a specific project andnot ordinarily interchangeable. It typicallyis only feasible when there are a relativelysmall number of items, having relativelyhigh unit values, where the added effort ofmaintaining individual item records can bejustified. In circumstances in which this isnot required, a choice between first-in, first-out (FIFO) and average costing will be avail-able. If the objective is to have inventorycosting be roughly congruent with the phys-ical flow of goods (which is not a requiredgoal for financial reporting), then the choiceof method may be dictated or suggested bythe movement of product. For example,for companies that attempt to sell the old-est goods in inventory first for some of theirproducts (e.g., perishable or fashion-sensi-tive goods), the FIFO method would bestmirror the actual physical flow.

Events after the reporting period (IAS10). The nature of information obtainedafter the reporting date (i.e., the date of thelatest statement of financial position) will,typically, dictate how that information isto be reported—that is, as an adjustmentto the financial statements themselves, oras mere disclosures. IFRS 1 requires anentity to treat information received after thetransition date that relates to estimates made

under previous GAAP as nonadjustingevents. In contrast, significant nonadjust-ing events that are indicative of condi-tions that arose after the reporting periodshould be disclosed.

Construction contracts (IAS 11). Inaddition to all other IFRS requirements,construction contracts where the outcomecan be estimated reliably, both parties haveenforceable rights, and the stage of com-pletion can be reliably estimated, necessi-tate the use of percentage-of-completionaccounting. If all requirements are not met,revenue is recognized only to the extentof contract costs incurred that are probableto be recovered, and contract costs are rec-ognized as an expense in the period inwhich they are incurred. An expected losswould be recognized immediately.

Depreciation methods (IAS 16). Anentity should select a depreciation methodthat reflects the pattern in which it expectsto consume the asset’s future economic ben-efits. In some cases, the benefits are evenlyconsumed and a straight-line method is mostappropriate, whereas in others, a decliningpattern of utility over time reflects econom-ic reality, inasmuch as many types ofequipment do become less productive withage. A “components” accounting is requiredfor the depreciation of an asset with differ-ing patterns of benefits.

Leases (IAS 17). Whether a lease is rec-ognized as a finance lease or an operatinglease depends on the substance of the trans-action rather than the form. At the incep-tion of the lease, the lease is classified asa finance lease if it transfers substantially

all the risks and rewards accompanyingownership to the lessee. Careful and objec-tive analysis of the substance of leasearrangements should reveal whichmethod of accounting is appropriate.

Governmental grants (IAS 20). A grantthat imposes specified future performanceconditions on the recipient is recognized asincome only when there is reasonable assur-ance that the entity will comply with suchconditions and that the grant will be received.Grants received before the recognition cri-teria are met are recognized as a liability.

Functional currency (IAS 21). Severalfactors, such as the currency in which mostoperating proceeds are maintained, must beconsidered when determining the function-al currency of a foreign operation, as well aswhether its functional currency is the sameas that of the reporting entity.

Development costs (IAS 38). Internaldevelopment costs are recognized as assets ifan entity can demonstrate technical and eco-nomic feasibility of a project in accordancewith specific criteria. The criteria includedemonstrating technical feasibility, an intentto complete the asset, the ability to use or sellthe asset in the future, how the intangible assetwill generate probable future economic ben-efits, the availability of resources to completethe asset, and the ability to reliably measurethe development expenditure.

Other Accounting Policy OptionsA number of IFRSs—as is also the

case with U.S. GAAP standards—providefor a choice among alternative acceptableaccounting policies that do not depend sole-ly on circumstances but, instead, reflectIFRS flexibility (i.e., free choices). Theoptional accounting policy choices avail-able upon first-time adoption of IFRS arediscussed below.

Optional exemptions (IFRS 1). IFRS 1provides for optional exemptions fromsome requirements upon first-time adop-tion of IFRS. Those optional exemptionsare discussed in the next section.

Noncontrolling interests (IFRS 3). Anentity has a choice of two methods to mea-sure a noncontrolling interest in theacquiree: measure at fair value, or measureat the noncontrolling interest’s share of theacquiree’s identifiable net assets, recog-nized in accordance with IFRS 3. Themethod selected affects the amount recog-nized as goodwill. The first method will

IFRS Accounting Policy Options

IAS 2 Specific identification or FIFO inventory methods

IAS 10 Adjustments for events after the reporting period

IAS 11 Percentage-of-completion versus completed-contract method

IAS 16 Choice of depreciation methods (e.g., components accounting)

IAS 17 Finance lease versus operating lease

IAS 20 Government grants

IAS 21 Selection of functional currency for translation

IAS 38 Internal development costs capitalization versus expensing

EXHIBIT 2Examples of Accounting Policy Options Dictated by Circumstances


result in recognizing all of the goodwillof the acquired business (allocating impliesgoodwill to the noncontrolling interest),while the second method will result in rec-ognizing goodwill associated with only thepercentage of ownership acquired by thecontrolling interest.

Insurance liabilities (IFRS 4). If aninsurer changes its accounting policies forinsurance liabilities, it is permitted, but notrequired, to reclassify some or all of itsfinancial assets as measured at fair value.An insuring entity is permitted, althoughnot required, to change its accounting poli-cies such that it remeasures designatedinsurance liabilities to reflect current mar-ket interest rates, and recognizes changesin those liabilities in current-period earn-ings. It may also adopt accounting policiesthat require other current estimates andassumptions for the designated liabilities.

Presentation of financial statements (IAS1). Two approaches to the presentation ofthe statement of comprehensive income areallowed. Under the single-statementapproach, all items of income (revenues,gains) and expense recognized during theperiod are presented in one statement thatencompasses all components of “profit orloss” and of “other comprehensive income.”Under the two-statement approach, theincome statement and statement of compre-hensive income are presented separately.

Inventories (IAS 2). The cost of inven-tories should be assigned by using the first-in, first-out (FIFO) or weighted averagecost formula (the last-in, first-out [LIFO]method is prohibited under IFRS). Asnoted, there is no requirement that thistrack the physical flow of goods. In addi-tion, certain inventories such as agriculturalproduce, minerals, and commodities aremeasured at net realizable value (versuscost) at certain stages of production.

Statement of cash flows (IAS 7).Operating cash flows can be presented inthe statement of cash flows using the director indirect method. In addition, interest anddividends received can be presented aseither operating or investing cash flows,and interest paid may be presented as eitheran operating or financing cash flow.

Property, plant, and equipment (IAS16). Items of property, plant, and equip-ment may be measured using the cost-depreciation-impairment model or therevaluation-through-equity model. Using

the revaluation model, those items are mea-sured at fair value as of the date of reval-uation, less any subsequent accumulateddepreciation and subsequent accumulatedimpairment losses.

Government grants (IAS 20). Variousapproaches to accounting for governmentgrants are available under IFRS; the choiceis partially dictated by the circumstances(e.g., for government grants related tobiological assets) and partially elective. Forexample, for government grants made inthe form of nonmonetary assets, the assetand grant are to be consistently recognized,either at the fair value of the nonmone-tary asset or at a nominal amount.

Investments in subsidiaries, associ-ates, and joint ventures (IAS 27). In sep-arate financial statements (i.e., not in theconsolidated financial statements of the par-ent, investor, or joint venturer), an entity isrequired to account for investments in sub-sidiaries, associates, and joint ventures atcost or in accordance with IFRS 9.

Intangible assets (IAS 38). The costmodel or the revaluation model can beapplied to intangible assets for which anactive market exists.

Financial instruments (IFRS 9/IAS39). A number of options exist pertain-ing to the accounting for financial instru-ments. Under certain circumstances, anentity can elect to use hedge accountingif the instruments had been designated ashedges under the reporting entity's pre-decessor financial reporting regime; itmay also designate financial assets andliabilities to be measured at fair valuethrough profit and loss; reassessments ofaccounting for embedded derivatives, per-mitted before IFRS 9, will no longer beallowed upon initial adoption of IFRS. Inaddition, in a cash flow hedge of a fore-casted transaction that subsequentlyresults in the recognition of a nonfinan-cial asset or a nonfinancial liability, orthat becomes a firm commitment forwhich fair value hedge accounting isapplied, the carrying amount of a nonfi-nancial hedged item can be adjusted forgains and losses on the hedging instru-ments that are determined to be aneffective hedge. Trade date versus set-tlement date accounting can also beapplied.

Investment property (IAS 40). Thecost model or the fair value model can be

used to account for investment property.Also, land use rights can be classified asinvestment property.

Exhibit 3 presents examples of account-ing policy options that do not depend uponcircumstances.

The IASB’s policy is to exclude optionsin accounting treatments from accountingstandards whenever possible. In imple-menting this policy, recently a choice inaccounting treatment for joint ventures waseliminated with the issuance of IFRS 11,Joint Arrangements (the equity method isnow required for all investments in jointventures), and the corridor approach fordeferred recognition of certain benefit plangains and losses was eliminated with theissuance of amended IAS 19, EmployeeBenefits. It is reasonable to assume that afurther narrowing of options currentlyavailable to issuers of financial statementsmay occur, both as a by-product of theIASB-FASB convergence efforts, and asIFRS continues to evolve.

IFRS 1 ExemptionsIn general, IFRS 1 requires a first-time

adopter to comply with each standardeffective at the end of its first IFRS report-ing period. But IFRS allows limitedexemptions for first-time adopting entitiesrelated to the following areas:

Share-based payment (IFRS 2). Undercertain circumstances, entities are encour-aged, but not required, to apply IFRS 2 to1) equity instruments that were grantedon or before November 7, 2002; 2) equi-ty instruments that were granted afterNovember 7, 2002 and vested before thelater of the date of transition to IFRS orJanuary 1, 2005; and 3) liabilities arisingfrom share-based payment transactions thatwere settled before the date of transition toIFRS or settled before January 1, 2005.

Business combinations (IFRS 3).Entities may elect not to apply IFRS 3retrospectively to business combinationsthat occurred before the date of transitionto IFRS. If one business combination isrestated to comply with IFRS 3, however,then all business combinations occurringafter that date must be restated.

Insurance contracts (IFRS 4). Entitiesmay apply the transitional provisions inIFRS 4, which restrict changes in account-ing policies for insurance contracts, includ-ing those made by a first-time adopter.


Deemed cost (IASs 16, 38, and 40). Attransition date, first-time adopters may electto measure an item of property, plant, andequipment either at its historical cost or atits deemed cost. The deemed cost may beits fair value at the date of transition toIFRS, provided certain criteria are met; ora previous GAAP revaluation, providedcertain criteria are met; or an event-drivenfair value measurement. This option is alsoavailable for investment property measuredunder the cost model and for intangibleassets that meet certain criteria.

Leases (IAS 17). Entities may determinewhether an arrangement existing at the dateof transition to IFRS contains a lease onthe basis of facts and circumstances exist-ing at that date (IFRIC 4).

Employee benefits (IAS 19). IFRS 1allows an entity using the corridor approachto recognize all previously unrecognizedcumulative actuarial gains and losses at thedate of transition to IFRS, even if it usesthe corridor approach prospectively. If anentity uses the defined benefit plan exemp-tion, it must be applied to all defined ben-efit plans.

Cumulative translation differences(IAS 21). Entities may set the cumulativetranslation adjustment for all foreign sub-sidiaries to zero at the date of transitionto IFRS.

Investments in subsidiaries, jointlycontrolled entities, and associates (IAS27). An entity electing deemed cost toaccount for investments in subsidiaries,

jointly controlled entities, and associatesin its separate financial statements maychoose either the fair value—determinedin accordance with IFRS 9—at the enti-ty’s date of transition to IFRS, or the car-rying amount under previous GAAP atthat date.

Assets and liabilities of subsidiaries, asso-ciates, and joint ventures. If a first-timeadopter reports earlier than its subsidiary(or associate or joint venture), the sub-sidiary can, in its (stand-alone) financial state-ments, measure its assets and liabilities ateither 1) the amounts that would be includ-ed in its parent’s consolidated financial state-ments based on its parent’s date of transitionto IFRS (except for consolidation adjust-ments), or 2) the carrying amounts requiredby IFRS 1, based on the subsidiary’s date oftransition to IFRS.

For entities adopting IFRS 1 in consol-idated financial statements later than itssubsidiary (or associate or joint venture),assets and liabilities of the subsidiary aremeasured at the same carrying amountsas in its stand-alone financial statements(except for consolidation adjustments).

Compound financial instruments (IAS32). Entities that have issued a compoundfinancial instrument need not separatetwo portions of equity (the original equitycomponent and the cumulative interestaccreted on the liability component), ifthe liability component is no longer out-standing at the date of transition to IFRS.

Designation of previously recognizedfinancial instruments (IAS 39). DespiteIAS 39 permitting a financial asset to bedesignated as a financial asset or financialliability at fair value through profit or lossupon initial recognition, a first-time adopteris permitted to make such designation atthe date of transition to IFRS.

Fair value measurement of financialassets or financial liabilities at initial recog-nition (IAS 39). Entities may apply therequirements of IAS 39 regarding the bestevidence of the fair value of a financialinstrument at initial recognition and thesubsequent measurement of the financialasset or financial liability and the subsequentrecognition of gains and losses, eitherprospectively to transactions entered into afterOctober 25, 2002, or prospectively to trans-actions entered into after January 1, 2004.

Decommissioning liabilities included inthe cost of property, plant, and equipment

IFRS Accounting Policy Options

IFRS 1 Apply optional exemptions from some requirements of IFRS

IFRS 3 Measure noncontrolling interest at fair value versus proportionate shareof the acquiree’s identifiable net assets

IFRS 4 Remeasure insurance liabilities to fair value during each accounting period

IAS 1 Present the statement of comprehensive income under the single-state-ment approach versus the two-statement approach; present expensesby nature versus by function

IAS 2 Measure inventories at FIFO versus the weighted average method (LIFO is prohibited)

IAS 7 Present operating cash flows using the direct or indirect method; classi-fy interest and dividends as operating, investing, or financing

IAS 16 Measure property, plant, and equipment using the cost model versusthe revaluation model

IAS 20 Use various approaches to accounting for government grants

IAS 27 Account at cost or in accordance with IFRS 9 for investments in subsidiaries, associates, and joint ventures in separate financial statements

IAS 38 Apply the cost model versus the revaluation model for intangible assetsin an active market

IFRS 9/ Use optional hedge accounting; designate individual financial assets andIAS 39 financial liabilities to be measured at fair value through profit and loss

(FVTPL); adjust the carrying amount of a hedged item for gains and losseson the hedging instrument; apply trade date versus settlement dateaccounting.

IAS 40 Use the cost model versus the fair value model for investment property;classify a property interest held by a lessee under an operating lease asinvestment property under certain circumstances

EXHIBIT 3Accounting Policy Options That Do Not Depend Upon Circumstances


(IASs 16 and 37). Entities need not com-ply with IFRIC 1 for changes in such lia-bilities that occurred before the transition toIFRS. They can use a simplified procedure.

Financial assets or intangible assetsaccounted for in accordance with IFRIC12. Entities may apply the transitional pro-visions of IFRIC 12.

Borrowing costs (IAS 23). Entities mayapply the transitional provisions includedin IAS 23 (as revised in 2007). The effec-tive date in IAS 23 should be interpretedas the later of July 1, 2009, or the date oftransition to IFRS.

Transfers of assets from customers.Transitional provisions provided in IFRIC18 (paragraph 22) may be applied, andthe effective date should be interpreted asthe later of July 1, 2009, or the date of tran-sition to IFRS. Entities may also desig-nate any date before the transition datefor the purposes of accounting under IFRIC18 for all transfers of assets from customersreceived on or after that date.

Extinguishing financial liabilities withequity instruments. Transitional provisionsin IFRIC 19 may be applied upon first-timeadoption of IFRS.

Severe hyperinflation. If, before thetransition to IFRS, an entity used to be sub-ject to a severe hyperinflation, it can mea-sure assets and liabilities at fair value onthe date of transition to IFRS at theirdeemed cost. Under severe hyperinflation,a reliable general price index for all enti-ties and exchangeability with a relativelystable currency are not available.

Transition to IFRS is a moving target.Although recent changes to IFRS havebeen incorporated in this article, as otherstandards continue to change, those con-templating first-time adoption shouldupdate their understanding of transitionoptions before making decisions.

Selecting Initial IFRS Accounting Policies

Upon first-time adoption of IFRS, entitiesdetermine the accounting policies that willbe used in preparing their financial state-ments, and establish the benchmark againstwhich their performance will be evaluatedin the future. Selecting accounting policiesshould, ideally, meaningfully reflect suchmatters as asset valuation, cost allocation,and revenue realization by the reporting enti-ty. First-time adopters must select initial

IFRS accounting policies based on relevanceand reliability, inasmuch as these choices willaffect the company’s financial reporting foryears to come.

Applying the requirements in IFRS totransactions and events often requires judg-ment. In some cases, management mustmake significant judgments in selecting itsaccounting policies. For example, in cer-tain circumstances, management mustmake judgments in determining the degreeof influence the entity exerts over anotheror whether certain properties should beaccounted for as investment property,inventory, or property, plant, and equip-ment. Entities should disclose the judg-ments made in selecting and applyingaccounting policies expected to have themost significant effect on the amounts pre-sented in the financial statements.

The effect on prior periods of themandatory exceptions and optional exemp-tions from some IFRS requirements(other than IFRS 1) at the time of first-timeIFRS adoption is recognized in equity, gen-erally in retained earnings. Equity is akey determinant of entity value and is usedin the computation of several key financialratios. Consequently, the selection ofaccounting policies can have significantfinancial and strategic implications, regard-ing both the equity balance to be reportedat the transition date and also through theeffect on periodic net income to bereported thereafter.

Research based on the experiences ofEuropean companies has revealed that enti-ties that reported mandatory adjustmentsthat increased equity and that had higherbook values and higher earnings multi-ples are more likely to select optionalexemptions that have a negative impact onequity at the date of transition to IFRS. Inaddition, entities with higher leverage areless likely to elect exemptions that decreaseequity.

For example, IFRS 1 allows recognitionin equity at the transition date of all pre-viously unrecognized cumulative transla-tion adjustment for all foreign subsidiaries.This may benefit entities with unrecognizedtranslation losses, because they can avoidfuture decreases in profits. In contrast, therevaluation model adopted for items ofproperty, plant, and equipment and intan-gible assets typically increases transitiondate equity and reduces future profits.

Advance Planning The next several years will bring major

changes to U.S. financial reporting, andthe effect on U.S. businesses will be con-siderable. Upon first-time IFRS adoption,entities are given a fresh start and arerequired to redetermine their accountingpolicies, fully restating past comparativeinformation. The limited voluntaryexemptions also present some opportuni-ties for entities to determine optimaloutcomes. Once an accounting policy isadopted, opportunities to change may berestricted to justifiable situations wherethe change would result in a more appro-priate presentation.

Advance planning is recommended inorder to most effectively prepare forimplementing IFRS and to take advantageof the opportunity to comprehensivelyreassess financial reporting policies andprocesses. Compared to U.S. GAAP,IFRS has several more areas where enti-ties have a choice of accounting policiesthat may be implemented. Companiesneed to be cognizant that the accountingpolicies they elect could have a signifi-cant impact on an entity’s future report-ed results of operations and financial posi-tion and, thus, could have significantfinancial and strategic implications.

Some may be tempted to choose thepath of least resistance—or least effort—by continuing to employ accounting poli-cies utilized under predecessor financialreporting regimes, assuming those areoptionally acceptable under IFRS. Butbecause the first-time adoption rules pro-vide a unique opportunity to optimize anentity’s accounting policies, it is stronglyrecommended that this default option beavoided. The attention paid to the selectionof accounting principles will pay handsomedividends in terms of more meaningful,transparent, decision-relevant financialstatements if this process is given theconsideration it deserves. ❑

Eva K. Jermakowicz, PhD, CPA, is a pro-fessor and head of the department ofaccounting and business law in the collegeof business, Tennessee State University,Nashville, Tenn. Barry Jay Epstein, PhD,CPA, is a partner with RNCO FinancialLitigation Advisors, Russell Novak &Company LLP, Chicago, Ill.

By David G. DeBoskey and Kevin M. Lightner

Stock options with graded vestingattributes create interesting choices forcorporate accounting personnel to

consider. Moreover, these choices varydepending on whether the company’s report-ing is based on U.S. GAAP or InternationalFinancial Reporting Standards (IFRS).

Under U.S. GAAP (ASC Topic 718-20-35-8), an entity shall make a policydecision about whether to recognize com-pensation cost for an award with service con-ditions only that has a graded vesting sched-ule in either of the following ways: 1) on astraight-line basis over the requisite serviceperiod for each of the award’s separately

vesting portions as if the award was, insubstance, multiple awards; or 2) on astraight-line basis over the requisite serviceperiod for the entire award (that is, over therequisite service period of the last separate-ly vesting portion of the award). However,the amount of compensation cost recognizedat any date must at least equal the portionof the grant-date value of the award that isvested at that date.

Conversely, under IFRS 2, straight-lineamortization is not permitted; instead,accelerated amortization must be applied.This means each individual vesting portionof an award—known as a tranche—isexpensed on a straight-line basis (i.e., grad-ed vesting attribution, where each awardtranche has a separately determined fair

value). This differs from ASC Topic 718,in which “service only” awards can beexpensed on a straight-line basis over theentire grant, and fair value can be deter-mined at either the tranche level or thegrant level. These differences can resultin significant variations in interperiod com-pensation expense for firms preparing theirfinancial statements under differentaccounting standards. This may require acompany to modify the way it approach-es areas such as valuation, tax accounting,and stock administration processes.

The purpose of this article is to highlightthe different approaches for determiningcompensation expense under both ASCTopic 718 and IFRS 2 for awards withgraded vesting attributes. We provide a


Accounting for Stock Options

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

a c c o u n t i n g

A Comparative Simulation for Straight-Line and Graded Vesting Attributions Methods

Category Comparison ASC 718 (GAAP) IFRS 2 DifferencesValuation Black-Scholes, Lattice, or Black-Scholes, Lattice, Under IFRS, country-specific valuations

Binomial or Binomial of share-based payments are required.Expense amortization Straight-line amortization or Only accelerated Under IFRS, straight-line amortization

accelerated amortization can amortization can be is not allowed.be applied. applied.

EXHIBIT 1Differences Between ASC 718 and IFRS 2

Tranche No. of Options Expected Life in Months of Each Vesting Segment Options × Months1 20% × 80,000 = 16,000 15 240,0002 35% × 80,000 = 28,000 27 756,0003 15% × 80,000 = 12,000 39 468,0004 30% × 80,000 = 24,000 51 1,224,000Total 80,000 – 2,688,000Result: Weighted average life in years = 2,688,000 / 80,000 / 12 = 2.8 years

EXHIBIT 2Simulation 1, Step 1

51AUGUST 2011 / THE CPA JOURNAL

summary of the major differences betweenASC Topic 718 and IFRS 2 with regard tovaluation and expense amortization undershare-based compensation arrangements.To better grasp the differences betweenstraight-line and graded vesting attribu-tion methods, we outline two step-by-stepsimulations that can be followed in deter-mining compensation expense under eitherASC 718 (straight-line or graded vestingattribution) or IFRS 2 (graded vesting attri-bution only). (See Exhibit 1.)

In Simulation 1, we examine the spe-cific steps required to apply the straight-line attribution method for an option grantwith graded vesting. This method isallowed by U.S. GAAP, but not allowedby IFRS for options with graded vesting.In Simulation 2, we examine the specificsteps to apply the graded vesting attribu-tion method. This method is allowed underU.S. GAAP and IFRS. The simulationsproceed through the main procedures thata manager would follow in determining thecorrect compensation expense to recognize.

Mr. Avery’s Option AwardBlack-Scholes Variable Inputs:

Market Price at Grant Date $22.50Exercise Price $22.50Expected Life 2.8Risk-Free Interest Rate 4.50%Volatility 40%Dividend Yield 0

Black-Scholes Model Output:Market Value per Option1 $6.9747

Number of Options Granted to Mr. Avery 80,000Market Value of Options1 $557,978

1. The Black-Scholes variable inputs are required in order to determine the marketvalue per option. The market value per option is multiplied by the number optionsgranted to derive the aggregate market value of the options granted.


2010. Take the higher of the straight-line (SL) calculation or the amount based on cumulative vesting to date

Balance of Compare Portion of Grant Date ExpenseDeferred Compensation compensation: Award Vested Market Expense Previously Compensation

SL Fraction Compensation Expense Take higher to Date Value to Date Recognized Expense1/4 $557,978 $139,495 amount. 20% $557,978 $111,596 0 $111,596

2011. Take the higher of the SL calculation or the amount based on cumulative vesting to date.

Balance of Compare Portion of Grant Date ExpenseDeferred Compensation compensation: Award Vested Market Expense Previously Compensation

SL Fraction Compensation Expense Take higher to Date Value to Date Recognized Expense1/3 $418,483 $139,495 amount. 55% $557,978 $306,888 $139,495 $167,393


Balance of Portion of Grant Date ExpenseDeferred Compensation Compare Award Vested Market Expense Previously Compensation

SL Fraction Compensation Expense compensation: to Date Value to Date Recognized ExpenseTake higher $139,495

1/2 $251,090 $125,545 amount. 70% $557,978 $390,585 $167,393 83,697$306,888


Balance of Portion of Grant Date ExpenseDeferred Compensation Compare Award Vested Market Expense Previously Compensation

SL Fraction Compensation Expense compensation: to Date Value to Date Recognized ExpenseTake higher $139,495

1/1 $125,545 $125,545 amount. 100% $557,978 $557,978 $167,393 $125,545$125,545$432,433


Simulation 1Stock options with graded vesting using

straight-line attribution simulation.Simulation problem: On January 1, 2010,when its stock price is $22.50 per share,CSinc. Corporation grants Mr. Avery, thecompany CEO, 80,000 stock options withan exercise price of $22.50. The options vestover four years and have a contractual lifeof six years. After one year 20% vest, fol-lowed by 35% after two years, 15% afterthree, and 30% in the last year. Each yearduring the four-year vesting, the company’srisk-free interest rate is 4.5%, and its esti-mated volatility is 40%. From the compa-ny’s experience, options are expected to beexercised three months past each vesting.The company has no plans to issue divi-dends. The Black-Scholes Option PricingModel is used by the company to deter-mine the fair value of options.

Using the data above, what is the com-pensation expense for 2010, 2011, 2012,and 2013?

Step 1: weighted-average expected life.Compute the weighted-average expectedlife for Mr. Avery’s 2010 option award,assuming the expected exercise date isthree months past the vesting date. Eachvesting portion of the award is referred toas a tranche. (See Exhibit 2.) The result isthat the weighted-average life in years = 2,688,000 / 80,000 / 12 = 2.8 years.

We note, however, that if all optionawards issued to all executives in 2010had been used to calculate a weighted-average life, the option-months for eachaward would be included in the totaloption-months to get a weighted-averagenumber of months. This figure would thenbe converted to a weighted-average


Tranche 1 2 3 4Black-Scholes Variable Inputs:

Market Price at Grant Date $22.50 $22.50 $22.50 $22.50Exercise Price $22.50 $22.50 $22.50 $22.50Expected Life (from Step 1) 1.25 2.25 3.25 4.25Risk-Free Interest Rate 4.5% 4.5% 4.5% 4.5%Volatility 40% 40% 40% 40%Dividend Yield 0 0 0 0

Black-Scholes Model Output:Market Value per Option1 $4.5176 $6.2034 $7.5506 $8.6949

Number of Options (from Step 1) 16,000 28,000 12,000 24,000Market Value of Options $72,282 $173,695 $90,607 $208,6781. The Black-Scholes variable inputs are required in order to determine the marketvalue per option. The market value per option is multiplied by the number optionsgranted to derive the aggregate market value of the options granted.


Market Value

Vesting (from Compensation Expense (IFRS 2)Tranche Time Step 2) Year 1 Year 2 Year 3 Year 41 1 year $ 72,282 $72,282 0 0 02 2 years $173,695 ½ × 173,695 = $86,848 ½ × 173,695 = $86,848 0 03 3 years $ 90,607 × 90,607 = $30,202 × 90,607 = $30,202 × 90,607 = $30,202 04 4 years $208,678 ¼ × 208,678 = $52,170 ¼ × 208,678 = $52,170 ¼ × 208,678 = $52,170 ¼ × 208,678 = $52,170

$545,262 $241,502 $169,220 $82,372 $52,170


Tranche Number of Options Expected Life1 20% x 80,000 = 16,000 (12 + 31) / 12 = 1.252 35% x 80,000 = 28,000 (24 + 31) / 12 = 2.253 15% x 80,000 = 12,000 (36 + 31) / 12 = 3.254 30% x 80,000 = 24,000 (48 + 31) / 12 = 4.25

80,0001. According to the simulation problem, options are expected to be exercisedthree months past each vesting, as follows:


16,000

28,000

12,000

24,000

1 year 2 year 3 year 4 year 5 year

1 3 1 3 1 3

number of years by dividing by 12. Inother words, the procedure for computingweighted-average life is the same, regard-less whether there is a single award ormultiple awards. This aggregate weight-ed average life is the number reported ina company’s 10K.

Step 2: fair market value. Compute thefair market value of Mr. Avery’s 2010option award using the Black-ScholesOption Pricing Model with the weighted-average expected life from Step 1. (SeeExhibit 3.)

Step 3: compensation expense. Using thefair market value calculated in Step 2,determine the compensation expense tobe reported in fiscal years 2010, 2011,2012, and 2013 for Mr. Avery’s 2010 stockoption award.

In Exhibit 4, we calculate the amount ofcompensation expense in each year as thehigher of either 1) straight-line over theremaining period until fully vested, or 2)based on the portion of the award vestedto date, less any previously recognizedexpense. ASC Topic 718-20-35-8 requiresthat compensation cost recognized at anydate must be at least equal to the amountattributable to options that are vested at thatdate. This is not required under IFRS 2because straight-line attribution is notallowed.

Simulation 2 Stock options with graded vesting using

graded vesting attribution. This method isallowed by both U.S. GAAP (ASC 718)and IFRS 2. This method treats each vest-ing portion of the award as a separateaward. Simulation problem: Use the sameproblem as in Simulation 1.

Step 1: expected life. Determine theexpected life and number of options foreach vesting portion of the award as if eachportion was a separate award. Each vest-ing portion is referred to as a tranche.(See Exhibit 5.)

Step 2: fair market value. Compute thefair-market value for each tranche usingthe Black-Scholes Option Pricing Model,the weight-average expected lives from Step1, the number of options from Step 1, andthe other Black-Scholes input variablesgiven in the problem. (See Exhibit 6.)

Step 3: compensation expense. Calculatethe compensation expense for each year.(See Exhibit 7.)

Key DifferencesThe simulations offered here highlight the

major differences between graded vestingand straight-line attribution methods whenapplied to a stock option award with agraded vesting schedule. (For a summary,see Exhibit 8.) IFRS 2 allows only graded-vesting attribution, while ACS 718 allowseither straight-line or graded-vesting attri-

bution. Graded-vesting attribution, however,provides a conceptually better choice becausethe accelerated compensation expense cre-ated by overlapping tranches best relates tothe accelerated pattern of vesting (or pat-tern of service). The overlapping of tranch-es in the earlier years causes accelerated

compensation expense similar to what weobserve with accelerated depreciation, ver-sus straight-line depreciation. In the earlyyears of the option grant, compensationexpense is higher than the straight-line attri-bution method, but in later years straight-linecatches up with the graded vested attributionmethod. However, over the vesting period,total compensation expense is similarbetween both straight-line and graded attri-bution methods. Compensation expense willdiffer because the fair value for acceleratedattribution is based on the sum of fair val-ues for each tranche, whereas for GAAP—utilizing straight-line attribution—the fairvalue is based on the total award.

These differences have implications forinterperiod financial statement analysis, asprofitability analysis such as return on invest-ment and return on equity ratios is poten-tially understated for firms’ using gradedvested attribution over those firms usingstraight-line attribution, especially in the ear-lier years of the vesting schedule. Moreover,cash flows and deferred taxes are impactedas well. It behooves managers to carefullyconsider the impact that choosing onemethod over the other has for financialreporting and disclosure purposes. ❑

David G. DeBoskey, PhD, CPA, is anassistant professor and the KPMG FacultyFellow, and Kevin M. Lightner, PhD, isa professor emeritus, both at the CharlesW. Lamden School of Accountancy at SanDiego State University, San Diego, Calif.


Compensation Expense Comparison

Compensation Year 1 Year 2 Year 3 Year 4 Total

Expense

IFRS 2 (Graded Vesting $241,502 $169,220 $82,372 $52,170 $545,262Attribution Method)

ASC 718 (Straight-Line $139,745 $167,393 $125,545 $125,545 $557,978Attribution Method)

Difference1 $101,757 $1,827 $(43,173) $(73,575) $(12,716)

1. A positive (negative) number indicates compensation expense is higher (lower)under IFRS 2 application.

EXHIBIT 8Comparison of Stock Compensation Expense

It behooves managers to carefully

consider the impact that

choosing one method over the

other has for financial reporting

and disclosure purposes.


By Robert S. Barnett

Losses and credits attributable to pas-sive activities are limited underInternal Revenue Code (IRC) sec-

tion 469. Such losses and credits are lim-ited to the income associated with thepassive activities, and any excess losses aresuspended and carried forward to subse-quent years (IRC section 469[a][1],[b]). Apassive activity is any activity involvingthe conduct of a trade or business in whichthe taxpayer does not materially participate.Material participation requires regular, con-tinuous, and substantial involvement in theoperations of the activity (IRC section469[h][1]).

These suspended losses can be utilizedto offset other passive income. In addition,they may offset non-passive income if a tax-payer disposes of the entire passive activityduring the tax year in a taxable transaction(IRC section 469[g]). The loss is then treat-ed as one that does not result from a pas-sive activity. Therefore, determining whatconstitutes the entire passive activity isextremely important; if the taxpayer dispos-es less than the entire activity, the lossesremain suspended and passive.

BackgroundTreasury Regulations section 1.469-4

provides rules for grouping activities forthe purpose of applying the passive activ-ity loss rules. These rules provide that “oneor more trade or business activities or rentalactivities may be treated as a single activ-ity if the activities constitute an appropri-ate economic unit for the measurement ofgain or loss purposes” (section 1.469-4[c][1]). Treasury Regulations section1.469-4(c)(2) provides guidelines for deter-mining when a taxpayer can group activ-ities together as a single unit. The regula-tions adopt a “facts and circumstances”approach to determine appropriate combi-

nations. Such circumstances include busi-ness similarity, common control, location,business interaction, and customers.

A partnership, C corporation, or S cor-poration that is subject to these rules mustindependently group its activities. Theshareholder or partner may then groupthose activities with each other or withother activities conducted directly by theshareholder or partner. The group’s lossesmay offset related income and gains; how-

ever, such benefits of a grouping may belost if a member disposes of less than theentire group because suspended losses willnot be realized.

Once a taxpayer has grouped activities,the taxpayer generally may not regroup insubsequent years. But if it is later deter-mined that the taxpayer’s original group-ing is “clearly inappropriate,” or if thereis a material change in the facts and cir-cumstances that makes the original

Revenue Procedure 2010-13 Provides Guidancefor Passive Activity Groupings

T A X A T I O N

f e d e r a l t a x a t i o n

grouping clearly inappropriate, the taxpayermust regroup, and comply with the dis-closure requirements (Treasury Regulationssection 1.469-4[e][2]). The IRS may sim-ilarly regroup a taxpayer’s activities inorder to prevent tax avoidance (TreasuryRegulation section 1.469-4[f]).

New GuidanceA recently issued IRS pronouncement,

Revenue Procedure 2010-13, requires tax-payers to report groupings that occur dur-ing taxable years beginning on or afterJanuary 29, 2010. Taxpayers must file awritten statement with their income taxreturn for the first taxable year in whichthey group two or more activities as asingle activity (or make new additions toexisting groupings). The taxpayer mustreveal names, addresses and employeridentification numbers, as well as declarethat the grouped activities “constitute anappropriate economic unit for the mea-surement of gain or loss for purposes of[IRC] section 469” (Revenue Procedure2010-13, part 4). Similar requirementsapply for regroupings due to inappropri-ate groupings or material changes.Partnerships and S corporations must reportgroupings on Schedule K-1. Reporting isgenerally not required for previously report-ed groupings (Revenue Procedure 2010-13, sections .04, .05).

Perhaps the most important part of thenew procedure is the section describingprior failures to report. Many taxpayers areinvolved in multiple rental or businessactivities, but have failed to group themwith related activities. As a result, eachactivity is treated separately for purposesof applying the passive activity loss uti-lization rules described above; this mayresult in extreme hardship for some tax-payers. Revenue Procedure 2010-13 (part4, section 07) contains a safety feature forsome taxpayers that states: “A timely dis-closure shall be deemed made by a tax-payer who has filed all affected income taxreturns consistent with the claimed group-ing of activities and makes the required dis-closure on the income tax return for theyear in which the failure to disclose isfirst discovered by the taxpayer.” But if theIRS first discovers the failure, the taxpay-er must show reasonable cause for the fail-ure to disclose. Because RevenueProcedure 2010-13 provides relief provi-

sions, relief is not available under the pro-visions in Treasury Regulations section301.9100-1(d)(2).

Implications for Real Estate Professionals

It is worth noting that the safety featurefor a late election for real estate profes-sionals, as described in IRC section469(c)(7), is currently not available. Thoseindividuals must still apply for a late elec-tion by means of a private letter ruling.

This distinction is extremely importantbecause rental activities are generallyconsidered passive regardless of the par-ticipation threshold. IRC section 469(i) pro-vides a $25,000 exception within limitedincome limits if the taxpayer materiallyparticipates in the real estate rental activi-ty. Qualifying real estate professionals,however, are permitted to treat rental realestate losses as non-passive (IRC section469[c][7]). This allows such a taxpayer’spassive losses to offset active income. Realestate professionals must meet the follow-ing tests:■ More than half of the personal servicesperformed in trades or businesses by the tax-payer during such taxable year are performedin real property trades or businesses in whichthe taxpayer materially participates.■ Such taxpayer performs more than 750hours of services during the taxable yearin real property trades or business in whichthe taxpayer materially participates.

Such real property trades or businessesinclude development and construction,acquisition and conversion, rental and leas-ing, management, and brokerage. It isimportant to note that unless a taxpayer

makes an election to group all rental realestate as a single activity, the materialparticipation requirement must be inde-pendently met with respect to each inter-est in rental real estate. This may requirethat the taxpayer prove at least 500 hoursof participation in each rental activity.

The IRS places a heavy burden of proofupon taxpayers claiming such status. A tax-payer with several rental activities may findit impossible to meet this hurdle. A recentcase, Anjum Shiekh v. Comm’r (TCM2010-126), confirms that merely includ-ing such activities on Schedule E of Form1040 is not sufficient. The taxpayer mustfile the activity grouping election as a state-ment with the income tax return initiallyclaiming such benefits. Such election maybe stated as follows: “Taxpayer X, SSN123-45-6789, is a qualifying taxpayer andhereby elects pursuant to IRC section469(c)(7)(A) to treat all interest in rentalreal estate as one activity.”

Qualified real estate professionals whofail to make the grouping election may notcurrently rely on the safe harbor reportingprovision of Revenue Procedure 2010-13.Such taxpayers must apply by means of aprivate revenue ruling request. PrivateLetter Ruling 2010271018, issued on July 9, 2010, indicates that the IRS is will-ing to grant positive acceptance withrespect to prior returns that omitted therequired election statement. The taxpayermust promptly request such ruling in good faith, and the grant of such relief must notprejudice the government’s interest.Reasonable reliance on a tax professionalemployed by the taxpayer who failed toeither make or provide advice with respectto the election will generally be sufficientfor this purpose.

But a private letter ruling request is timeconsuming and expensive. The author hashad informal discussions with a memberof the IRS’s Chief Counsel’s Office, whoindicated that there are thoughts of expand-ing the late disclosure provisions of thenotice to include real estate professionals,which would be a welcome change. ❑

Robert S. Barnett, CPA, JD, MS, a found-ing partner of Capell Barnett Matalon & Schoenfeld LLP, in Jericho, N.Y.,heads the company’s tax and estate plan-ning departments.


Each activity is treated separately for

purposes of applying the passive

activity loss utilization rules described

above; this may result in extreme

hardship for some taxpayers.


By Rahnuma Ahsan

With a 9.2% unemployment rateand increasing default rates, cred-it risk management has become

more difficult than ever. In October 2009,Bloomberg reported that the number of U.S.lenders with a 20% default rate is at an 18-year high. For commercial real estate mort-gages, the default rate during the first quar-ter of 2010 (4.17%) was at its highest levelsince 1992, and this figure does not includebank-held mortgages on apartment buildings.In February 2009, the Obama administrationlaunched a Home Affordable ModificationProgram (HAMP) to assist defaulting realestate borrowers. In June 2010, the WallStreet Journal reported that the redefault ratewithin one year under HAMP, predicted byFitch Ratings Ltd., would be 65% to 75%.These disparate perspectives of the credit cri-sis draw a challenging picture for overallcredit risk management.

In contrast, Grameen America, a non-profit microfinance institute and affiliate ofBangladeshi microfinance instituteGrameen Bank, reported a 99% loan repay-ment rate from 2008 to 2010. The differ-ence in the repayment rate of GrameenAmerica compared to other lenders maybe attributed to Grameen’s lending meth-ods, as well as the size and types ofloans. Grameen America lends to high-riskborrowers who generally earn less than$11,000 annually, do not have any collat-eral, do not have a prior credit history, andhave been ignored by commercial andretail banks.

Grameen America’s high repaymentrecord with these borrowers has beenattributed to its group-lending or peer-lending methodology. Peer lending is oneof the major contributions of the originalGrameen Bank model, which wasdesigned after trial and error in the vil-lages of Bangladesh in the 1970s. Underthe initial Grameen model, which was

used until 2001, borrowers formed theirown groups (social collateral), elected agroup leader, and were responsible foreach group member’s loan amount (jointand individual liability). In case of defaultby one borrower, each member of the

group was responsible for repayment.After the full loan was repaid on time, thegroup could apply for a higher amount(repayment incentives). If one member ofthe group defaulted, none of the groupmembers could apply for any future loans(lowers strategic default). Since 2001,Grameen has implemented a modifiedpeer-lending model whereby the borrow-ers still form their own groups and mustcontinue to support each other’s projects,but are no longer jointly liable for eachother’s payments. As the borrowersreceive the loan as a group, however,this modified peer-lending approach stillenforces and establishes social collateralconditions. Under this model, GrameenBank has reported a 95% to 99% loanrepayment rate since 1976.

Peer Lending in the United StatesDuring the 1980s and 1990s, the peer-

lending model was replicated in the UnitedStates with mixed results. According to a1999 report by Michael Conlin, the defaultrate for these projects ranged from 3% to

40%, and some of the projects were unsus-tainable and failed to reach their goals com-pletely (“Peer Group Micro-LendingPrograms in Canada and the United States,”Journal of Development Economics, vol. 60,no. 1, October 1999, pp. 249–269). Forinstance, the Good Faith Fund of SouthernDevelopment Bancorporation in Arkansashad a 40% default rate in the first two yearsand after modification of its lending method,the default rate decreased to 3% in thethird year. The Women’s Self EmploymentProject (WESP), a nonprofit affiliate ofSouth Shore Bank in Chicago, had a loandefault rate of 5% but spent more on over-head and administrative costs than it loaned.The Women’s Economic DevelopmentCompany (WEDCo) in Minneapolis,Minnesota, and the South Madison

Cultural Aspects of Credit Risk Management

F I N A N C E

b a n k i n g

A Lesson from the Microfinance Industry

Neighborhood Housing Service in Madison,Wisconsin, terminated their programswithin a few years due to limited success.

In 2008, Grameen Bank opened the non-profit entity Grameen America in Queens,N.Y. Unlike the previous experience ofother U.S. peer-lending models, GrameenAmerica has thrived since its beginning.By August 2010, Grameen America had4,048 borrowers, disbursed $9.1 million inloans, opened three new branches, and hadplans to open branches in seven otherstates. The suitability of the Grameen peer-lending model in the United States hasengendered much debate. The GrameenAmerica website states, “Grameen micro-credit programs have succeeded all overthe world, demonstrating that the conceptof credit as a basic human right transferseasily across cultures. We have notchanged the Grameen group-lending modelat all; the only difference is the averageloan size.”

History of GrameenGrameen Bank started its journey in 1976

when the founder, Muhammad Yunus,then a professor at the University ofChittagong, Bangladesh, loaned $27 fromhis own pocket to 42 people in the tinyBangladeshi village of Jobra. The first groupof borrowers repaid the small loanspromptly and inspired Yunus to establish theGrameen Bank Project. Gradually, this pro-ject evolved into a bank and spread among81,000 villages in Bangladesh, reaching 8.1 million borrowers within 34 years. Yunuscrafted and perfected the peer-lending modelover time. In retrospect, the cultural charac-teristics embedded in Bangladeshi societymight have paved the way for peer-lendingmethodology. Bangladeshi culture valuescollective decision making more than indi-vidual decision making and accepts the highpower distance among members of society.A power-distance dimension indicates theextent to which the less-powerful membersof organizations and institutions (like thefamily) accept and expect that power is dis-tributed unequally. For instance, a power-distance index (PDI) rating of 80 indicatesa high level of perception of inequality ofpower and wealth and acknowledgementof hierarchy within a society. In an envi-ronment where the loan officer does not havesufficient information about the credit wor-thiness of the borrower, this collective behav-

ior and perception of high power distancerooted in the culture could help to establishsocial collateral.

In Grameen America, the majority ofborrowers are immigrants from LatinAmerican countries such as Mexico, PuertoRico, Guatemala, and Ecuador. Some ofthe cultural characteristics of these coun-tries are significantly similar to that ofBangladesh. For instance, Latin Americancultures value collective decision makingand have similar acceptance of inequalitywithin their societies. Because of these cul-tural similarities, the methods that havebeen successful in Bangladesh have alsobeen successful in similar cultures. Amongother factors, cultural orientation and teach-ing can shape how an individual manageshis personal finances and how he inter-

acts within a group setting. A lendingsystem designed around the distinct cul-tural elements of the borrowers might helpachieve two things: First, the familiaraspects of the methodology would makethe borrower comfortable with the sys-tem, and second, it would help the creditmanager manage the loan portfolio betterin terms of reducing the credit default rate.

Value DimensionsDutch social psychologist Geert

Hofstede, who conducted a pioneeringstudy of cultures, classified the valuesthat distinguish countries from one anoth-er into four clusters: individualism (IDV,the relationship of the individual with hisprimary group), power distance index (PDI,ways of coping with inequality), uncer-


EXHIBIT 1Hofstede’s Cultural Value Dimensions for Bangladesh and the United States

U.S. Bangladesh91

2040

8062 55

4660

IDV PDI MAS UAI

EXHIBIT 2Hofsted’s Individulism Dimension Score for Latin American Countries,

Bangladesh, and the United States

VenezuelaPeru

PanamaMexico

GuatemalaEl Salvador

EcuadorCosta Rica

ColombiaBangladesh

U.S.

0 10 20 30 40 50 60 70 80 90 100

1216

1130

619

815

1320

Source: www.geert-hofstede.com/geert_hofstede_resources.shtml

91


tainty avoidance (UAI, ways of copingwith uncertainty), and masculinity (MAS,the emotional implications of gender).Subsequently, two other value dimensionswere added—long-term orientation andindulgence versus restraint—and thesevalue dimensions were replicated in sixinternational studies. In the past threedecades, Hofstede’s value dimensions havebeen extensively applied in business andmarket research.

According to Hofstede’s value dimen-sions, Bangladesh scores low in individu-alism—20 out of 100. This reflects the collective behavior of Bangladeshis in deci-sion making: Decisions are made as a

group and group improvement is empha-sized over individual self-actualization. Thepeer-lending model, where all borrowersare responsible for each other’s repayment,is a natural fit for Bangladeshi culture. Ahigh sense of collectivism that is ingrainedin this culture ensures joint responsibility,promotes social collateral, and results in ahigh repayment rate.

Conversely, the individualism score forthe United States is high—91 out of 100—where individual decision making is empha-sized. A significant difference is present inthe power distance value score as well—the United States scores 40, Bangladeshscores 80. These differences show that by

bringing the Grameen peer-lending modelfrom Bangladesh to the United States,Grameen has imported the model from ahighly collective, high–power-distance cul-ture to a highly individualist, low–power-distance culture. These cultural differencesmight be the reasons for the dismal resultsof the earlier peer-lending efforts in theUnited States. In a country where individ-uality is nurtured, making borrowersresponsible for each other’s loan repaymentmight create more problems than solutions.Interestingly, there isn’t much difference inUAI or MAS scores between these two cul-tures (Exhibit 1).

If we compare the cultural value dimen-sions of Bangladesh with those of someLatin American countries (i.e., the cultureof Grameen America borrowers), a patternemerges (Exhibit 2). All the LatinAmerican countries have individualismscores of less than 31, with the highestscore of 30 for Mexico and lowest scoreof 6 for Guatemala. The average of theindividualism score for Latin Americancountries is 14.44, whereas Bangladesh’sscore is 20. This high collectivism (lowindividualism) means that people in thesesocieties are integrated into strong, cohe-sive groups, which continue to protect themin exchange for unquestioning loyalty.Collectivism (the opposite of individual-ism) is a fundamental social value, whichforms individual values, norms, and behav-ior, and eventually can evoke and ensuregroup loyalty in the peer-lending model.

We see a similar pattern in the power dis-tance dimension score of the borrowers’ cul-tures and Bangladeshi culture (Exhibit 3).The PDI scores range from a low of 35 forCosta Rica to a high of 95 for Guatemalaand Panama. The average PDI score forthese Latin American countries is 73.5,whereas Bangladesh scores 80 and theUnited States scores 40. In a group of bor-rowers with a hierarchical structure, a highpower-distance rating ensures high social col-lateral, which generally leads to a high repay-ment rate. The similarity in power distancescores for Latin American countries andBangladesh might have worked as anotherthrust for successfully applying the samepeer-lending model across cultures.

In essence, Grameen has brought theoriginal peer-lending model fromBangladesh to the United States and thensuccessfully identified the target group that

EXHIBIT 3Power-Distance Dimension Score for Latin American Countries,

Bangladesh, and the United States


EXHIBIT 4Individualism and Power-Distance Scores for the Countries

with Grameen Replication BOT and BOO Projects

40


8067

35

7866

9581

95

6481

U.S.

Bangladesh

Colombia

Costa Rica

Ecuador

El Salva

dor

Guatemala

Mexico

PanamaPeru

Venezuela

Turkey

Zambia

Costa Rica

Guatemala

IndonesiaChina

India

Colombia

Bangladesh

Mexico

66 6435

9578 80 77 81 67 80

37 27 15 6 14 2048

3013 20

Source: www.grameentrust.org/bot.html and www.geert-hofstede.com/geert_hofstede_resources.shtml

IDV PDI

would be able to best adapt to its model.In the end, this strategic fit of the model’sstructure with its client’s culture has helpedGrameen America achieve its 99% repay-ment rate. Grameen America’s continuedsuccess with its repayment rate using thepeer-lending method is proof of the impor-tance of understanding and appreciatingcultural differences and utilizing the cul-tural components to design lending meth-ods and practices.

In addition to the United States, Grameenhas replicated its microfinance model in 37countries with or without local partners. Itreplicated its model through Grameen Trust’sReplication program, and the projects arecategorized into Build, Operate, and Transfer(BOT) and Build, Operate, and Own (BOO)groups. Grameen projects have continued toshow the same high results for repayment—98% to 100%. The individualism and power-distance value dimensions of the countrieswhere Grameen has its BOT or BOO pro-jects show familiar patterns. The countrieswith Grameen projects (Exhibit 4) have rel-atively low individualism scores and rela-tively high power-distance scores. The indi-vidualism scores range from 6 for Guatemalato 48 for India, with an average of 23.33.For the power-distance dimensions, otherthan Costa Rica’s score of 35, the score forothers range from 64 for Zambia to 95 forGuatemala. The peer-lending model’s strate-gic fit with the low individualism,high–power-distance cultural componentsmight be the propelling force behindGrameen’s worldwide success.

Lessons to Be LearnedCredit managers working with multicul-

tural clientele have much to learn fromGrameen’s experience. Grameen’s storysuggests that for low individualism,high–power-distance cultures, the peer-lend-ing model can successfully garner a highrepayment rate. More importantly, Grameenhas done what U.S. commercial and retailbanks have failed to do: During the worst eco-nomic crisis in decades, Grameen Americahas extended loans to high-risk customers inAmerica and managed to achieve and main-tain a high repayment record by focusing onthose clients whose cultural orientation bestfits its model.

Culture is a dynamic process. Doesthis mean Grameen will become irrele-vant in an increasingly individualist

society? Grameen must have thoughtabout this shift, because since 2002Grameen has tested and implemented amore flexible lending method inBangladesh. Under Grameen II, the newermodel, a borrower’s capacity to borrowin the future would depend on her indi-vidual repayment record, not on the grouprepayment history. Perhaps Grameen is

getting ready to address the more indi-vidualist sections of society and extend itsreach to other markets. ❑

Rahnuma Ahsan, PhD, MBA, is an assis-tant professor of accounting and financeat York College, the City University of NewYork, Jamaica, N.Y.


Reacting to a Changing Landscape: Implementing New Compliance and Regulatory Procedures

Wednesday, August 24, 2011

New York Marriott Marquis at Times SquareAlso Available via Live Webcast

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Hedge Funds andAlternative Investments

Con fe r ence

The Sarbanes-Oxley Act of 2002 (SOX)shortened the maximum allowable peri-od an audit partner may serve on a U.S.publicly traded company’s audit

engagement from seven years to five yearsand lengthened the minimal allowable cool-ing-off period from two years to five years.Since adoption of the revisions, concerns havebeen raised about the potential erosion ofclient-specific and industry knowledge result-ing from mandatory audit partner rotation andthe resulting potential negative impact onaudit quality and financial reporting quality(U.S. Department of the Treasury, AdvisoryCommittee on the Auditing Profession[ACAP], February 4, 2008 meeting). Theseconcerns are potentially due to auditengagement partners requiring two to threeyears to fully familiarize themselves withclient-specific issues, processes, and con-trols on newly assigned audit engagements(Brian Daugherty, Denise Dickins, and JuliaHiggs, “Mandatory Audit Partner Rotation:Partners’ Perceptions of Impacts on Qualityof Life and Audit Quality,” working paperpresented at the American AccountingAssociation’s annual meeting, August 2010).

In this article, the authors report theresults of a survey of audit partners sub-ject to the rotation rules. Their views aboutthe impact of rotation on audit qualityand mechanisms they have adopted tocompensate for the potential negativeimpact of rotation on audit quality are sum-marized. In doing so, possible unintendedconsequences of audit partner rotation areidentified, as well as practices that may par-tially negate the spirit of SOX mandates.

Mandatory Audit Partner RotationSOX requires that auditors serve as lead

engagement partner or concurring/quality

control partner of an audit of a publicly trad-ed company for no more than five consecutiveyears. Once rotating off, partners must observea minimum five-year cooling-off period beforereturning to the audit engagement. Technical,national, or other specialty partners servingaudits of publicly traded companies are exemptfrom these rotation requirements. Prior to SOX,the AICPA’s Securities and ExchangeCommission Practice Section required only thelead audit partner to rotate off audits of pub-licly traded companies after seven consecu-tive years of service, and required only a two-year cooling-off period before the partner couldbe reassigned to the audit engagement (AICPA,“Comments on SEC’s Proposed Rules toEnhance Independence of AccountingProfession,” 2003; SEC, “Strengthening theCommission’s Requirements RegardingAuditor Independence,” 2003).

Benefits of rotation include the opportu-nity for a “fresh look” at audit issues and

engagement risk, and the possibility ofenhanced auditor independence (in fact andin appearance). Auditing firms likely rec-ognize the benefits of periodic engage-ment personnel rotation, evidenced by thepolicies of some to require engagementpartner rotation even for audits of private-ly held companies. However, the benefitsof rotation must be balanced against thepotential negative impact of the loss ofclient-specific engagement knowledge onaudit quality.

It is likely auditors have taken steps tomitigate these potential negative effects,protect their reputations, and minimizeassociated economic damages by imple-menting mechanisms that facilitate auditpartner rotation. To gather informationabout these mechanisms, the authors dis-tributed surveys to 370 practicing auditpartners from 14 audit firms, representingapproximately 40 distinct practice office

Reducing the Potential Negative Effectsof Mandatory Partner Rotation

M A N A G E M E N T

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


By Brian Daugherty, Denise Dickins,and Julia Higgs


locations of varying size. Of the surveysdistributed, 170 (46% response rate) werereturned. All participants had public com-pany audit experience with audit firms subject to mandatory partner rotation.Exhibit 1 provides demographic data of thepartners participating in the survey.

Participants averaged 47 years of ageand have been audit partners for approxi-mately 11 years. Approximately 22% areemployed by Big Four accounting firms,and 73% are employed by the eight largest(Big Four and the next four) U.S. account-ing firms. Participants conduct their workin offices averaging 11 partners.

Perceptions of Mandatory RotationBelow, we report partner participants’

beliefs about the impact of rotation on auditquality and the audit firm, and mechanismsemployed to reduce the potential negativeeffects of rotation and successor audit part-ners’ client familiarization period.Responses relevant to perceptions about theimpact of mandatory partner rotation onaudit quality are presented in Exhibit 2.

Measured on a 7-point scale where 1 = strongly disagree, 4 = neutral, and 7 = strongly agree, surveyed partners, in gen-eral, are neutral in their perceptions regard-ing the impact of mandatory rotation on auditquality. However, they believe the SOX-man-dated rotation changes placed additional bur-dens on the audit firm. Interestingly, exam-ining differences based on firm size, theperceived negative impact of rotation on auditquality and audit firm burdens (includingSOX changes) increases with audit firmsize and varies significantly between thelargest (Big Four) and smallest (Other) firms.That is, audit partners of larger firms are morelikely to believe rotation negatively impactsaudit quality and is more of a burden thando audit partners of smaller firms. Results donot vary significantly based on office size. Itmay be that smaller firms have fewerclients subject to the rotation rules as a per-centage of their entire (firmwide orofficewide) practice and, therefore, do notperceive the rules as being as burdensome aslarger firms do. It is also possible that somesmaller firms may focus on niche industries,so that the potential successor partners havedesired industry expertise.

Written comments from surveyed part-ners are expressive of their concerns about

the burdens of rotation. For example, onepartner commented that the initial year ofrotation is most difficult, diminishes asthe partner learns the client’s unique char-acteristics, and is offset to a degree by con-sulting with the prior partner for their per-spectives prior to transition. Anothercommented that the rotation cooling-offperiod puts more strain on quality reviewpartners than engagement partners, as theyserve more clients.

Somewhat in contrast, and indicative thatsome auditing firms (particularly, but not sole-ly, the Big Four) perceive value in periodicrotation, 22.5% of survey participants report-ed their firms have rotation requirements foraudits of privately held companies, eventhough these companies are not covered inthe rotation mandate. On average, auditingfirms imposing these requirements haveadopted a nine-year rotation policy.

Minimizing the ImpactSurvey statements and participants’

responses describing certain mechanismsdesigned to minimize the impact of manda-tory rotation are presented in Exhibit 3.

Partners reported an average of 1.64 yearsof internal planning in advance of rotation.Further, 54.3% reported requiring at least twoyears of internal planning. Preplanning coordination with clients occurs, on average,1.15 years in advance of rotation, with only22.1% of partners reporting requiring at leasttwo years. Preplanning times did not differ sig-nificantly based on audit firm size or office size.

Written comments support these data.Example comments report better trackingof requirements by partner as comparedto the pre-SOX era, involvement of the to-be-assigned partner in understanding issuesand audit approach perspective during theyear prior to rotation, and continuedinvolvement of the former partner in thequality control process (including planningthe audit following rotation). These com-ments suggest the time a partner is asso-ciated with a client engagement may be upto as many as seven years—one yearprior to becoming the “official” leadengagement partner, five years as the leadengagement partner, and one year afterrotating off the audit engagement. Whilethis continuing influence of a single audit

Big Four Midsizea Otherb Total n = 37 n = 86 n = 47 n = 170

MeanAge, Expertise, and ExperienceAge in years (n = 167) 44.6 47.8 46.3 46.7 Years as an audit partner (n = 167) 9.4 11.9 10.2 10.9 Calculated age at partner (n = 167) 35.2 35.9 36.1 35.8 # of expert industries (n = 166) 2.1 2.8 2.5 2.6 # of lead partner public-company 2.1 2.1 0.64 1.7audits last year (n = 166)# of concurring partner public- 1.5 2.5 0.73 1.8 company audits last year (n = 166)# of audit partners locally (n = 165) 21.2 8.1 8.4 11.0

PercentageFirm type (n = 170) 21.8% 50.6% 27.6% 100.0%Response rate (n = 170) 56.1% 45.7% 40.5%

Female Male TotalGender (n = 166) 20.0% 80.0% 100.0%a. BDO Seidman, Crowe Horwath, Grant Thornton, and McGladrey & Pullen.b. All other firms, primarily the top 25 firms not categorized as Big Four or Midsize.

EXHIBIT 1Demographic Data of Surveyed Audit Partners


partner may serve to minimize theamount of lost client experience, it also cir-cumvents the spirit of the SOX rotationmandate, and may negate the newlyassigned lead engagement partner’s abili-ty to take a fresh look at audit risks andengagement issues.

Since it is likely these rotation-facil-itating mechanisms were in place prior

to SOX, the real benefit of SOX changesmay have been in extending the cool-ing-off period. Recall that prior to SOX,lead engagement partners could serve onan audit engagement for up to sevenyears and were required to cool off twoyears, suggesting that the primary leadengagement partner’s involvement andinfluence may have been substantial

throughout the pre-SOX cooling-offperiod.

One partner was particularly descrip-tive of his audit firms’ processes, statingthat planning for rotation to find the rightpartners begins about three years before therotation and includes having the clientinterview possible candidates. Partnersare required to educate themselves aboutnew industries and clients, and all rotationpartners have to be approved by hisfirm’s regional technical partners.Another partner wrote that partners whowill be rotating onto audit engagements areusually kept aware of issues and signifi-cant audit and accounting judgments, andparticipate in significant meetings withthe client and audit committee to build rela-tionships. This partner emphasized man-ager/senior manager retention through part-ner transition to the extent possible.

Measured on a 7-point scale where 1 = strongly disagree, 4 = neutral, and 7 = strongly agree, surveyed partners believeaudit quality is higher when the engagementpartner and quality review partner rotationsare staggered. Partners nearly unanimouslyreported a mechanism key to maintainingaudit quality during engagement partner rota-tion was not having a concurrent qualityreview partner change. Example commentsincluded that the concurring partner doesn’tchange in the year of partner rotation, andthat concurring partners are generally rotat-ed one or two years before the lead partnerchanges to provide continuity. Sometimes,the concurring partner then becomes the leadpartner, while in other circumstances, theconcurring partner remains in the concurringpartner role for the remainder of the fiveyears. It should be noted that years servedboth as lead or concurring partner counttoward the five-year tenure limit imposed bySOX. Like other rotation-facilitating mech-anisms, while these practices reduce the like-lihood of lost client-specific engagementknowledge, they also reduce the benefitsassociated with a fresh look, and may not bein the spirit of the SOX rotation mandate.

Coordinating skill sets of engagementand concurring partners was also empha-sized. As one partner wrote, lead andconcurring partners are tracked by engage-ment and region, with a focus on engage-ments requiring specialized industry exper-tise. These findings are consistent withthe Center for Audit Quality’s (CAQ)

Mean Difference Endpoints, (standard from

Statement Midpoint deviation) Neutrala

1. Periodic audit engagement 1 = Strongly Disagree 4.08 (1.45) 0.08partner rotation increases the 4 = Neutralrisk that audit quality will decline. 7 = Strongly Agree2. Periodic audit engagement 1 = Strongly Disagree 4.09 (1.43) 0.09partner rotation decreases audit 4 = Neutral quality because the rotation 7 = Strongly Agreeplaces additional burdens onthe audit firm.3. The change from the 7- to 1 = Strongly Disagree 4.86 (1.59) 0.86b

5-year partner rotation 4 = Neutralrequirement has created 7 = Strongly Agreehardships in managing audit partner assignments in mylocal office.4. The change from the 2- to 1 = Strongly Disagree 4.88 (1.52)0. 88b

5-year cooling-off period has 4 = Neutral created hardships in managing 7 = Strongly Agreeaudit partner assignments in mylocal office.

PercentageMean Selecting

Question Scale (std. dev.) “Yes” 5. Does your firm have a Yes 22.50mandatory audit partner rotation Nopolicy for nonpublic clients?6. If the answer to the previous Number of Years 8.97question was yes, what is the (2.21)maximum period of time an audit engagement partner may serve a nonpublic client?a. Difference from neutral value of 4.b. Denotes significance at p < 0.001 (two-tailed).Note: The number of responses for the individual statements may be less than theoverall number of partners responding (n = 170) due to responses left blank.Difference values in parentheses indicate disagreement, while nonparentheticalvalues indicate agreement, relative to neutral.

EXHIBIT 2Impact of Rotation on Audit Quality and the Audit Firm


observation that concurring/quality controlpartners bring deep industry expertise to anaudit engagement and play an importantrole in the overall quality of public com-pany audits (“Discussion Outline forConsideration by the Advisory Committeeon the Auditing Profession,” 2008).

Although results of prior research suggestclient experience and industry expertise aretwo of the most important audit partner char-acteristics contributing to audit quality (J. V.Carcello, D. R. Hermanson, and N. T.McGrath, “Audit Quality Attributes: ThePerceptions of Audit Partners, Preparers, andFinancial Statement Users,” Auditing: AJournal of Practice & Theory, 1992, vol. 11,no. 1), more than one-half of surveyedpartners report having to learn a new indus-try to satisfy an audit partner rotation require-ment (not tabulated). Further, audit partnersin the smaller firms surveyed were signifi-cantly more likely to have to learn a newindustry. This finding is consistent with thoseof other studies that suggest smaller audit-ing firms may have been disproportionatelynegatively impacted by SOX mandates ingeneral. For example, more trienniallyinspected auditors (smaller auditing firms)resign from their publicly traded clients orcease to be registered with the PCAOB fol-lowing receipt of PCAOB inspection defi-ciencies (Brian Daugherty, Denise Dickins,and Wayne Tervo, “Negative PCAOBInspections of Triennially Inspected Auditorsand Involuntary Client Losses,” Journal ofInternational Auditing, vol. 15, no. 2, 2011).

ImplicationsResults of the authors’ survey suggest

that audit partners share the concernsexpressed during testimony heard by theACAP about the potential negative effectsof the accelerated rotation and extendedcooling-off periods mandated by SOX.Results also indicate mechanisms areemployed to minimize the negativeimpacts of rotation to the extent possible.Specifically, auditors recognize the impor-tance of detailed tracking of rotationrequirements by partner and client,avoiding concurrent engagement partnerand quality review partner changes, pre-planning engagement partner changes well in advance of rotation, and minimiz-ing changes of other engagement teammembers in the year of rotation. One part-ner summarized this process saying,

“Coordination of outgoing, incoming part-ners is critical and time-consuming andultimately, is in the hands of those twopartners.” Somewhat ironically, andagainst the spirit of the rotation mandate,certain of these mechanisms may act toreduce the intended benefits of rotationas they extend the influence lead engage-ment partners have over newly assignedengagement partners.

Consistent with the results of other stud-ies that suggest certain SOX mandates mayhave had a disproportionately negativeimpact on smaller audit firms, acceleratedrotation may have more negative impactson smaller firms with fewer resources.These disproportionate impacts mayresult in an even greater concentration ofaudit services for publicly traded compa-nies. Currently, only auditing firms withfewer than five partners are exempt frommandatory audit partner rotation.

Regulators may want to considerchanges to the current rotation requirements

in order to address these issues. Thesechanges may include allowing an auditcommittee to justify extended partnertenures to shareholders, which would pro-vide companies flexibility, when it is nec-essary or desirable to have a partner on theengagement longer than five years, fur-ther extending the cooling-off period toreduce the likelihood that a singleengagement partner will continue to exertinfluence over an audit engagement, andincreasing the auditing firm size exemp-tion in order to reduce the possibility ofdisproportionate effects of rotation. ❑

Brian Daugherty, PhD, CPA, is anassistant professor at the University ofWisconsin–Milwaukee. Denise Dickins,PhD, CPA, CIA, is an assistant professorat East Carolina University, Greenville,N.C. Julia Higgs, PhD, CPA, is an asso-ciate professor at Florida AtlanticUniversity, Boca Raton, Fla.

Percentage Mean Selecting at(std. Least Two

Question Scale dev.) Years1. How far in advance is the transition Less than One Year 1.64 54.3of audit engagement partners to Five Years (.92)(required to comply with the mandatory rotation requirements) planned internally by your firm?2. How far in advance is the transition Less than One Year 1.15 22.1of audit engagement partners to Five Years (.75)(required to comply with the mandatory rotation requirements) coordinated with clients?

Mean Endpoints, (std. Difference

Statement Midpoint dev.) from Neutrala

3. Audit quality is higher when the 1 = Strongly 5.64 1.64b

audit engagement partner and Disagree (1.29) quality review (concurring) partner 4 = Neutral rotations are staggered. 7 = Strongly Agreea. Difference from neutral value of 4.b. Denotes significance at p < 0.001 (two-tailed).Note: The number of responses for the individual statements may be less than theoverall number of partners responding (n = 170) due to responses left blank.

EXHIBIT 3Audit Firm Mechanisms to Minimize Impact of Rotation

Professional life would be so muchsimpler if ethical issues were clear-cut. Professional life is not so sim-ple, however. Ethical and other pro-

fessional problems often present them-selves in unstructured and unfamiliar set-tings. The ability to recognize an ethicalissue is as important as the problem-solv-ing process that one engages in once anethical issue is raised. This article exploresthe benefits of a threats-and-safeguardsapproach to ethical issues. It then illustrateshow this approach might be applied tothe ethical challenges of performing auditsbelow cost.

Threats-and-Safeguards Approach to Ethics

The AICPA Professional EthicsExecutive Committee (PEEC) adopted athreats-and-safeguards approach as part ofits Conceptual Framework for AICPAIndependence Standards. In addition, thePEEC has approved a similar nonauthori-tative “Guide for Complying with Rules102-505,” which includes substantially allAICPA ethics rules other than indepen-dence. The AICPA threats-and-safeguardsapproach has been patterned after standardsdeveloped by the International EthicsStandards Board for Accountants (IESBA).

The broad-based threats-and-safeguardsconcept can be helpful in resolving avariety of ethical issues not explicitlycovered in codes of conduct. In an erathat puts a premium on professional judg-ment, it is impossible to define every pos-sible ethical threat. The public interest iswell served when practitioners recognizesignificant ethical risks and put appropri-ate safeguards in place to ensure that eth-

ical behavior and professional judgment arenot compromised.

When applying the threats-and-safe-guards approach, practitioners should viewpotential ethical issues from the perspec-tive of a reasonable and prudent personwho possesses both knowledge and expe-rience. It is important for practitioners tonot just view a situation from their own

personal perspective. Rather, they shouldconsider how a potential ethical threatwould be viewed by a reasonable andprudent member of the public.

It is important for practitioners to 1) rec-ognize threats to fundamental ethicalprinciples, 2) evaluate the significance ofthose threats, and 3) determine the appro-priate safeguards that might be put in place

Audit Fees and Engagement Profitability

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

e t h i c s


By Raymond N. Johnson and Gaylen R. Hansen

An Approach to Strengthen Compliance with Standards of Ethical Behavior


to reduce the threat to an acceptable level.If no safeguards are available to eliminatea threat or reduce it to an acceptablelevel, the CPA should not take the actionthat raises the ethical threat. TheConceptual Framework approach assistsprofessional accountants in complying withthe ethical requirements and meeting theirresponsibility to act in the public interest.

Audit Fees and ProfitabilityDoes a significant ethical threat arise

when an audit firm conducts an audit fora very low fee or performs an audit at aloss, or when an audit firm, office, orpartner is financially dependent on an indi-vidual client? This issue is a common dis-cussion topic among CPAs, who are underpressure not only to comply with theincreasing requirements of the public butalso to compete with other firms forwork. Accusations of lowballing and theiradverse impact on the public and the pro-fession have long been the “elephant in theroom” in discussions among practitioners,regulators, and private-sector standards set-ters wary of antitrust ramifications.Regardless of the reluctance, the time todeal with this issue has come.

Practitioners often cite business reasonsfor bidding audits at a loss. For example,some firms will bid audits at a loss to—■ keep audit staff busy during slow periods,■ gain entrance into an industry wherethe firm has not performed audits,■ gain entrance to a geographic marketwhere the firm has not performed audits,■ obtain access to members of an enti-ty’s board of directors in hopes of gainingadditional and more profitable work, or■ provide work for a not-for-profit orga-nization as a charitable contribution.

In addition, a firm may absorb a loss inan initial audit with the hope that theengagement will become profitable in thelong run.

Perhaps this issue is so difficult becauseit involves significant professional judgment.What happens, for example, when an auditfirm bids an audit for what it believes is areasonable fee but then encounters unex-pected problems, and the cost of additionalwork cannot be recovered from the auditclient? If the firm follows professional stan-dards, it may encounter a loss. Where doesthis fit into the discussion? And how do auditfirms balance the public interest in high-qual-

ity audits, when there is the private benefitto a CPA firm in performing an auditbelow the firm’s cost?

Further, it is easy for accountants to getsidetracked by debating the merits of dif-ferent methods of measuring the prof-itability of an engagement. Most auditfirms have their own methods of trackingengagement profitability. While some ofthese measures may differ, the nuances ofsuch a debate regarding how to measureengagement profitability are lost on a pub-lic that relies on reliable audited financialstatements. When viewed through thelens of the public, the key issues arewhether a firm identifies a very low-feeor below-cost audit as an ethical threat,whether it considers appropriate safeguards,and whether it takes appropriate action.

The remainder of this article focuseson three specific threats and the appropri-ate safeguards that might be put in placeto ensure that ethical principles are met.These are the threats that arise when—■ fees are too low to reasonably perform an engagement and comply withstandards;■ inadequate fees pose a threat to the sub-ordination of judgment, independence,integrity, and objectivity; and■ a firm, office, or partner is financiallydependent on an individual client.

Engaging in these fee-related activitiesis not by itself a violation of ethics; how-ever, appropriate safeguards need to be putin place to ensure that ethical principles arenot compromised.

When Low Fees Jeopardize StandardsAs noted above, there may be valid

reasons why firms may choose to bid avery low fee on an audit or attest engage-ment. But performing an engagement forfees inherently too low to allow the firmto reasonably comply with standards is asignificant threat to due professional careand compliance with professional stan-dards. A recent National Association ofState Boards of Accountancy (NASBA)discussion paper noted that board membershave cited low fees as a common denom-inator involving inadequate audit work(Gaylen Hansen, “Audit Fees andEngagement Profitability: A Threats andSafeguards Approach to StrengthenCompliance with Standards of EthicalBehavior,” 2010, www.nasba.org/

n a s b a w e b / N A S B A W e b . n s f / P S /8AA249A4EF682AB8862577F20057F232?OpenDocument). In addition, if auditmanagers are evaluated or compensatedwholly or partially based upon engagementrealization, and fees are quoted at a verylow level, an audit manager may be putin a position where it is difficult orimpossible to perform the work requiredby professional standards and at the sametime realize earnings aspirations. When feesare unreasonably low, some auditors assertthat they actually performed the work butdid not document it, leading to a failureto comply with professional standards.

When engaging in a discussion aboutengagement profitability, a number of audi-tors have expressed concern over auditsappearing to be profitable at the outset,only to subsequently discover more workthan expected needed to be done, that is,an engagement expected to be profitableturns into a loss. This is a vivid exampleof where a firm must recognize the risksand put compliance with ethical standardsabove engagement profitability. Whetherthe firm realized it or not, the threat wasidentified and appropriate safeguardswere applied.

It is important that an audit firm recog-nize the threat to due professional care andcompliance with professional standards atthe outset of an engagement and put appro-priate safeguards in place to ensure thefirm’s responsibility to the public. Suchsafeguards might include—■ instituting an adequate system ofquality control, including approval ofacceptance and continuance of engage-ments by those responsible for managingthe auditing firm, preferably those who oth-erwise have no participation in the audit;■ requiring adequate supervision andreview;■ allocating a reasonable amount oftime to complete the engagement; and ■ assigning qualified staff to the engage-ment team.

Many auditors might argue that thesesafeguards are normally instituted in theiraudits. That may be true. Many auditors rec-ognize that when fees are not sufficient tocover the costs of performing an audit,they need to communicate different expec-tations about the realization of the engage-ment by allocating an appropriate amountof time and staff to the engagement.


Unfortunately, this is not always the case.The disciplinary records of many stateboards of accountancy include instanceswhere one or more of the safeguards sug-gested above were not performed.

Another safeguard suggested by theIESBA’s Code of Ethics for ProfessionalAccountants is requiring disclosure to thosecharged with governance of the client. In thecontext of low audit fees, the auditor shoulddisclose to an audit committee 1) that the feeis so low that a loss is anticipated in order toreasonably comply with standards, and 2) thatthe safeguards will be applied in order toreduce the threat of noncompliance withprofessional standards. This approach informsthe client’s audit committee of the fact thatthe audit fee is unreasonably low and forcesthe audit committee to be informed about suchmatters and to take some responsibility for theimplications of an unreasonably low audit fee.This is particularly important in an erawhere management is asking for—and obtain-ing—significant reductions in audit fees.Perhaps it is time for the AICPA and stateboards of accountancy to add a discussion ofthis safeguard to relevant codes of professionalconduct in the United States.

Performing an audit for a fee that is toolow to reasonably comply with professionalstandards is not, by itself, a violation ofprofessional ethics. Further, this threat todue professional care can be overcome byapplying appropriate safeguards to ensurethat the public is protected.

In general, when fees are significantlylow, there is a presumption by the publicand regulators that performing an audit fora very low fee, or performing an audit at aloss, is a significant threat to due profes-sional care and compliance with professionalstandards. Indeed, virtually all firms, whenaddressing client acceptance or continuance,ask the question, “Does the prospective feejustify pursuing the engagement, in light ofthe anticipated cost of obtaining and con-ducting the engagement?” This question isfocused on the threat of very low fees, whichcan be mitigated by appropriate safeguardsto ensure that due professional care is exer-cised and that the audit or attest engagementcomplies with professional standards.

Independence, Integrity, and ObjectivityNot only may low fees pose a threat to

due professional care, but they may alsothreaten independence, integrity, and objec-

tivity. For example, an auditor might subor-dinate judgment to the client rather thandevote additional time to investigating anaudit issue. The NASBA discussion paperaddresses a situation brought to a state boardinvolving a low fee audit, where a materialissue arose at the end of the engagement.Rather than taking the time to fully investi-gate a problem, the auditors subordinatedtheir judgment to that of the client. It waslater determined that the subordination ofjudgment resulted in a material misstatementin the financial statements. While this situ-ation involved an element of failure to usedue professional care, it also was a result ofa firm’s failure to act with integrity, objec-tivity, and, arguably, independence.

Further, just as a firm may have overduefees bearing on independence, performingservices below cost may indicate underly-ing financial considerations that impair inde-pendence. There are times when auditorsopenly talk about “investing in a client”when they perform an audit at a loss. Athreat exists that the audit firm may subor-dinate judgment in order to make the“investment” pay off. If the auditor needsto keep the client satisfied in order to getother work (e.g., from the client or from aboard member), the auditor may not havean independent attitude.

The accounting profession has witnessedthese problems with public companyaudits. Stephen A. Zeff documents a 30-yearspan where some auditors shifted from mak-ing professional judgments in the interest andwell-being of the shareholder, to makingthose judgments in the interest of manage-ment (“How the U.S. Accounting ProfessionGot Where It Is Today: Part I,” AccountingHorizons, September 2003, pp. 189–205, and“How the U.S. Accounting Profession GotWhere It Is Today: Part II,” AccountingHorizons, December 2003, pp. 267–286).This trend is also clearly discussed by C.Richard Baker in a CPA Journal article(“The Varying Concept of AuditorIndependence: Shifting with the PrevailingEnvironment,” August 2005, pp. 22–28).There is well-documented evidence thatsome of this shift was associated with usingthe audit as a “loss leader” to obtain morelucrative consulting services, which causedsome auditors to subordinate their judg-ment and lose their independence.

This problem has been addressed forpublic companies because the Sarbanes-

Oxley Act of 2002 prohibits performingcertain nonattest services for audit clients.For private company reporting, the issueof using the audit as a loss leader toobtain more lucrative services is less rig-orous but is addressed by the AICPA inInterpretation 101-3, Performance ofNonattest Services. However, the risk ofsubordinating judgment in order to gainmore profitable work still exists.

The accounting profession recently wit-nessed a variation of the threat that inade-quate fees pose to the subordination of judg-ment in the purported audit of Bernard L.Madoff Investment Securities LLC (BMIS)by Friehling & Horowitz, CPAs, P.C. A glar-ing red flag existed when Madoff’s multi-billion-dollar fund paid Friehling & Horowitzonly $186,000 for its 2008 audit. While thefee was sufficiently low to raise a questionof whether an audit could be performedand comply with professional standards,the engagement may have been profitablefor Friehling & Horowitz. The SEC con-tended that Friehling merely “pretended” toconduct minimal audit procedures of cer-tain accounts to make it appear it was con-ducting an audit. Friehling subsequentlypleaded guilty to fraud charges associatedwith the audit of BMIS. (For more on theFriehling & Horowitz audit of BMIS, seewww.sec.gov/litigation/litreleases/2009/lr21274.htm.) In the Friehling & Horowitzcase, the issue is not whether the attestengagement was profitable. The issue wasa fee so low that the auditor resorted to thesubordination of judgment and did not per-form reasonably expected audit work.

When an attest engagement is performedfor a very low fee or at a loss, there is a realthreat to independence, integrity, and objec-tivity. But appropriate safeguards can be putin place to reduce the threat to the point whereprofessional judgment is not compromised.Such safeguards might include—■ consultation with technical specialists onissues of significant professional judgment; ■ requiring engagement quality reviews(e.g., concurring, post- or preissuancereviews); and ■ discussion of safeguards against sub-ordination of judgment with thosecharged with governance of the entity.

The focus of attention here is to estab-lish a way to ensure that professionaljudgment is not subordinated to that of theclient. If an audit firm is sufficiently small,


such as a sole practitioner, it may beprudent to engage another auditor to per-form some level of preissuance peerreview to ensure that judgment has notbeen subordinated to that of the client,even if it may increase the risk of a lossfor the audit firm.

Financial Dependence on an Individual Client

When the fees from an attest engage-ment represent a large proportion of totalfirm fees, the dependence on a client andconcern about losing the work create aninherent self-interest or intimidation threat toindependence, integrity, and objectivity. Asimilar threat arises when the fees from aclient represent a large proportion of the rev-enue from an individual partner’s book ofbusiness or a large proportion of the revenueof an individual office of the firm. Thiswas the case in the Enron audit failure forboth the engagement partner and the per-forming office. There also may be circum-stances when fees are accepted in excess ofthose required—solely as an inappropriateresponse for the auditor to report what theclient may want and to compensate the audi-tor for not being independent.

Both the PEEC and the IESBA recognizethat an ethical threat exists when a large pro-portion of fees come from a single client.The Conceptual Framework recognizes thata financial self-interest threat to independenceexists when there is “excessive reliance on therevenue from a single client” (AICPA Codeof Professional Conduct, ET section100.01.18[c]). The IESBA has recently adopt-ed a rule requiring application of the threats-and-safeguards approach when the amountof fees from an individual client deemed to bea “public interest entity” exceeds 15% oftotal firm fees (International Federation ofAccountants, Code of Ethics for ProfessionalAccountants, section 290.220–222).

In general, when total fees from anyaudit client represent a large proportion ofthe total firm fees, the IESBA recommendsthe following safeguards:■ Reducing the dependence on the client; ■ Instituting internal or external qualitycontrol reviews of the engagement; and ■ Consulting an independent third partyon key audit judgments.

When fees from a public interest entityaudit client exceed 15% of total firm fees,the IESBA recommends that the firm

address the following issues with thosecharged with governance of the client:■ Disclose that total fees represent morethan 15% of the total fees of the firm. ■ Discuss the safeguards the firm willapply to reduce the threat to an accept-able level (e.g., preissuance or postissuanceengagement quality control reviews).

When a CPA firm commences itsattest practice, there will likely be a timein which the audit firm is dependent on afew clients. This is not an ethical viola-tion per se; however, the firm should applythe safeguards discussed above. Theclient should be aware that the audit firmis dependent on the client’s fees, and theauditor should discuss the safeguards thathave been put in place. It would be quiteappropriate, for example, to engageanother audit firm for some level of preis-suance review.

Other General Safeguards In addition to the safeguards discussed

above, there are a number of generalsafeguards to help recognize threats to eth-ical behavior. A firm’s senior leadershipmight, for example—■ stress the importance of ethical behav-ior and an expectation that members ofattest engagement teams act in the publicinterest;■ implement training and timely com-munication of policies and procedures foridentifying ethical threats associated withvery low fees or fees representing a sig-nificant proportion of firm revenues; and■ document policies regarding the iden-tification of ethical threats, the evaluationof the significance of those threats, and theapplication of safeguards.

Antitrust ConsiderationsWhenever the profession discusses ethics

and fees in the same sentence, antitrust con-siderations are raised. A threats-and-safe-guards approach should not be consideredas an effort to stifle competition. Thisapproach recognizes the professional judg-ment involved in pricing an engagementand attempts to find a balance between afirm’s interest in pricing an audit engage-ment with the public’s interest in high-qual-ity audits. It is sometimes appropriate fora firm to quote a low fee, a fixed fee, oreven fees insufficient to cover the cost ofperforming an audit, as long as the relat-

ed threats are identified and appropriatesafeguards are applied and documented.

Time for a Comprehensive LookThe time has come for the auditing

profession in the United States to moveforward with a more comprehensive lookat adopting a threats-and-safeguardsapproach to ethical issues. It is also timeto recognize that low fees and low engage-ment profitability are an ethical issue. It isnot an issue that demands a prohibitionon performing audits for a low fee or at aloss; however, the threats to due profes-sional care and potential subordination ofjudgment are real.

Some of the safeguards suggested aboveare already addressed in Generally AcceptedAuditing Standards (GAAS) and in theAICPA Code of Professional Conduct.However, it is suggested that firms take theadditional safeguards described above, suchas discussing the low-fee threat and the safe-guards applied with those responsible for thegovernance of the client. When a firm, office,or partner is financially dependent on anaudit client, it is also appropriate to imple-ment some form of preissuance internal orexternal quality review and to implementconsultation with an objective third partyon matters of significant professional judg-ment.

The benefit of a threats-and-safeguardsapproach is that it recognizes that auditorswork in a complex environment thatrequires the exercise of professional judg-ment. When a firm has a strong tone at thetop, it will take steps to help its auditorsrecognize potential threats of all sorts andthen take steps to ensure compliance withboth the spirit as well as the letter of eth-ical standards of professional conduct. ❑

Raymond N. Johnson, PhD, CPA, is theHarry C. Visse Excellence in TeachingFellow and professor of accounting atPortland State University, Portland, Ore.,and currently serves as chair of the OregonBoard of Accountancy. Gaylen R. Hansen,CPA/ABV, CVA, is partner and director ofquality control with Ehrhardt Keefe Steinerand Hottman PC in Denver, Colo. He is aformer chair of the Colorado State Board ofAccountancy, a member of the AICPAProfessional Ethics Executive Committee,and a NASBA director-at-large.


By August A. Saibeni

Several years ago, the author was respon-sible for the operations of a new skillednursing division of a regional medical

center. In addition to operations, part of theresponsibilities included facility acquisitions.While reviewing acquisition possibilities, theauthor noticed that many skilled nursingfacility (SNF) residents or patients had Medi-Cal (California’s version of Medicaid) as thepayment source. On average, Medi-Cal resi-dents constituted approximately 80% of theresidents of area SNFs. Since Medi-Cal paysSNFs far less than private-pay residents, it isimperative that operators try to increase thenumber of private-pay residents if a facility isto remain solvent. Increasing the private-paycensus is a goal of most SNFs, however, mak-ing this a difficult goal to achieve. The com-mon sense reason for the high Medi-Cal cen-sus among facilities is that many residents donot have the resources to fund more than abrief stay before exhausting their own fundsand thus defaulting to Medi-Cal as the sourceof payment.

Semi-Markov ProcessIn addition to the common sense reason for

a high Medi-Cal census, the author won-dered if there might be some type of mathe-matical model that could describe the transi-tion of patient or resident payment sources(financial classes) from one category to anoth-er. After considerable searching, the authorfound a probability process that helps modelthe various changes of financial classes amongresidents. The process is called a semi-Markovprocess (see Sheldon M. Ross, Introduction toProbability Models, 5th ed., Academic PressInc., 1993, pp. 331–333). A semi-Markov pro-cess is a process that can be in any of Nstates (financial classes for our example) 1,2…, N. Each time the process enters a statei, it stays there for a random amount of timewith a mean time of μi. The process then tran-

sitions to the next state j, with a probabilityof Pij (Ross, p. 331).

In order to have a valid semi-Markovmodel, two assumptions must be met: theMarkov assumption and the assumption of sta-tionary transition probabilities from one state

to another. The Markov assumption requiresthat each change of state be independent ofany previous transition. The stationary transi-tion assumption requires that the transitionprobabilities remain constant over time.Although in practice the transition probabili-

Semi-Markov Process and Microsoft Excel

T E C H N O L O G Y

t h e c p a & t h e c o m p u t e r

Using Mathematical Tools to Improve Operations

Bed Pay Type Mean Days in State Transition to Probability of TransitionPrivate Pay 120 Private 0.6

Medicare 0Medi-Cal 0.3HMO 0Vacant 0.1Total sum =1

Medicare 90 Private 0.2Medicare 0.2Medi-Cal 0.4HMO 0Vacant 0.2Total sum =1

Medi-Cal 540 Private 0Medicare 0Medi-Cal 0.6HMO 0Vacant 0.4Total sum =1

HMO 12 Private 0Medicare 0.2Medi-Cal 0.2HMO 0.2Vacant 0.4Total sum =1

Vacant 10 Private 0.25Medicare 0.1Medi-Cal 0.2HMO 0.05Vacant 0.4Total sum =1

EXHIBIT 1Skilled Nursing Facility Model Input for Semi-Markov Process

ties may change a bit over time, as long asfairly current data are used, forecasts will mostlikely be accurate enough for planning pur-poses for an operating cycle.

To explain a semi-Markov process, Rossuses an example involving a machine beingin one of three states: good condition, faircondition, or broken down. The questionfor Ross is what proportion of time is themachine in each state of good condition,fair condition, or broken down.

The problem above was to find the aver-age time the payment source of residentsin an SNF would be in each of the fol-lowing states: private payment, Medicare,Medi-Cal, or HMO/insurance. In addi-tion, the state of a bed being vacant—anal-ogous to the state of “broken” in Ross’s

example—had to be considered. Results ofthe model could then be used for budget-ing or forecasting.

Constructing a ScenarioConsider the SNF financial class exam-

ple: If, for a given SNF, the mean time for


Financial Class Percent of Time

Private 11.1%

Medicare 1.7%

Medi-Cal 85.8%

HMO 0.1%

Vacant 1.3%

Total 100%

EXHIBIT 2Census Forecast

Pi = πiμi , i = 1,2,3,4,5 5∑ πjμjj=i

P1 = 11.1%P2 = 1.7%P3 = 85.8%P4 = 0.1%P5 = 1.3%

EXHIBIT 3Calculating Long-Run Time

in Each State

Case 1Mean Days % of % Financial Net Revenue

Financial Class in State Admissions Class Mix per Patient Day Net RevenuePrivate Pay 120 33% 11.1% $140 $567,536 Medicare 90 7% 1.7% $ 50 $ 30,745 Medi-Cal 540 57% 85.8% $ 5 $156,545 HMO/Insurance 12 3% 0.1% $ 45 $ 1,640 Vacant 10 1.3% $ 0 $ 0Total 100% 100% $756,466

Case 2Private Pay 120 33% 11.2% $140 $571,338 Medicare 90 7% 1.7% $ 50 $ 30,951 Medi-Cal 540 57% 86.4% $ 5 $157,594 HMO/Insurance 12 3% 0.1% $ 45 $ 1,651 Vacant 5 0.7% $ 0 $ 0Total 100% 100% $761,534

Case 3Private Pay 150 33% 13.5% $140 $690,254 Medicare 90 7% 1.6% $ 50 $ 29,915 Medi-Cal 540 57% 83.5% $ 5 $152,316 HMO/Insurance 12 3% 0.1% $ 45 $ 1,595 Vacant 10 1.3% $ 0 $ 0Total 100% 100% $874,080

Case 4Private Pay 120 38% 13.0% $140 $666,791 Medicare 90 6% 1.7% $ 50 $ 30,618 Medi-Cal 540 53% 83.2% $ 5 $151,814 HMO/Insurance 12 3% 0.1% $ 45 $ 1,633Vacant 15 2.0% $ 0 $ 0Total 100% 100% $850,856

EXHIBIT 4Comparison of Planning Strategies

each financial class “visit” and the transitionprobabilities are as shown in Exhibit 1, onecan use Microsoft Excel to calculate the long-run mean time a patient has in each financialclass payment category. With the assumedinput shown in Exhibit 1, one can calculatethat, in the long run, Medi-Cal patients or res-idents will represent about 86% of the facil-ity’s census, which is close to what the authorobserved when investigating facilities for pur-chase. Exhibit 2 shows the long-run mean timea bed serves a given financial class orbecomes vacant.

In order to calculate the long-run propor-tion of time that a patient is in each state shownin Exhibit 2, first calculate the long-run pro-portion of transitions between each state (seethe Appendix for these calculations).

The long-run average time a patientremains in each state is the weighted aver-age of the transition probabilities calculatedin the Appendix and the average amount oftime the patient spends in each state (Ross,pp. 331, 333). For example if a patient spendson average 120 days in state 1, 90 days instate 2, 540 days in state 3, and 12 days instate 4, with the bed vacant on average 10days (state 5), each respective state visit—the long-run amount of time a patient is ineach state—is calculated as shown inExhibit 3 (Ross, p. 333).

The model is useful to forecast a percent-age mix of financial classes based upon aninput of transition probabilities and the meantime stay in each financial class, as well asfor other planning purposes. For example,an operator could compare the impact of mar-keting efforts to reduce the vacancy rate com-pared to other planning strategies. Exhibit 4shows a comparison of four planning strate-gies. Case 1 represents the base scenario. Case2 assumes that the number of days that abed is vacant is reduced from 10 days tofive days, while holding the same inputassumptions as Case 1. Given an assumed100-bed SNF and the assumed net patient rev-

enue per day estimates as shown, Case 2increases net revenue from $756,466 to$761,534. Case 3 assumes that patients whocan pay for 150 days of care at private ratesinstead of 120 days are admitted. Case 3increases net patient revenue from $756,466to $874,080. Finally, Case 4 assumes that abed is allowed to remain vacant for 15 daysinstead of 10 days, with the assumed increaseof a transition probability for a vacant bedwith a private-pay patient increasing to 30%of the vacant transitions, compared to the priorassumption of 25%, with a similar reductionin Medi-Cal transition probability, from20% to 15%. The result would increase pri-vate-pay admissions from 33% to 38% andreduce Medi-Cal admissions from 57% to53%. This increases net patient revenuefrom $756,466 to $850,856. Case 4, howev-er, entails greater risk of private-pay vacancy, which SNF operators fear. Case 4vacancy risk is briefly presented in Exhibit 5(discussed below).

Due to the complex interplay of variables,including average length of stay by financialclass, transitions among various financial class-es, financial class admission ratios, and netpatient revenue for each financial class, it isvery difficult and time-consuming to try todevelop scenarios similar to these exampleswithout the use of a semi-Markov process.The changes between Case 1 and Cases 2,3, and 4 have been minimized in order to iso-late the impact of the changes. UsingMicrosoft Excel and a semi-Markov pro-cess, however, it is very easy to analyzenumerous scenarios in a brief period of time.Of great benefit is the ability to make explic-it assumptions for each input variable and seehow the changes affect the census mix andnet patient revenue.

Semi-Markov processes seem to have appli-cation to many situations, as evidenced by asignificant number of published academic arti-cles. One fairly recent article requiringadvanced mathematics related to revenue plan-

ning for the airline industry as applied to dis-count tickets (see Shelby Brumelle and DariusWalczak, “Dynamic Airline RevenueManagement with Multiple Semi-MarkovDemand,” Operations Research, vol. 51, no.1, January/February 2003, pp. 137–148). Thegoal was to create a strategy to optimize pas-senger revenue between full-charge tickets anddiscount tickets, while the SNF model is inter-ested in optimizing patient or resident revenue.

Other ToolsTo enhance forecasts of resident arrivals,

an operator may also consider the use ofa Poisson probability model. Although afull discussion of the Poisson and expo-nential distributions are beyond the scopeof this article, it could be helpful for oper-ators to consider them when planning forfinancial class admissions.

Case 1 of the SNF example above assumesthat approximately 36 private pay patients willbe admitted each year; this translates to approx-imately three patients per month, or approxi-mately 0.1 per day. A Poisson distribution canbe used to compute the probability of variousarrivals per day, week, or month. An opera-tor’s fear of vacancy would be reinforced,given that the Poisson distribution (Ross, p.30), using the assumed data above, would fore-cast that the probability of zero private paypatients arriving each day is about 90%, withabout one private patient arriving every 10days. In addition, the exponential distribution(Ross, p. 214) would calculate that there is stilla 37% and 22% chance that a private-paypatient would not arrive within 10 days or 15 days respectively. Exhibit 5 shows the prob-ability calculations for the 10-day case.

Looking for an EdgeGiven the difficulty of surviving and

thriving in the current business environ-ment, SNF and many other industry oper-ators need any edge they can find. Usingthe power of a semi-Markov process andMicrosoft Excel may be “just what the doc-tor ordered” for SNF operators, as well asoperators in other industries. ❑

August A. Saibeni, CPA (inactive), is anadjunct professor of accounting atCosumnes River College, Sacramento,Calif. The author thanks James J. Solberg,PhD, for his generous review of themanuscript and his expert recomendations.


Let: λ = Poisson parameter = 0.10x = number of private patient arrivalse = base of natural logarithms

P(x = 0) = λx e-λ= 0.100 e−0.10

≈ 90%x! 0!

Exponential: Probability that a private-pay arrival exceeds 10 daysP[time>10 days] = e−(10)(0.10) ≈ 37%

EXHIBIT 5 Poisson: Probability of Zero Private-Pay Patient Arrivals in One Day


APPENDIX

Letting the states be 1,2,3,4,5, the proportion of transitions π1, π2, π3, π4, π5

into each state must satisfy the following equations: (1) π1 + π2 + π3 + π4 + π5 = 1(2) π1 = 0.6π1 + 0.2π2 + 0π3 + 0π4 + 0.25π5

(3) π2 = 0π1 + 0.2π2 + 0π3 + 0.2π4 + 0.1π5

(4) π3 = 0.3π1 + 0.4π2 + 0.6π3 + 0.2π4 + 0.2π5

(5) π4 = 0π1 + 0π2 + 0π3 + 0.2π4 + 0.05π5

(6) π5 = 0.1π1 + 0.2π2 + 0.4π3 + 0.4π4 + 0.4π5

State 1 is private pay, state 2 is Medicare, state 3 is Medi-Cal, state 4 isHMO, and state 5 is vacant. Equation (1) says that the sum of the transitionproportions must equal one. Equation (2) says that 60% of the time, a private-pay patient retains this financial class, 20% of the time a Medicare patienttransitions to private pay, zero percent of the time a Medi-Cal transitions toprivate pay, zero percent of the time an HMO patient transitions to privatepay, and 25% of the time a vacant bed transitions to private-pay status.Similar interpretations can be made for equations 3 through 6.

The solution to these equations can be found by either manually manipulatingthe equations or by using Excel’s matrix manipulation functions. The equationscan be arranged in a transition matrix (A) that describes how a patient movesthrough the financial class states, as shown in Appendix Exhibit. Matrix (A) isthen transposed (using Excel’s Transpose function), resulting in the transposematrix (B), which rearranges the rows and columns of the transition matrix inorder to put the matrix into a proper linear algebra format needed to solve forthe values of πi. Another needed step that results from combining equation 1with each of the other equations is to adjust the transpose matrix (B) by addingones to each entry, except for the diagonals, to which zero is added. For anexcellent discussion of semi-Markov processes, see James J. Solberg, ModelingRandom Processes for Engineers and Managers, Wiley, 2009. For a moredetailed and a more advanced spreadsheet solution to the above matrix manipu-lations, see Solberg, pp. 90–91.

Appendix Exhibit (A) Transition Matrix (B) Transpose Matrix

1 2 3 4 51 0.60 0.00 0.30 0.00 0.10 0.60 0.20 0.00 0.00 0.252 0.20 0.20 0.40 0.00 0.20 0.00 0.20 0.00 0.20 0.103 0.00 0.00 0.60 0.00 0.40 0.30 0.40 0.60 0.20 0.204 0.00 0.20 0.20 0.20 0.40 0.00 0.00 0.00 0.20 0.055 0.25 0.10 0.20 0.05 0.40 0.10 0.20 0.40 0.40 0.40

(C) Adjusted Transpose Matrix (C)−1 Inverse of Matrix (C) (C) × (C)−1 = Identity Matrix (I)0.60 1.20 1.00 1.00 1.25 −1.41 0.29 0.67 0.57 0.11 1 0 0 0 01.00 0.20 1.00 1.20 1.10 0.40 −0.89 0.31 0.01 0.20 0 1 0 0 01.30 1.40 0.60 1.20 1.20 × 0.30 0.15 −1.05 0.50 0.48 = 0 0 1 0 01.00 1.00 1.00 0.20 1.05 0.29 0.27 0.25 −0.99 0.20 0 0 0 1 01.10 1.20 1.40 1.40 0.40 0.62 0.37 0.02 0.11 −0.79 0 0 0 0 1

(C)−1 Inverse of Matrix (C) Vector Vector−1.41 0.29 0.67 0.57 0.11 1 0.22490.40 −0.89 0.31 0.01 0.20 1 0.04550.30 0.15 −1.05 0.50 0.48 × 1 = 0.38600.29 0.27 0.25 −0.99 0.20 1 0.02020.62 0.37 0.02 0.11 −0.79 1 0.3234

Solutionπ1 = 0.2249π2 = 0.0455π3 = 0.3860π4 = 0.0202π5 = 0.3234

Note: Except for solution, matrices show maximum of three digits

The calculations made in the Appendix Exhibit solved the matrix equation shown below:

0.60 1.20 1.00 1.00 1.25 π1 11.00 0.20 1.00 1.20 1.10 π2 11.30 1.40 0.60 1.20 1.20 × π3 = 11.00 1.00 1.00 0.20 1.05 π4 11.10 1.20 1.40 1.40 0.40 π5 1

The adjusted transpose matrix (C) is multiplied (using Excel’s Mmult function) by the inverse (using Excel’s Minverse function) of matrix (C). The resultis the identity matrix (I), which is similar to the number 1 in nonmatrix format. The product of (C) and (C) −1 on the left side of the equation leaves π1

through π5 in a column vector. Multiplying (using Mmult) the right side of the equation by the inverse of matrix (C) forms a column vector showing thenumerical solutions as presented. The described matrix multiplication is similar to a nonmatrix solution; for example, with the equation 4x = 8, bothsides of the equation could be multiplied by the inverse of 4 to arrive at the answer x = 2.

To State

From

Sta

te


By Susan B. Anders

The Global Corporate GovernanceForum promotes corporate gover-nance in developing countries and

emerging markets. Its mission is to presentincentives for corporations to operate effi-ciently and responsibly, promote econom-ic growth from the private sector, andreduce market susceptibility to crisis.Founded by the World Bank and theOrganization for Economic Cooperationand Development (OECD) in 1999, theforum operates as a subsidiary of theInternational Finance Corporation (IFC).

The forum’s website, www.gcgf.org,provides free access to forum-createdresources dedicated to practical solutions,information, and training on corporate gov-ernance issues in emerging markets, as wellas in developed nations. The website isorganized around its main functionalresource categories: “about us” pages thatprovide background information, focusareas related to the forum’s professionalactivities, and a variety of publicationsranging from newsletters to case studies.

Visitors can use the main index—foundon the left side of all webpages—to navigatethe website. The homepage highlightssome of the website’s resources, such asreports, presentations, videos, and newslet-ters. The home and main pages provideselected materials, toolkits, publications, andevents. Most articles open in a separate win-dow and longer reports are generally avail-able for download by section.

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and topical content of the kit. The user guideincludes a country index, allowing readersto focus on U.S. practices or those of othercountries. The user guide is a useful fea-ture; it is much shorter than the completetoolkit and makes it easier to determinewhether the toolkit meets a user’s needs.

The “Developing Corporate GovernanceCodes of Best Practice” toolkit provides astep-by-step approach to creating and usingcorporate governance codes. Volume 1 dis-cusses the importance and usefulness ofcorporate governance, highlights lawsthat affect corporate directors, providesexamples of best practices, presents a

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appendix contains a wealth of examples,such as a sample consultant engagementletter and sample telephone interview let-ter. A summary of OECD principles oncorporate governance includes controllingexecutive and director remuneration, abusein consolidated groups, self-dealing byinsiders, improved financial market integri-ty, improved enforcement, and more effec-tive shareholder participation.

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The “Building Director TrainingOrganizations” toolkit focuses on creatingorganizations to train corporate directors.It provides a sample charter, code of ethics,and code of conduct for the training enti-ty. One module offers sample curriculum,case study methods, and a reading list.

The forum’s website provides access toindividual country corporate governancecodes through the European CorporateGovernance Institute. There are currentlymore than 70 country codes available,including Australia, Canada, New Zealand,the United Kingdom, and the United States,as well as other African, Asian, European,Latin American, and Middle Eastern coun-tries. Visitors interested in information oncorporate governance outside of the UnitedStates, especially in emerging markets, willfind a large number of practical and easy-to-read resources on this website.

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site offers access to case studies and dis-cussion papers. The most recent case stud-ies are generally 60 to 90 pages in length,while the earlier discussion papers are 25 to50 pages. The earliest focus paper is“Corporate Governance and Development,”a policy study that defines corporate gover-nance and explores its importance. Theauthor, Stijn Claessens, finds a positiverelationship between a good corporate gov-ernance framework and better access to

financing, a lower cost of capital, and greaterperformance. Interestingly, market mecha-nisms cannot overcome weak country cor-porate governance policies.

“Enforcement and Corporate Governance:Three Views” presents a collection of threearticles about enforcement’s role inimproving markets. The first article providesan overview of practical approaches forstrengthening corporate governance in theprivate sector. The second addresses corpo-rate governance activities in India, as wellas the importance of ethics in business. Thethird examines both public and private enti-ty enforcement in developing countries. Theappendix contains a matrix of points of inter-vention for a variety of issues.

“The Moral Compass of Companies:Business Ethics and Corporate Governanceas Anti-Corruption Tools” provides back-ground definitions on corruption, corporategovernance, and ethics. The study exam-ines corporate governance and ethicsleadership as tools to combat corruption.The paper includes several useful tablesand a lengthy list of Internet resources forbusiness ethics and other related topics,with hyperlinks to the original source.“Mediating Corporate GovernanceConflicts and Disputes” reviews such con-flicts, examines the main characteristicsof—and obstacles to—mediation, andoffers specific recommendations on the useof mediation. The appendix provides aglossary of alternatives to mediation.

The most recent focus paper is“Shareholder Engagement and the Board:Integrating Best Governance Practices,” whichdevelops support for stakeholder involvementto help companies identify and managechanges in the global environment. The paperincludes best practices and practical examples,as well as a list of Internet resources onaccountability and sustainability.

“Private sector opinion publications” isa collection of 10- to 12-page monographswritten by members of the Private SectorAdvisory Group (PSAG). The papersaddress topics such as noncontrolling share-holders, auditors and independence,whistleblowing, board performance eval-uation, and board diversity. For example,“Corporate Governance: A NorthAmerican Perspective” addresses the shiftin power from the shareholders to corpo-rate management, and more recently tomanagement and the board. “Governance

Scorecards as Tools for BreakthroughResults” discusses basic requirements fora corporate governance system and howthe scorecard provides a useful tool to meetthe demands.

The Global Corporate GovernanceForum offers three newsletters: “ProgressReport,” “Network Bulletin,” and the new“Emerging Markets CorporationGovernance Research Network.” “ProgressReport” is published biannually and isavailable on the website. Issues oftencontain 20 pages, covering initiatives devel-oped by the forum and its members. Itsrecent thought leadership section highlightspublication additions to the website and theresearch updates section covers new aca-demic research available through the SocialScience Research Network. The Winter2010 issue includes an excellent article,“High Profile Failures DemonstrateNecessity of Succession Planning,” thatdiscusses one board’s role in providing forCEO succession. “Network Bulletin,”issued several times each year, is availableby e-mail subscription or archived on theforum’s website. It provides brief descrip-tions and links to new publications, events,and news items. Visitors can access thenew “Emerging Markets CorporationGovernance Research Network” newslet-ter in webpage format. It provides sum-maries of, as well as links to, recently pub-lished articles from the Journal ofCorporate Finance, the National Bureauof Economic Research, and the SocialScience Research Network.

The Guidelines, Reviews, and CaseStudies section presents practical guidanceand research prepared by the forum andrelated entities. The IFC Family BusinessGovernance Handbook is a 66-page guide-book covering a variety of issues such asthe role of family members in governance,the board of directors, senior management,and going public. A four-page brochure,also prepared by the IFC, details 10 factsabout corporate governance in theEuropean Union. “The EU Approach toCorporate Governance” is a 20-page book-let that addresses boards, disclosures, share-holder rights, and other issues. ❑

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



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The Path to International Accounting Standards—Condorsement and Other Must-Know Hot Topics!

Tuesday, October 25, 2011FAE Conference Center

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Keynote Speaker: Leslie F. Seidman, Chair, Financial Accounting Standards Board (FASB)

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IFRS ConferenceSave the Date!

Selected Interest Rates 06/30/11 05/31/11Fed Funds Rate 0.10% 0.11%3-Month Libor 0.25% 0.25%Prime Rate 3.25% 3.25%15-Year Mortgage 3.73% 3.77%30-Year Mortgage 4.57% 4.55%1-Year ARM 3.17% 2.94%3-Month Treasury Bill 0.01% 0.06%5-Year Treasury Note 1.77% 1.70%10-Year Treasury Bond 3.16% 3.06%10-Year Inflation Indexed Treas. 0.75% 0.80%

E C O N O M I C & M A R K E T D A T A

m o n t h l y u p d a t e

The information herein was obtained from various sources believed to be accurate; however, Forté Capital does not guarantee its accuracy or completeness. This report was prepared forgeneral information purposes only. Neither the information nor any opinion expressed constitutes an offer to buy or sell any securities, options, or futures contracts. Forté Capital’sProprietary Market Risk Barometer is a summary of 30 indicators and is copyrighted by Forté Capital LLC. For further information, visit www.forte-captial.com, send a message [email protected], or call 866-586-8100.

Forté Capital’s Selected Statistics

U.S. Equity Indexes 06/30/11 YTD Return

S&P 500 1,321 5.00%

Dow Jones Industrials 12,414 7.20%

Nasdaq Composite 2,774 4.50%

NYSE Composite 8,319 4.50%

Wilshire 5000 13,968 5.10%

Dow Jones Transports 5,424 6.20%

Dow Jones Utilities 433 7.00%

Forté Capital's Proprietary Bullish Neutral BearishMarket Risk Barometer 10 9 8 7 6 5 4 3 2 1

Market ValuationMonetary Environment Investor PsychologyInternal Market Technicals

Overall Short-Term Outlook 5.21Overall Long-Term Outlook 6.41

666

5

Equity Market Statistics 06/30/11 05/31/11

Dow Jones IndustrialsDividend Yield 2.57% 2.53%Price-to-Earnings Ratio (12-Mth Trailing) 13.78 13.94Price-to-Book Value 2.76 2.79

S&P 500 IndexEarnings Yield 6.58% 6.47%Dividend Yield 1.96% 2.06%Price/Earnings (12-Mth Trailing as Rpt) 15.19 15.47Price/Earnings (2010 EPS Est as Rpt) 13.42 13.72

Commentary on Significant Economic Data This Month

Oil prices fell in June 2011 after the International Energy Agency said it would release 60 million barrels of oil to compensate for theloss of Libyan exports, which account for around 2% of the world’s exports of oil. Thirty million barrels will come from the United States,while the United Kingdom will contribute about 3 million barrels. The decision to release barrels from the emergency stocks comes onthe heels of the OPEC cartel’s refusal to increase production of oil to help ease rising global prices.

Most Prior Key Economic Statistics Recent Month

National

Producer Price Index (monthly chg) 0.20% 0.80%

Consumer Price Index (monthly chg) 0.20% 0.40%

Unemployment Rate 9.20% 9.10%

ISM Manufacturing Index 55.30 53.50

ISM Services Index 53.30 54.60

Change in Non-Farm Payroll Emp. 18,000 54,000

New York State

Consumer Price Index - NY, NJ, CT 0.60% 0.50%

Unemployment Rate 7.90% 7.90%

NYS Index of Coincident Indicators 1.60% 6.80%

As of 06/30/11


Chart of the Month

Price of Crude Oil

Source: Federal Reserve

$80$85$90$95

$100$105$110 $115 $120

12/3

1/20

10

1/14

/201

1

1/31

/201

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The Audit Reporting Process

E D I T O R I A L

a m e s s a g e f r o m t h e e d i t o r - i n - c h i e f

An Opportunity for Fundamental Change

The standard audit report was adopt-ed during the 1940s to provide uni-form language in an effort to ensure

comparability and consistency. Since then,little has been done to address the inade-quacies of this cookie-cutter approach forauditors’ communication with users of thisreport, despite the growing complexities in the financial and business environ-ments today.

Because many CPA Journal readershave heard the hype before regardingexpected changes to the audit report, onlyto be disappointed, skepticism is under-standable. This time, however, may be dif-ferent. As a new PCAOB concept releasenotes, “Though the auditor’s reportingmodel has been studied by many groupsthat have provided recommendations overtime, they were not in a position to effectchange as they did not have standards-setting authority.” The PCAOB has anopportunity to oversee real, fundamentalchanges that could help to protectinvestors’ interests—and now that oppor-tunity is knocking, let’s answer the door.

PossibilitiesOn June 21, the board issued PCAOB

Release 2011-003, “Concept Release onPossible Revisions to PCAOB StandardsRelated to Reports on Audited FinancialStatements” (pcaobus.org/Rules/Rulemaking/Docket034/Concept_Release.pdf).Some of the possible changes suggested inthe concept release include the following: ■ Auditor’s discussion and analysis,■ Required and expanded use of empha-sis paragraphs,■ Auditor assurance on other informationoutside the financial statements, and■ Clarification of language in the stan-dard auditor’s report.

The document makes clear that these arejust some of the possibilities under con-sideration. Perhaps they also can tackle the

timeless question of how auditors can trulyrepresent investors’ interests when the com-pany being audited(the “client”) hires,fires, and pays theauditor. Even thoughSOX shifted hiringand oversight respon-sibilities to the auditcommittee, in prac-tice, the auditorsdepend on the supportof management torecommend their con-tinued engagement. Does anyone else sensean inherent conflict of interest here? Yetthere is still resistance to the idea of insert-ing a third-party intermediary between theauditor and the auditee. There isn’t an easyanswer—but that doesn’t justify ignoringthis key issue. After all, it goes to the heartof auditor independence, which is a mainpremise of the Code of ProfessionalConduct of both the AICPA and theNYSSCPA. Simply stated, it requires thatthe CPA must be independent “in fact” and“in appearance” from the client whenproviding auditing or other attestation ser-vices. The time has come again to have adialogue about “who” engages the auditor.Appropriately structuring the relationshipsamong the involved parties is critical toimproving the credibility of the audit.

In an effort to reduce liability, auditorshave devoted much time and resources tolimiting their responsibility, particularlyin the area of detecting financial state-ment fraud. This has simply opened theaudit process to questions regarding itsrelevance. But in the current “pass/fail”audit report model, auditors don’t havethe breadth of options they need to ade-quately assess the risk of material mis-statement in the financial statements. Apass/fail system generally promotes medi-ocrity and increases the risk related to

marginal passing grades. A more detailedranking of the auditee’s operational envi-

ronment and controlscould help to betteridentify risks and alertinvestors and others ofpotential problems. Theaudit profession can takea page from a growingtrend in academe on thismatter and expand thechoices to include thefollowing: excellent,pass, low pass, and fail.

Share Your IdeasThere is no doubt that communication

between the auditor and users of the auditreport leaves room for improvement.Enhancements to the integrity, clarity,and comprehensiveness of the auditors’work and communications thereof are longoverdue. CPAs have a historic opportuni-ty to participate in this important discus-sion and help the PCAOB shape the auditreporting process of the future.

Those interested in submitting commentsto the board on this concept release shouldsend them in writing to the Office of theSecretary, PCAOB, 1666 K Street, N.W.,Washington, DC 20006-2803, or by e-mailto [email protected] or through theboard’s website at www.pcaobus.org by5:00 p.m. EDT on September 30, 2011.Refer to PCAOB Rulemaking DocketMatter 34.

As always, I welcome your comments,and, in this case, so does the PCAOB. ❑

Mary-Jo Kranacher, MBA, CPA/CFF,CFEEditor-in-ChiefACFE Endowed Professor of FraudExamination, York College, The CityUniversity of New York (CUNY)[email protected]