2012-08 cpa journal august

Plus• Tax Consequences of Currency Trading• Hybrid Business Entities• Non-Compete Agreements

AdvisoryServices Rise Again at Large Audit Firms

ESSENTIALS

20 Accounting & Auditing❙ Auditing

Material Internal Control Weakness Reporting Since the Sarbanes-Oxley Act

By Thomas G. Calderon, Li Wang, and Edward J. Conrad

❙ AccountingThe Two-Class Stock Method for

Calculating Earnings per Share:Stock Compensation Awards as Participating Securities

By Josef Rashty

❙ AuditingThe Transformation of Internal Auditing:

Challenges, Responsibilities, and ImplementationBy Gaurav Kapoor and Michael Brozzetti

36 Taxation❙ Federal Taxation

Tax Savings from the Sale of Qualified Small Business Stock

By Sidney J. Baxendale and Richard E. Coppage

❙ International TaxationForeign Currency Strategies Can

Produce Unforeseen Tax ConsequencesBy Lee G. Knight and Ray A. Knight

54 Management❙ Practice Management

The Increased Importance of Non-Compete Agreements for Accounting Firms

By Michael C. Lasky and David S. Greenberg

C O N T E N T S

a u g u s t 2 0 1 2

20

48 Finance❙ Not-for-Profit Organizations

The Need for Hybrid Businesses:Examining Low-profit Limited Liability Companies

and Benefit CorporationsBy Valeriya Avdeev and Elizabeth C. Ekmekjian

6

68 Technology❙ IT Management

Business E-mails and Potential Liability:Protecting Privilege and Confidentiality Through

Disclaimers and Prudent Use PoliciesBy John Ruhnka and Windham E. Loopesko

❙ What to BookmarkWebsite of the Month: Accountability Central

By Susan B. Anders

6 PerspectivesIFRS for Privately Owned Businesses

Publisher’s Column: A Pound of Cure: Preparing for the ACA’s 2014 Deadline

2011 Max Block Awards Presented

The Imprecise Nature of Accounting

Teaching and Advising a New Generation of Accounting Students:

A Glimpse into the NYSSCPA’s 2012Higher Education Conference

Quick Response Codes: A Marketing Tool for Accounting Firms

Inbox: Letter to the Editor

58 Responsibilities & Leadership❙ Perceptions of the Profession

Advisory Services Rise Again at Large Audit Firms:Like a Phoenix, Revenues Reborn amid Renewed Concerns

By R. Mithu Dey, Ashok Robin, and Daniel Tessoni

PERSPECTIVES

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

80 EditorialThe SEC Staff Report on IFRS:

Kicking the Decision Down the Road

79 Economic & Market Data

74 Classified Ads

ESSENTIALS58

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Not-for-Profit Series, with Allen L. Fetterman, CPAInternal Controls for Smaller NFPsTuesday, September 11, 2012, 12:00–2:00 p.m.

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Introduction to Tax ExemptionMonday, October 15, 2012, 12:00—2:00 p.m.

Nonprofit Going Concern IssuesMonday, October 15, 2012, 2:30-3:30 p.m.

Federal Tax Series and Tax Exempt Organizations Series, with Lynn Nichols, CPA

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AUGUST 2012 / THE CPA JOURNAL6

Since 1976, U.S. GAAP has grownto more than 10,000 pages of rules, notcounting the publications of theEmerging Issues Task Force (EITF). Inthe meantime, the InternationalAccounting Standards Board (IASB) andits predecessor, the InternationalAccounting Standards Committee(IASC), have issued more than 2,500pages of standards, currently styled asInternational Financial ReportingStandards (IFRS) and previously knownas International Accounting Standards.

In July 2003, the IASB com-menced deliberations on a project, car-ried over from the agenda of the IASC,to produce a document on accountingstandards for small- and medium-sizedentities (SME). The discussion belowfocuses on accounting standards forSMEs and related problems, such ascomplexity and accounting standardsoverload.

IFRS for SMEsIn July 2009, the IASB issued

IFRS for SMEs, which created a stand-alone set of accounting principles anddisclosures for SMEs. One of the mem-bers of the IASB has reported that“74 jurisdictions have adopted [IFRSfor SMEs] or announced plans to doso” (“International Adoption Issues:

A View from the IASB,” The CPAJournal, December 2011, p. 10).

Although the term “SME” is usedhere because it is widely understoodinternationally, the IASB definitiondoes not limit the term to small- ormedium-sized entities. Instead, the def-inition merely requires that an entitydoes not have public accountability andthat an entity publishes general-purposefinancial statements for external users.Public accountability means that anentity has debt or equity instrumentsthat are publicly traded, or that the enti-ty is contemplating issuing such instru-ments. The term also refers to entitiesthat hold assets as fiduciaries for abroad group of outsiders, such as“banks, credit unions, insurance com-panies, securities broker/dealers, mutu-al funds, and investment banks” (IFRSfor SMEs, p. 226, http://eifrs.iasb.org/eifrs/sme/en/IFRSforSMEs2009.pdf).

IFRS for SMEs boils down the2,500 pages that make up IFRS to 230pages. To achieve this result, the IASBdid not only propose vastly simplifiedand reduced disclosures; it also provid-ed for simplified—and, in some cases,different—measurement standards. Thus,a company that adopts IFRS for SMEswill not only have different disclosuresin its financial statements, but it will alsoclassify debits and credits in the state-ments differently.

IFRS for SMEs represents an impor-tant milestone in the search for a simpli-fied and less costly approach to account-ing in general-purpose external financialstatements of privately held entities—aproblem on which the accounting pro-fession in the United States had previ-

By Charles A. Werner

n 1976, the AICPA’s Committee on Generally Accepted Accounting Principles[GAAP] for Smaller and/or Closely Held Businesses issued a report andachieved something of a breakthrough: as a result of its work, FASB abol-ished the requirement for mandatory disclosure of earnings per share dataand business segment information for privately held companies.Accordingly, FASB approved the idea that there could be a different set ofrequired disclosures under GAAP for privately held companies. Since that

time, the AICPA has addressed the problems caused by one set of U.S. GAAPfor both privately and publicly held enterprises on a number of occasions.

IFRS for Privately Owned Businesses

I

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

s t a n d a r d s s e t t i n g

(Continues on page 8)

AUGUST 2012 / THE CPA JOURNAL 7

p u b l i s h e r ’ s c o l u m n

Alittle over two years ago, I wroteabout the important role that CPAs

will play in translating the provisions ofObama’s healthcare reform law, not onlyto their clients, but also to the public. Sincethat time, some of the law’s provisionshave gone into effect, but the legislation’scenterpiece—the individual mandate thatevery American have health insurance orbe charged a penalty administered by theIRS—was challenged on the grounds thatthe mandate is unconstitutional. That leftmost Americans, including employersand the professionals who advise them, toplay a waiting game that ended on June 28, when the United States SupremeCourt ruled that the Affordable Care Act(ACA) is constitutional—and it is consti-tutional because it is a tax.

So although nothing has changed, every-thing has changed. While the law, as it wasadopted, was always going to rely on tax-ing high-wage earners to pay for some ofthe law’s cost—2013 comes with a newtax on interest income for individualswho earn more than $200,000 ($250,000for married couples filing jointly) annual-ly—what is different is that the 2014 man-date is actually going to happen (althoughthe presidential election does bring with itsome level of continuing uncertainty).

The net costs—the combined effectson federal revenues and mandatoryspending—reflect gross additional costs of$1.5 trillion for Medicaid, the Children’sHealth Insurance Program, tax credits, andother subsidies for the purchase of healthinsurance through newly establishedexchanges, as well as tax credits for smallemployers, according to the CongressionalBudget Office (CBO); they are offset, inpart, by about $0.4 trillion in receipts frompenalty payments, the new excise tax onhigh-premium insurance plans (set to gointo effect in 2018), and other budgetaryeffects (mostly increases in tax revenues).Shortly after the Supreme Court handeddown its decision, the CBO announced thatit would assess the effects of the court’s

ruling on the ACA (due to be releasedafter this issue went to press).

Get ReadyThose who were preparing for the

changes the law requires by 2014 arein a better place than those whowaited on the Supreme Court’s deci-sion: right now there are plenty ofemployers scrambling to find out whatexactly they have to do to prepare, notonly as individuals but as CFOs,CEOs, human resource managers, andcompliance officers—and most ofthem will be looking to their mosttrusted advisor to figure it out, theirCPA. With the availability of health-care exchanges, and certain econom-ic incentives within the law, theACA has the potential to result infewer companies offering health insur-ance packages to their employees,depending on the size of their work-force and their industry, which couldlead to a more cost-effective arrangementfor the employer and a higer salary forthe employee. But such speculation doesn’t even scratch the surface of theeffect the law might have on Americanbusinesses and what CPAs need to knowto appropriately advise their clients or theircolleagues.

To prepare these advisors, the NYSSCPA has multiple opportunities forCPAs and the press to learn about theprovisions of the law and how to preparefor it. A free September 5 BreakfastBriefing, “SCOTUS Approved: TheAffordable Care Act: What It Means forYour Clients and Business,” will providea high-level discussion moderated by TrudyLieberman, contributing editor of theColumbia Journalism Review, focusing oncompliance issues and tax planning forCPAs and their clients. The Foundation forAccounting Education’s (FAE) upcomingHealthcare Conference on September 13 isa daylong event in Manhattan, also avail-able as a webcast, that will provide tech-

nical guidance so CPAs and other finan-cial professionals can gain a deeper under-standing of the law and its implications fortheir clients and themselves. Ready ornot, change is on its way.

CPAs of every professional discipline—taxation, audit, industry, nonprofit, andgovernment—will be called upon by theiremployers or clients to help comply withthe ACA. Not only will CPAs need tounderstand the implications of thesechanges, but they’ll also need to translatethem for clients and colleagues in their ownorganizations. Decide now what kind of CPA you want to be: the CPA who isahead of the curve, or the CPA who spends the majority of 2013 playingcatch-up. Whichever camp you are in, theNYSSCPA and FAE will help you get towhere you need to be. ❑

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

A Pound of Cure: Preparing for the ACA’s 2014 Deadline

ously expended a good deal of effort (e.g.,Invitation to Comment: Financial Reportingby Private and Small Public Companies,FASB, November 1981; Sunset Review ofAccounting Principles, Technical IssuesCommittee of the AICPA Private CompaniesPractice Section, 1982; Report of the [AICPA]Special Committee on Accounting StandardsOverload, February 1983).

In 1976, many respected CPAs believedthat the profession should not have two ormore sets of allowable accounting princi-ples in the United States; today, account-ing professionals believe that U.S. GAAPis more complex than ever and that IFRSis complex as well. But many also believethat the SEC will prescribe IFRS for U.S.publicly held companies, possibly as earlyas 2015; this means that there will be at leasttwo sets of GAAP: IFRS for public com-panies and some form of U.S. GAAP forprivately held companies. This situation hasalready occurred in Canada, where IFRSwas adopted for public companies in 2011;the Canadian Institute of CharteredAccountants devoted section 1500 of its lat-est accounting manual to rules for private-ly held companies.

One of the major problems smaller pri-vately held entities have had with U.S.GAAP is the voluminous and constantlychanging nature of the published stan-dards—sometimes referred to as account-ing standards overload. The IASB has rec-ognized this problem and has proposed thatIFRS for SMEs only be amended onceevery three years through the use of anomnibus document.

U.S. Reporting and Ethical StandardsRule 203 of the AICPA Code of

Professional Conduct requires member CPAsto take exception to financial statementspurporting to be in accordance with GAAPthat use accounting principles that depart fromthose “promulgated by bodies designatedby Council.” In 1973, the Council—the leg-islative body of the AICPA—designatedFASB as the body referenced in this rule.

In May 2008, the Council designated theIASB as a Rule 203–designated body withrespect to establishing international finan-cial accounting and reporting principles. Asa result of an interpretation issued by the

AICPA’s Auditing Standards Board(ASB), an auditor reporting on statementsprepared in conformity with IFRS wouldrefer only to IFRS conformity rather thanU.S. GAAP conformity.

Because IFRS for SMEs had not beenissued in 2008, the ASB interpretation ref-erenced above did not contemplate it; accord-ingly, it is unclear how a U.S. auditor shouldreport on financial statements prepared inaccordance with IFRS for SMEs. One pos-sibility would be for the auditor to include,in the opinion paragraph of the audit report,that the statement is “fairly presented in con-formity with IFRS for SMEs.”

The AICPA has already provided thefollowing encouragement about IFRS forSMEs:

The AICPA welcomes the introduction ofIFRS for SMEs in the United States.Private companies should be allowed tochoose the financial accounting and report-ing framework that best suits their objec-tives and needs of their financial statementusers. IFRS for SMEs represents anothervaluable financial accounting and report-ing option for private companies to con-sider using, depending on their unique cir-cumstances. (http://www.ifrs.com/overview/IFRS_SMES/IFRS_SMES_FAQ.html#q10)

Differences Between IFRS for SMEsand U.S. GAAP

The AICPA is committed to publishinga technical comparison between IFRS forSMEs and U.S. GAAP. The followingare some of the major simplified mea-surements provided for in IFRS for SMEs:■ Expense all research and developmentcosts. This is the same as U.S. GAAP(except for software costs) but would dif-fer from IFRS, which requires capitaliza-tion of certain development costs.■ Expense all borrowing costs, such asinterest. This would differ from both IFRSand U.S. GAAP, which require the capi-talization of certain borrowing costs.■ Simplify the measurement of definedbenefit pension obligations. Many SMEsdo not have defined benefit plans; instead,they have defined contribution plans.■ Require the amortization of indefinitelife intangible assets, including goodwill,and prohibit the IFRS revaluation option

for intangibles. A presumption of a 10-yearamortization period is specified, unless areliable estimate can be made of anotheruseful life.■ Do not require an annual review forresidual value and useful lives of proper-ty plant and equipment, and prohibit theIFRS revaluation option.■ For first-time adopters of IFRS for SMEs,allow a pass on the recognition of deferredtax assets and liabilities related to the carry-ing amounts at the time of transition.

In a separate document summarizing thebasis for its conclusions, the IASB dis-cussed various simplifications that wereconsidered but rejected. Some of the reject-ed simplifications were as follows:■ Do not require cash flow statements.■ Treat all leases as operating leases (notcapitalize any leases).■ Adopt a taxes-paid approach forincome taxes and eliminate deferred taxaccounting.■ Account for all employee benefit plansas defined contribution plans.

The Blue Ribbon PanelThe AICPA, the Financial Accounting

Foundation (FAF), and the NationalAssociation of State Boards of Accountancy(NASBA) formed the Blue Ribbon Panel onPrivate Company Financial Reporting in2009, which was tasked with addressingquestions concerning the application of IFRSfor SMEs. According to a September 2010Journal of Accountancy article, at least threemodels were under consideration by thepanel, including the following:■ U.S. GAAP with exclusions for privatecompanies■ Baseline U.S. GAAP with add-ons forpublic companies■ Separate, stand-alone GAAP for pri-vate companies, but based on currentU.S. GAAP, similar to the Canadianapproach.(http://www.journalofaccountancy.com/Issues/2010/Sep/20103099.htm)

AICPA Request for an IndependentBoard

The AICPA has requested that the FAF(and indirectly FASB, which is overseenby the FAF) set up an independent boardto establish accounting principles for pri-vately held businesses. In October 2010,


(Continued from page 6)

however, the FAF rejected the AICPA’s rec-ommendation for a separate board; instead,it suggested an approach that included rati-fication by FASB of proposals from a sep-arate board responsible for GAAP for pri-vately held businesses. FASB Chair LeslieF. Seidman stated that such a separate boardwould have its proposals ratified in accor-dance with a set of pre-established criteriain a similar fashion to FASB’s relationshipwith the EITF (“FASB Looks to theFuture: Standards Setting in a Post-Convergence World, An Interview withLeslie F. Seidman, FASB Chair,” The CPAJournal, December 2011). In the mean-time, the AICPA organized a letter-writingcampaign to the FAF, arguing for a stand-alone board whose decisions do not requireFASB ratification (http://blog.aicpa.org/2011/11/chairs-letter-aicpa-turns-125-in-2012.html).

In May 2012, the FAF announced thecreation of the Private Company Council(PCC), which will be responsible for con-sidering whether exceptions to U.S. GAAPare warranted to meet the needs of privatelyheld companies. In a change from theOctober 2001 proposal, the PCC’s recom-mendations will be subject to the endorse-ment of FASB, rather than ratification; inaddition, the PCC chair will not be a FASBmember. The PCC will also have fewermembers and meet more frequently than

initially proposed. These changes wereintended to strengthen the PCC’s inde-pendence and led to the AICPA’s eventu-al support of the council, as voiced byAICPA President Barry Melancon(http://blog.aicpa.org/2012/06/why-(PCC)the-aicpa-supports-fafs-creation-of-private-company-council.html).

RecommendationsThe problems of accounting standards

overload and excessively complex stan-dards have festered long enough. FASBoften attempts to resolve accounting issuesby seeking the one best answer that rep-resents an accounting “truth,” but the focusshould instead be on finding answers thatare practical and cost-effective for pri-vately held entities.

In addition to the solutions provided in theIASB’s IFRS for SMEs, a number of fun-damental measurement standards should beconsidered for repeal or modification. Thefollowing are among the most troublesomestandards for privately held entities:■ Deferred tax accounting. This standardcould be replaced with an approach thatcauses privately held entities to simplyreport as annual income tax expense theamount payable according to the tax return(a taxes-paid approach). Because the pre-sent deferred tax approach causes thereporting of an undiscounted liability that

will never be paid, or might only be paidmany years in the future, such a taxes-paidapproach would be justified on theoretical,as well as practical, grounds.■ Lease accounting. It seems probablethat FASB and the IASB will soon issuenew, and vastly different, guidance on leaseaccounting. Rather than put privately heldentities through another exercise inchanging their accounting for leases, theboards should consider a simple approachthat would allow all leases to be account-ed for as operating leases.■ Pension accounting. The boards shouldallow privately held entities to accountfor defined benefit plans as if they weredefined contribution plans.

The use of such standards for privatelyheld entities would be accompanied by asimple reference to published simplifiedstandards for those entities. The relatedauditors’ reports would state that the finan-cial statements are “fairly presented in con-formity with accounting standards for pri-vately held entities (published by …).” Inthis author’s opinion, these methods rep-resent a simple solution for common issuesfacing the profession and privately heldbusinesses. ❑

Charles A. Werner, CPA, is a professorat Loyola University, Chicago, Ill.


Let Us Hear From YouLet Us Hear From YouThe CPA Journal welcomes letters from readers in response to articles published in the mag-

azine, as well as those concerning issues of general interest to the accounting profession.

Although we receive more letters than we are able to publish, all letters receive consideration.

The editors reserve the right to edit letters for clarity and length. Writers should

include their contact information, including a daytime telephone number and an

e-mail address, if possible.

Letters may be addressed to Letters to the Editor, The CPA Journal, 3 Park Avenue,

18th Floor, New York, N.Y., 10016, or to [email protected].

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

2011 Max BlockAwards Presented

The winners of the 2011 Max BlockDistinguished Article Awards were

honored during The CPA Journal EditorialBoard meeting on June 4, 2012. Thisaward recognizes excellence in three cat-egories that reflect the mission of The CPAJournal: Technical Analysis, InformedComment, and Policy Analysis.

CPA Journal Editor-in-Chief Mary-JoKranacher presented the awards. Oneauthor, Sandra B. Richtermeyer, was inattendance at the meeting to accept theaward in person; FASB Chair Leslie F.Seidman participated via conference call.The 2011 winners are as follows:

Technical Analysis. “Estimating the FairValue of Investments in Entities ThatCalculate Net Value per Share,” by MatthewCrane and Robert A. Dyson, March 2011,won in the Technical Analysis category. Thisarticle analyzed Statement of FinancialAccounting Standards (SFAS) 157, FairValue Measurements (now AccountingStandards Codification [ASC] Topic 820-10). The authors focused on the difficultythat can occur when applying the guidanceto investments in certain nonpublic entities.In addition, they discussed diverging viewson fair value and the difficulty in obtaininginformation on alternative investments.

Matthew Crane, CPA, ABV, is a valua-tion specialist at McGladrey & Pullen LLP.Robert A. Dyson, CPA, is a director atMcGladrey & Pullen LLP, as well as amember of the CPA Journal Editorial Board.

Informed Comment. “Better AnalyticalReviews of Charitable Organizations:Using Financial Ratios and Benchmarks,”by Janet S. Greenlee, David W. Randolph,and Sandra B. Richtermeyer, July 2011,placed first in the Informed Commentcategory. The article examined Form 990tax information submitted to the IRS inorder to develop meaningful financial ratiosand suitable benchmarks for evaluating theperformance of charitable organizations.

Janet S. Greenlee, PhD, CPA, is an asso-ciate professor of accounting in theschool of business administration at theUniversity of Dayton, Dayton, Ohio. DavidW. Randolph, PhD, CPA, is an assistant

professor of accountancy in the WilliamsCollege of Business at Xavier University,Cincinnati, Ohio. Sandra B. Richtermeyer,PhD, CPA, CMA, is a professor of accoun-tancy, also in the Williams College ofBusiness at Xavier University.

Policy Analysis. “FASB Looks to theFuture: Standards Setting in the Post-Convergence World: An Interview withLeslie F. Seidman, FASB Chair,” pub-

lished in the December 2011 issue, wonthe Max Block Award for Policy Analysis.In the article, Seidman discussed her per-spective on standards setting and a globalset of standards. In addition, she shared herthoughts on the challenges and opportuni-ties currently facing the CPA profession,as well as on FASB’s role in the future.

Seidman assumed the position of FASBchair in 2010; she had first been appoint-ed to FASB in 2003 and then reappointedto a second term in 2006. As chair, sheleads the organization in providing guid-ance on both global and domestic concerns.

Determining the WinnersThe Max Block Distinguished Article

Awards are determined by the members of

The CPA Journal Editorial Board andEditorial Review Board, who rank a selec-tion of articles from a list of nomineesdetermined by the editorial staff. The edi-tors thank all of the board members whojudged the nominated articles.

About Max BlockMax Block (1902–1988) was a found-

ing partner of Anchin, Block & Anchin

LLP, and he served as managing editor ofthe NYSSCPA’s Journal (now The CPAJournal) from 1958 to 1972. Many indi-viduals who knew him have described himas a visionary whose ideas helped form thebasis for many reporting and practice-man-agement concepts used today.

Since 1975, The CPA Journal hasrecognized his contributions and achieve-ments by bestowing the Max BlockDistinguished Article Award on the mostoutstanding articles published in thepast year. Although the judging and selec-tion procedures continue to evolve, thecriterion remains the same: “An innova-tive and stimulating article which is ofcurrent significance and which is likelyto be of lasting value.” ❑


Max Block Award winner Sandra B. Richtermeyer with CPA Journal Editor-in-Chief Mary-Jo Kranacher.

The Imprecise Natureof Accounting

Questions on Measurement,Standards Setting, and the

IASB’s Course for the Future

By Hans Hoogervorst

The following is an edited transcript of HansHoogervorst’s speech at an InternationalAssociation for Accounting Education andResearch conference in Amsterdam on June 20, 2012.

Accounting should be the most straight-forward of topics for policymakers

to deal with. Accounting is mainly aboutdescribing the past in order to faithfullyreflect what has already happened. Thisshould be dull business, better left to “beancounters.” Surely, counting beans cannotcause too many problems; yet, over theyears, many securities regulators havetold me of their surprise upon finding outthat accounting policy is one of the mostdifficult and controversial topics to dealwith. It is the same around the world—justask the Japanese FSA [Financial ServicesAgency], the U.S. SEC, or the EuropeanCommission. Why is accounting the sourceof such heated debates? There are manyreasons why this is the case. Sir DavidTweedie, my predecessor as chairman ofthe IASB [International AccountingStandards Board], used to say that it wasthe job of accounting to keep capitalismhonest. It is no wonder that accountingstandard setters come under so much pres-sure. Some business models can thriveoff of a lack of transparency—just think ofthe pre-crisis Special Purpose Vehicles inthe banking industry.

There is another reason why account-ing can be so controversial: the inescapablejudgment and subjectivity of accountingmethods. Put simply, there is a lot to dis-agree about.

When I became chairman of the IASBin July last year, I knew enough aboutaccounting to know that I was not enter-ing a world that was governed by the ironrules of science. I knew that accounting

has the same problem as its sibling, eco-nomics: you need math to exercise it, butyou should not count on outcomes withmathematical precision. In short, I did nothave naïve expectations of accounting—orso I thought. One year later, now that I amwell ahead on a steep learning curve, Imust admit that I may have been a bitnaïve after all. Let me give you a coupleof examples that served to open my eyes.

Measurement Techniques and OutcomesFirst of all, I was struck by the multitude

of measurement techniques that both IFRS[International Financial Reporting Standards]and U.S. GAAP [Generally AcceptedAccounting Principles] prescribe, from his-toric cost, through value-in-use, to fair valueand many shades in between. In all, our stan-dards employ about 20 variants based on his-toric cost or current value. Because the dif-ferences between these techniques are often

small, the significance of this apparently largenumber should not be over-dramatized.Still, the multitude of measurement tech-niques indicates that accounting standards set-ters often struggle to find a clear answer tothe question of how an asset or liabilityshould be valued.

It is also remarkable that our standardscan cause one and the same asset to havetwo different measurement outcomes,depending on the business model accordingto which it is held. For example, a debt secu-rity has to be measured at market valuewhen it is held for trading purposes, but itis reported at historic cost if it is held tomaturity; in this case, the business modelapproach certainly provides a plausible

answer. Still, some may find it counterin-tuitive that a government bond that is heldto maturity would be valued at a higher pricethan the same bond held in a trading port-folio, where it may be subject to a discount.In the exact sciences, such a dual outcomewould certainly not be acceptable.

One of the biggest measurement dilem-mas relates to intangible assets. We knowthat they are there. While the value ofFacebook’s tangible assets is relatively lim-ited, its business concept is immenselyvaluable (although 25% less immense thana month ago). Likewise, the money-mak-ing potential of pharmaceutical patents isoften quite substantial; however, both typesof intangible assets go unrecorded (orunderrecorded) on the balance sheet. Understrict conditions, IAS [InternationalAccounting Standard] 38, IntangibleAssets, allows for limited capitalization ofdevelopment expenditures, but we know

the standard is rudimentary because it isbased on historical cost, which may notreflect the true value of the intangible asset.

The fact is that it is simply very diffi-cult to identify or measure intangible assets.High market-to-book ratios may provideindications of their existence and value.After the excesses of the dot.com bubble,however, there is understandable reluctanceto record them on the balance sheet.

Although our accounting standards donot permit the recognition of internally gen-erated goodwill, our standards do requirecompanies to record the premium they payin a business acquisition as goodwill.This goodwill is a mix of many things,including the internally generated goodwill


v i e w p o i n t

It is also remarkable that our standards can cause one and

the same asset to have two different measurement outcomes,

depending on the business model according to which it is held.


of the acquired company and the synergythat is expected from the business combi-nation. Most elements of goodwill are high-ly uncertain and subjective, and theyoften turn out to be illusory.

The acquired goodwill is subsequentlysubject to an annual impairment test. Inpractice, these impairment tests do notalways seem to be done with sufficientrigor. Often, share prices reflect the impair-ment before the company records it onthe balance sheet; in other words, theimpairment test comes too late. All in all,it might be a good idea if we took anoth-er look at goodwill in the context of thepost-implementation review of IFRS 3,Business Combinations.

Defining IncomeIt is not only the balance sheet that is

fraught with imprecision and uncertainty;we also have a problem defining whatincome is and how to measure it. Wereport three main components of income:the traditional profit or loss or netincome, other comprehensive income[OCI], and total comprehensive income.Total comprehensive income is the easypart; it is simply the sum of net incomeand other comprehensive income. Not toomany people seem to be paying attentionto it, even if they should.

The distinction between net income andOCI lacks a well-defined foundation, how-ever. While the P&L [profit and loss state-ment] is the traditional performance indica-tor on which many remuneration and divi-dend schemes are based, the meaning of OCIis unclear. It started as a vehicle to keepcertain effects of foreign currency translationoutside net income and gradually devel-oped into a parking space for “unwanted”fluctuations in the balance sheet. There is avague notion that OCI serves for recordingunrealized gains or losses, but a clear defi-nition of its purpose and meaning is lacking.

But that does not make OCI meaning-less. Especially for financial institutionswith large balance sheets, OCI can containvery important information; it can giveindications of the quality of the balancesheet. It is very important for investors toknow what gains or losses are “sitting” inthe balance sheet, even if they have notbeen realized.

In the future, OCI will certainly be animportant source of information about insur-ance contracts. Several weeks ago, bothFASB and the IASB proposed that changesin the insurance liability due to fluctuationsin the discount rate would be reported inOCI. Many of our constituents requested usto do so; both preparers and users wantedto prevent underwriting results being snowedunder by balance sheet fluctuations. As aresult, OCI will become bigger and will con-tain meaningful information, such as indi-cations of duration mismatches betweenassets and liabilities.

This decision for the use of OCI was noteasy to make. Our fellow board memberStephen Cooper showed us in a razor-sharpanalysis that, in this presentation, both netincome and OCI—if seen in isolation—might give confusing information. We willtry to tackle some of these problems withpresentational improvements. But it is alsoclear that a full picture of an insurer’sperformance can only be gained by con-sidering all components of total compre-hensive income. We will point this outexplicitly in the basis for conclusions ofthe new standard.

More fundamentally, we will look at thedistinction between net income and OCIduring the upcoming revision of theConceptual Framework. All of our con-stituents have asked us to provide a firm

theoretical underpinning for the meaningof OCI, and we will endeavor to do so. Fornow, while we may not always knowhow important OCI exactly is, we can besure that net income is not a very preciseperformance indicator either. Both needto be used with judgment, especially in thefinancial industry.

Standards SettingWhat is the reason for all this ambigu-

ity and lack of precision in accounting?Well, to a great extent it is simply thenature of the beast. Valuation is as muchof an art as a science, and we are fullyaware of that. Our Conceptual Frameworksays: “General purpose financial reports arenot designed to show the value of a report-ing entity; but they provide information tohelp users to estimate the value of thereporting entity.” Value is ultimately in theeye of the beholder. There is often not aclear-cut answer to the question of whichmeasurement technique is most appropri-ate to capture it.

These comments about the imperfectionsof accounting should not be interpreted asa sign of wary relativism about the signif-icance of our standards. Quite the oppo-site: I am deeply convinced that ouraccounting standards are an essential ingre-dient of trust in our market economy. Inan economic system in which so many par-ties are working with other people’smoney, high-quality accounting standardsthat provide transparency to the market areof paramount importance.

High-Quality StandardsIFRS, as a global standard, has had a

tremendously beneficial impact for globalinvestors, who lacked all comparability inthe pre-IFRS days. Several academic stud-ies have shown that the introduction ofIFRS has contributed to lowering the costof capital. Moreover, financial reportingdoes not need to be mathematically exactto be useful; it is a tool to help investorson their way. Warren Buffett is known touse financial reports as a rough-and-readychecklist: more than five or six questionmarks are enough for him to decide againstmaking an investment.

One has only to look at the insuranceindustry to see how essential proper

For now, while we may not always

know how important OCI exactly is,

we can be sure that net income is

not a very precise performance

indicator either.

accounting standards are. Currently, IFRSdoes not have a full-blown standard forinsurance. As a result, financial reportingby the industry is riddled with non-GAAP measures, and there is a serious lackof comparability. Because the industry’sreporting lacks the underlying rigor of uni-form accounting, investors demand a high-er price for capital to make up for thelack of transparency.

Public sector accounting also demonstratesthe primitive anarchy that results without thediscipline and transparency that good finan-cial reporting provides. While the IPSASB[International Public Sector AccountingStandards Board] has created good standardsfor the public sector, based on IFRS, theyare used only haphazardly. Around theworld, governments give very incompleteinformation about the huge, unfunded socialsecurity liabilities they have incurred.Many executives in the private sector wouldend up in jail if they reported like ministersof finance, and rightly so.

There can be no question about the rele-vance and importance of our standards. Asthe convergence program comes to a close,and the IASB is ready to take on a new agen-da, we should concentrate on further improv-ing the quality of our standards. Although weknow that some of the imprecision and ambi-guity I mentioned before is inevitable, it isour job to push back the grey areas inaccounting as far as possible. So howshould we go about it? I believe we shouldbe guided by the following three terms: prin-ciples, pragmatism, and persistence.

For the very reason that accounting isnot an exact science, principles-based stan-dards setting remains the right way for-ward. If the use of judgment is inescapable,it should be guided by clear principlesand not by detailed, pseudo-exact rules. Wewill strengthen our basic principles byfinishing the review of the ConceptualFramework and by tackling thorny issuessuch as measurement, performance indi-cators, OCI, and recycling.

While I am not so naïve to think that anew Conceptual Framework will solve allour problems, I think it can serve to giveus firmer ground under our feet. Even ifprecise answers are not always available,a completed Conceptual Framework shouldgive us more guidance on the recognition

of assets and liabilities, measurement tech-niques, and performance indicators.

If we know that there is not always aprecise answer to every question, our workneeds to be grounded in pragmatism andcommon sense. As [economist JohnMaynard] Keynes said, it is better to beroughly right than to be precisely wrong.We should avoid trying to get companiesto achieve precision without accuracy.Pragmatism also means we need to lookvery carefully at any possible undesirable

use of our standards. Whenever we areconfronted with a high degree of uncer-tainty, we should act with great caution.

I just gave the example of intangibleassets. We know they are there, but mea-surement is a big problem. If our standardswere to provide too much room for recog-nition of intangible assets, the potential formistakes or abuse would be immense. Insuch circumstances, it is better for ourstandards to require more qualitative report-ing than pseudo-exact quantitative report-ing. People always tell us we should notset our standards from an anti-abuse per-spective; I think that is nonsense. If we seeample scope for abuse in a standard, we hadbetter do something about it. There aresufficient temptations and incentives for cre-ative accounting as it is.

Pragmatism is important, but itshould not be confused with opportunism.

That is why we need persistence, too. Inthe face of the pressures we are contin-ually facing, persistence is an importantquality for standard setters. Accountingstandards setting should be sensitive tolegitimate business concerns, but shouldalso be firm and independent in the faceof special interests. Many times, doom-sayers have predicted their businesswould come to an end as a result of ourstandards. Just as often, the industry inquestion miraculously seemed able to sur-vive our rules very well indeed. Wealways need to listen, but we have to takedecisions, too.

Looking to the FutureFor the IASB to persist on a steady

course, it would be hugely beneficial ifinvestors’ views were heard more loudlyand clearly than currently is the case. Whileinvestors are our prime audience, theirvoice is too often drowned out by vocif-erous business interests. In the comingyears, we are determined to further investour relationship with investors in order toensure that we get more balanced feedbackon our proposals than currently is the case.

We are especially interested in strength-ening our relations with what I would liketo call our “end-users.” With this term, Irefer to true investors, in the sense that theyactually own assets, such as institutionalinvestors. The support of the investor com-munity will make it easier for us to stayour course.

So it is with principles, pragmatism, andpersistence that the IASB will take on its newagenda. We should use the coming years tostrengthen the underlying principles of ourwork. We should improve the significanceof the quantitative outcome of our standardswhere possible. Where this is impossible, weshould make this clear and put moreemphasis on qualitative information.

This is all much easier said than done,but my board looks forward to taking onthis challenge with our highly motivatedstaff. Whatever the coming years maybring, it is clear that they will not be a peri-od of calm. ❑

Hans Hoogervorst is the chairman of theIASB.


While investors are our prime

audience, their voice is

too often drowned out by

vociferous business interests.

e d u c a t i o n

Teaching andAdvising a NewGeneration of

Accounting StudentsA Glimpse into the NYSSCPA’s

2012 Higher EducationConference

By Stephen Scarpati and Patricia Johnson

College students considering a major inaccounting and a career as a CPA

quickly learn that there is nothing easyabout the process: they discover that theundergraduate accounting curriculum ismore rigorous than that of other businessmajors and they are told that this must befollowed by demanding graduate studies.Students then hear of the infamously dif-ficult CPA exam, as well as stories of longhours once they start work. To an 18- or19-year-old student, the entire prospect canseem frightening.

Consequently, individuals pursuingcareers as a CPA frequently look to pro-fessionals they know for guidance andadvice. CPAs who are in a position to offersuch counsel usually welcome the oppor-tunity; often, they find it rewarding to sharetheir experiences and instill an under-standing of the profession in students.Mentors also learn something in the pro-cess: this generation of young people dif-fers from the generations that preceded it.Furthermore, the work environment thatthese young people are entering offers newsets of challenges.

College accounting professors, by neces-sity, are at the forefront of advising stu-dents about CPA careers. This adviceusually takes multiple forms. First are thefacts—explaining the requirements forlicensure in the particular state in which astudent wants to work. Second is reassur-ance to an often-overwhelmed freshman orsophomore that this formidable career pathis a road worth taking. While some stu-dents back away, others step up. ManyCPAs often recall that the encouragement

of an accounting professor pointed themtoward a rewarding career.

With full recognition of their need toremain current with this mission, a largegroup of educators met at KPMG head-quarters in New York City for theNYSSCPA’s 2012 Higher EducationConference. To assist accounting profes-sors in their dual role of advisor and teach-er, the Higher Education Conference cov-ered the following topics:■ The Millennial generation■ Careers in accounting■ CPA licensure ■ Program assessments■ Technology■ A professional update.

The Millennial GenerationDuring the conference, a fascinating

wealth of information came from RichardSweeney, university librarian at the NewJersey Institute of Technology, Newark. Hepresented his research on the Millennialgeneration, which comprises individualswho were born between 1980 and 1994.Because this includes current undergradu-ate students, college professors attendingthe event were extremely interested in thetopic. According to Sweeney’s research,this generation definitely has differentbehaviors from the generations that pre-ceded it. (Exhibit 1 presents an excerptfrom Sweeney’s research.)

An intercollegiate focus group ofaccounting majors from FordhamUniversity and Manhattan College in theBronx, N.Y., and Sacred Heart University,in Fairfield, Conn., augmented the pre-sentation. The ensuing dialogue with thestudents reinforced many of the researchpoints and acted as a learning experiencefor attendees. The following lessons can beincorporated into accounting classes:■ More “hands-on” learning■ Further engagement of students, whenpossible■ Creating a sense of personal involve-ment and interaction in the classroom.

Careers in AccountingThe conference featured four sessions

that covered the following topics related tocareers in accounting:■ Government accounting

■ Internal auditing■ Management accounting■ Accounting recruiting.

Government accounting. Because gov-ernment accounting is not usually includedin core accounting curriculums, careers in thisfield can often be overlooked. Michele MarkLevine, director of accounting services forthe New York City Office of Managementand Budget, increased accounting educa-tors’ awareness of the nature, variety, andquantity of career opportunities in govern-ment. She provided information and resourcesthat were useful for interested educators andstudents. Levine also identified and discussedissues related to government accounting andauditing that are currently facing the account-ing profession. The first issue she discussedwas governmental GAAP, which is pro-mulgated by—■ the Governmental AccountingStandards Board (GASB) for U.S. state andlocal governments,■ the Federal Accounting StandardsAdvisory Board (FASAB) for the U.S. fed-eral government, and■ the International Public SectorAccounting Standards Board (IPSASB) formany non-U.S. government entities. (Whilethere are some project collaborations betweenGASB and IPSASB, there is no plannedconvergence between the sets of standards.)

A second issue that Levine addressedwas the question of what CPAs in gov-ernment actually do. The answer, in short,was: almost everything that CPAs in anyorganization do. Most private sectoraccounting and auditing work has a gov-ernmental counterpart; however, some gov-ernmental work, such as law enforce-ment, is only performed in or under theauspices of government.

Levine also mentioned some of theattractions of careers in government,including—■ favorable work/life balance,■ attractive employee benefits such as healthinsurance and defined benefit plans, and■ a spirit of public service.

A vigorous discussion with conferenceparticipants followed, focusing on the roleof politics in government accounting. Someattendees believed that this might be adrawback to careers in the field; Levineacknowledged a need to tolerate some pol-


itics but thought that, in the end, talentedpeople will rise through the governmentranks.

Internal audit. Another career fieldthat can be overlooked is internal auditing.Charles Windeknecht, vice president of theinternal audit function of Atlas AirWorldwide, updated attendees on whyinternal auditing represents an importantcornerstone in corporate governance.Windeknecht indicated that an internalaudit is an objective assurance and con-sulting activity designed to add value andimprove an organization’s operations; ithelps an organization accomplish its objec-tives by using a systematic, disciplinedapproach in order to evaluate and improvethe effectiveness of risk management, con-trol, and governance processes.

Windeknecht said he believes that it’sa great time to be an internal auditorbecause, not only is the profession grow-ing, it offers accountants the opportunityto understand a business, its risks, and itscontrols. He also briefed educators on theInstitute of Internal Auditors (IIA), theinternational professional association estab-lished in 1941 that has more than 150,000members and operates in 165 countries andterritories. The IIA’s vision is to be theglobal voice of the internal audit profes-sion—advocating its value, promoting bestpractices, and serving its members.

Management accounting. JeffreyThomson, president and CEO of the Instituteof Management Accountants (IMA), sharedhis perspective on this field. According toThomson, too much time is spent recordingrather than driving businesses. He discussedthe importance of “preparing students forcareers in accounting and not just their firstjob.” In addition, he stated that about 80% ofstudents will eventually work in the field ofmanagement accounting and that the globalmarket for accountancy remains “healthy andresilient.”

The IMA and the management account-ing division of the American AccountingAssociation are currently developing amodel curriculum for managementaccounting. Student chapters and academ-ic partnerships play an important role inthis curriculum. Resources for facultyinclude case studies for use in the class-room, as well as research opportunities.

Accounting recruiting. A panel of col-lege recruiters from KPMG, Pricewater-houseCoopers, McGladrey, Protiviti, andO’Connor Davies spoke about the currentstatus of recruiting young accountants, aswell as their expectations for new graduates.Representatives from both big and smallfirms debated the relative benefits of eachentity. Recruiters from smaller firms empha-sized the opportunities for young accoun-tants to experience a greater variety of indus-tries and more fully develop their skill sets.

Recruiters from large firms noted the trendtoward increased specialization earlier in thecareers of young accountants who joinedtheir firms, as well as more exposure to bothinternational and larger clients. Additionalcomments from the panel included the fol-lowing:■ The expansion of the definition of pub-lic accountancy in New York State has nothad an impact.■ Increasingly, an internship is the optimalfirst step on the path to a full-time position.■ All firms place a high priority on stu-dents’ plans to attain their 150 hours ofeducation prior to beginning employment.■ The lack of business writing skillsamong college graduates continues to bea problem.■ The current generation of young adultsis more “laid-back,” with a more casualcommunication style that is often notappropriate in business circumstances.■ Educators were urged to get to know

the partners and recruiters of the firms vis-iting their campuses.

CPA Licensure: New York State UpdateMary Beth Nelligan-Goodman, acting

executive secretary of the New YorkState Board of Accountancy, providedtimely information about the educationrequirements for 1) sitting for the CPAexam and 2) becoming licensed as aCPA. For the former, applicants need tohave completed 120 credit hours andmust have taken one course in each of thefollowing areas: ■ Financial accounting and reporting■ Cost or managerial accounting■ Taxation■ Auditing and assurance services.

In order to become licensed, applicantsmust show that they have completed 150credit hours, including 33 hours in account-ing and 36 hours in business, as well asone year of experience. They must demon-strate that they have covered ethics andprofessional responsibilities, business andaccounting communications, and accountingresearch; however, these areas can be embed-ded in a variety of courses. Applicants cancount internships in accounting as belongingto either the accounting or business contentareas. The 2009 accountancy reform lawexpanded the scope of practice in New York;now a broad range of experience, under thedirection of a CPA, will qualify an individ-ual for licensure.

The passing rate on the CPA exam hasremained relatively consistent over the pastseveral years. In 2011, coverage ofInternational Financial Reporting Standards(IFRS) was added to the exam, alongwith changes in the simulations, a newresearch task format, new authoritativeliterature (FASB codification), and theinclusion of the written communicationcomponent in the business environmentconcepts (BEC) section of the exam.Candidate satisfaction with the examremained high. Starting in August 2011,the CPA exam was offered in selectedPrometric testing centers overseas; theexam is given in English, and candidatesabroad must meet the same requirementsas U.S. candidates.

One noteworthy change in the continu-ing education requirements relates to the


Many CPAs often recall that the

encouragement of an accounting

professor pointed them toward a

rewarding career.

professional ethics requirement: effectivefor registrations taking place on or afterJanuary 1, 2012, the required four creditsof ethics must be completed within thethree prior calendar years.

Program AssessmentThe issue of program assessment is

one that all educators have been dealingwith, in one form or another. Eileen Beiter,an assistant professor at Nazareth College,Rochester, N.Y., and Maxine Morgan-Thomas, an assistant professor at Long

Island University, Brooklyn, N.Y., sharedtheir experience developing and refiningprogram-assessment strategies. Theyemphasized the importance of identifyingwhat is being assessed, how it is beingassessed, and where it is being assessed(what course or series of courses), as wellas keeping the process simple. Takeawaysfor conference attendees included curricu-lum-mapping examples and sample rubrics.To stay competitive, programs must let theresults, both favorable and unfavorable,inform future changes in the curriculum.

TechnologyIt is important for both educators and

students to understand the role of account-ing information systems, as well as theavailable technology tools, in making thepractice of accounting more efficient.

Accounting information systems. Theimportance of understanding how to effec-tively provide information in order to sup-port decision making and business process-es has grown as the role of accounting inan organization has evolved. One relatedtopic, requested by conference attendees in


Millennials Born from 1980 to 1994; ages 32 to 18 in 2012; largest generation since Baby Boomers; mostracially and ethnically diverse U.S. generation ever; more than 40% are children of divorce.

More Consumer Choices; Selectivity One of the most important Millennial behaviors is their expectation for more selectivity and options.They have grown up with a huge array of choices and they believe that it is their birthright. Theyfeel less need to conform in their consumer choices to everyone else in their generation or othergenerations. The converse is also true: they are most unhappy with limited choices.

Personalization and Customization Once Millennials do make their choices in products and services, they expect many personal-ization and customization features that meet their changing needs, interests, and tastes.

Impatient Millennials, by their own admission, have no tolerance for delays. They require almost con-stant feedback to know how they are progressing. They hate it when they are delayed,required to wait in line, or have to deal with some lengthy unproductive process. The need forspeed and efficiency—or, as some believe, instant gratification—permeates virtually all oftheir service expectations.

Experiential Learners Millennials strongly prefer learning by doing. They almost never read the directions; they loveto learn by interacting. Multiplayer gaming, computer simulations, and social networks aresome of their favorite environments and provide little penalty for their trial-and-error learning.By and large, Millennials have said that they find their average lectures boring. With suchexperiential learning, Millennials get much more interactivity and feedback about what worksand what does not.

As Employees They expect to spend no more than 18 months to two years in their first job, expect constantpractical training and useful skills, want office hours with flexible schedules, and are morelikely to be recruited online. Sixty-one percent of CEOs say they have difficulty attracting andintegrating younger workers.

Balanced Lives They don’t want to work 80 hours per week and sacrifice their health and their leisure time,even for considerably higher salaries; free time is more important than compensation. Yet,they typically expect incomes exceeding their parents.

Flexibility/Convenience Millennials prefer to keep their time and commitments flexible longer in order to take advan-tage of better options; they also expect employers, other people, and institutions to give themmore flexibility. They want to “time and place–shift” their services, where and when they areready. They want more granularity in the services, so they can be interrupted and finish whenthey are ready without loss of productivity.

Source: Richard Sweeney, New Jersey Institute of Technology, 2012, used with permission under a Creative Commons attribution,share-alike, noncommercial license.

EXHIBIT 1Research Excerpt: How Millennial Behavior Differs from Previous Generations at the Same Age

previous years, focused on how to developand implement a course in accounting infor-mation systems. James Goldstein, an assis-tant professor at Canisius College, Buffalo,N.Y., shared tips on establishing a course,topics to cover, and software and textbooksthat educators can utilize.

The following were the objectives for acourse in accounting information systems:■ Identifying and modeling business processes■ Designing and implementing systemsto carry out routine tasks■ Designing and implementing internalcontrols in information systems.

Tools for improving efficiency andeffectiveness. CPAs Stephen Valenti andPeter Frank shared how they utilized a vari-ety of technology tools, both at work andat home. Whether organizing a music col-lection or accessing client tax returnsremotely, users should select the rightdevice for the task at hand, consideringboth costs and benefits. Whether individ-uals are students, educators, or practition-ers, the key is to identify the features ofnew tools that are most important to thoseindividuals. Functionality is crucial.

For educators interested in augmentingthe classroom experience, it can be time-consuming to try to understand the limita-tions of technology, such as device speci-fications or wireless data plan contracts,but it is definitely time well spent. The abil-ity to access files anywhere at any time hasbecome a reality; the choice of what deviceto use in doing so is an individual deci-sion. Valenti and Frank’s presentation con-cluded with a look into the near future, andhighlighted the following near-termdevelopments:■ New operating systems■ Cross-platform compatibility■ Enhanced processor, graphics, and battery life■ Lighter devices■ Hybrids■ Improved cloud options.

Professional UpdateKeeping current on what is happening

with the SEC, FASB, the InternationalAccounting Standards Board (IASB), andthe Public Company Accounting OversightBoard (PCAOB) is important to all

accounting professionals. Teresa E.Iannaconi, a partner at KPMG, presentedan update on issues currently under dis-cussion within the profession. Her remarksfocused on what constitutes risk—accountants and auditors need to considerrisk not only with regard to what shouldbe quantified on the financial statements,but at a broader level. Exposure to repu-tational risk in the Internet age is an areaof increasing concern for corporations.

The SEC has recently issued guidanceon assessing the need for disclosures aboutcyber security, as well as European debtexposure. Disclosure overload continues tobe discussed, and the question of enhanc-ing understanding—utility—should be themain concern in determining the right levelof disclosure. Foreign operations are alsohigh on the SEC’s agenda as legal and cul-tural differences continue to complicateinternational transactions. In addition,Iannaconi encouraged educators to famil-iarize students with uncertainty in financialstatements; everything on the statements,with the possible exception of cash,involves uncertainty to some degree. Fairvalue, the use of non-GAAP measures, andloss contingency disclosures have alsoreceived recent attention from the SEC.

Two current FASB-IASB joint projectsfocus on revenue recognition and account-ing for leases. The final revenue recogni-tion standard is expected later this year.The scope of the proposal is limited to rev-enue arising from contracts with customers.One of the key impacts of the new stan-dard for lease accounting is the inclusionof virtually all leases on the balancesheet, effecting key ratios and covenants.The boards received more than 800 com-

ment letters in response to the originalexposure draft, which led to the reexposureof the proposed leasing standard. The finalleasing standard is expected in 2013, witha likely effective date of 2016 or later.

Modifications to the auditor’s report,auditor independence, and auditor rota-tion have all been under discussion by thePCAOB. The final standard on communi-cations with audit committees is expectedlater this year.

Collaborative BenefitsCollaboration among practitioners and

educators provides students with a bridge tothe profession, and taking the opportunityto learn from each other helps ensure thatstudents receive a relevant education thatmeets the needs of their future employers.For those in attendance, the NYSSCPA’s2012 Higher Education Conference pro-vided information that can be applied inthe classroom to improve accounting edu-cation. In addition, professors gained updat-ed insight and knowledge that will helpthem better advise a new generation ofaccounting students as they embark on thepath to becoming a CPA. ❑

Stephen Scarpati, CPA, CLU, ChFC, isan accounting professor at the John F.Welch College of Business at Sacred HeartUniversity, Fairfield, Conn., and a mem-ber of The CPA Journal Editorial Board.Patricia Johnson, MBA, CPA, CFE, is anaccounting professor at Canisius College,Buffalo, N.Y.; past chair of the NYSSCPA’sHigher Education Committee; and a boardmember of the Foundation for AccountingEducation.


CorrectionIn “The Best Firms to Work For: Popularity, Prestige, and Quality of LifeRankings Explored,” published in the July 2012 CPA Journal, Ernest PatrickSmith was incorrectly identified as a professor of fraud and forensic accounting atHofstra University; he is an adjunct instructor of fraud and forensic accounting. In addition, one statement attributed to Smith—“And in at least one graduatingaccounting class at Hofstra, not one person has plans to work at a large account-ing firm, according to Smith”—was meant to refer to one accounting class that he taught that included six students, rather than the entire graduating class of theuniversity. The editors apologize for any confusion. ❑

Quick Response Codes:A Marketing Tool for

Accounting FirmsBy James Alexander

In today’s technological world, it is criti-cal for businesses to have an online mobile

presence that contacts can easily access.More than 50% of online searches nowbegin on a mobile phone. Approximately500 million Facebook users have usedmobile devices to access their pages.Professional networking site LinkedIn hasreported that nearly one quarter of its uniquevisitors in a recent three-month periodaccessed the site from a mobile device. Yetmost accounting firms don’t have mobile-optimized websites, even though a weak ornonexistent mobile presence can cost anaccounting firm business.

Quick response (QR) codes are a mar-keting tool widely used by top consumerbrands to bolster their mobile marketingefforts. QR code use is also making seri-ous inroads into the marketing strategies ofprofessional services firms, and for goodreason: according to a recent comScorestudy, more than 20 million Americansscanned a QR code with a smartphone injust one three-month period last fall(http://www.comscoredatamine.com/2011/12/20-million-americans-scanned-a-qr-code-in-october/). These two-dimen-sional codes can be printed on businesscards, brochures, proposals, and other mate-rial in order to direct users to a websitefor further information.

Professional services organizations, suchas accounting firms, are increasingly usingthe codes to provide potential clients andbusiness contacts with additional informa-tion online. QR codes can be an excellentmarketing tool, but professionals who usethem should follow best practices in theirQR code campaign to ensure that visitorslearn something new and retain the contactinformation for later reference.

Delivering Value and OptimizingMobile Viewing

The most important consideration foraccounting professionals contemplating the

addition of QR codes to their overall mar-keting strategy is the information that theywill convey with the code. It’s not enoughjust to integrate QR codes into a firm’s over-all marketing campaign. If the code mere-ly leads visitors to the standard firm web-site, it can even be counterproductive if thesite isn’t optimized for mobile viewing.

Ideally, the QR code should lead usersto a site containing unique information. Thesite should showcase items like the firm’scontact information, credentials, andvalue proposition. For example, the sitelinked to the QR code could serve as amobile business card that allows newacquaintances who scan it to retain theaccounting professional’s contact informa-

tion on their smartphone for future refer-ence. It could also deliver one-click accessto hand-picked Google search results toconnect users to relevant links that makea positive first impression, videos of theprofessional discussing an area of exper-tise, access to online bios, and other rele-vant information.

Firms should keep in mind that the web-site linked to the QR code will almostalways be viewed on a mobile device.For that reason, it’s important to direct con-tacts who scan the code to a mobile-opti-mized site; visitors are unlikely to scrollfrom side-to-side to view a standard web-site on a small smartphone screen.

Bridging the Digital Gap with QR CodesAccording to a 2012 Nielsen study,

about half of all mobile phone users inthe United States use smartphones, whichrepresents a nearly 40% increase over theprevious year (http://blog.nielsen.com/

nielsenwire/online_mobile/smartphones-account-for-half-of-all-mobile-phones-dom-inate-new-phone-purchases-in-the-us).Thus, accounting firms that do not have amobile web presence could be at a com-petitive disadvantage.

QR codes are an inherently mobile toolbecause people scan them with smartphonesand other mobile devices, such as tablets.Accounting firms that use QR codes canstay ahead of the curve when it comes tomobile marketing if they choose a QR codeservice partner that offers mobile siteoptions, such as a microsite, that canbridge the gap between the firm’s printedmaterial and mobile information.

For example, Melissa Burnside, mar-keting coordinator at REDW LLC, aNew Mexico CPA and business consult-ing firm, recently began using QR codeson accounting professionals’ businesscards. She observed:

QR codes are still somewhat novel on busi-ness cards. In fact, I believe we are one ofthe first CPA firms to implement QRcodes. They make a great conversationstarter with clients and business contacts,but more importantly, they fit nicely withour social media strategy because they giveour accountants another way to connectwith new contacts and share informationon a mobile device. It’s an instant mobilepresence that also conveys the fact that ourfirm is forward-thinking.

Adding It All UpMobile marketing is an increasingly

important component of a total marketingstrategy for individual professionals andfirms. A QR code strategy can be anexceptional marketing tool, but it pays forprofessionals to think through the approachand make sure that using QR codes willthe codes deliver their information in theappropriate form.

With the right QR code approach, aswell as QR code service partner that deliv-ers more than just a code and a link to amain website, accounting firms can effec-tively showcase their qualifications. ❑

James Alexander is founder and CEO ofVizibility Inc., New York, N.Y., an onlineidentity management platform.


t e c h n o l o g y

A QR code strategy can be an

exceptional marketing tool, but it

pays for professionals to think

through the approach.


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

Rethinking the Audit

The NYSSCPA, the editors of The CPAJournal, and those who write for the

Journal each month should all be com-mended for the quality of their work andtheir commitment to the accounting pro-fession. The recent articles, “Enron TenYears Later: Lessons to Remember”(Anthony H. Catanach, Jr., and J. EdwardKetz, May 2012) and, earlier, “Mark-to-Market's Real Role in the Crisis: HowAccounting Standards Helped Build the‘Super Bubble’” (Gina McMahon,February 2011), are outstanding examplesof what should be found in journals writ-ten for practitioners and financial account-ing statement users. I doubt that any otherpublication would have the courage or theinsight to make available the results of sim-ilar research, carried out on critical issuesof professional import.

The assessment of the AICPA byCatanach and Ketz is well received. TheAICPA is a reflection of a problem iden-tified in a monograph by John Buckley(University of California, Los Angeles) forthe California Society of CPAs, publishedin 1969. In it, Buckley asserted that CPAshad lost their identity. Robert K. Mautz, ina monograph for the American AccountingAssociation, drew an important distinc-tion between accounting as a practice andauditing as a profession. Professions holda socially granted franchise, mandate, ormonopoly to provide an essential service,which is acknowledged through licensingand government oversight. My own dis-sertation research from 1987 to 1988 doc-umented the validity of Buckley's concern.When a large number of CPAs in prac-tice and in industry were asked one ques-tion—“What is the unique role (function)of the CPA?”—more than two-thirds didnot answer with auditing/attestation.

In my opinion, the AICPA fell into thetrap of the times in the 1980s: head countand membership revenue. Almost anywarm body could join. The AICPA “soldout” the audit side of the profession whenit agreed to the Justice Department’sdemand for a change in the Code ofProfessional Ethics, which had long pro-tected the profession from commercializa-tion. Subsequently, the management of the

then–Big Eight decided to compete noton quality but on price, thus destroying thetraditional economics of the firms and forc-ing the pursuit of non-audit revenues.Ultimately, the non-audit revenue produc-ers—the consultants—took over the man-agement of the firms, and marketing pres-sure, rather than accounting and auditingexpertise, came to dominate. ArthurAndersen’s consulting partners, fed up withsubsidizing auditing, split from AndersenConsulting to become Accenture. The sameforces were at work in the other firms, lead-ing to the mergers that have since result-ed in the creation of the Big Four.

If one looks carefully at the economicmodel of an audit-based firm, the future is

bleak. Using the basic accounting equation,the situation becomes clear. A firm can mon-etize its assets, but most of its real valueresides in its professional staff. The equitycan be monetized by measuring the part-nership/LLC capital. The problem lies withliabilities. The reality is that the number isimmeasurable, potentially infinite; there is astructural reason for this. The statutoryaudit is a socially demanded product. Theproduction has been outsourced to CPAs,but the auditor has no statutory power or pro-tection to do the work.

The private sector has not been giventhe investigative power, authority, and pro-tection it needs. If financial statement audi-tors had the same legal status as IRS

auditors, they would have government-granted power and protection. The conse-quences for lying to an IRS auditor aresevere and well known. The consequencesfor lying to a private sector auditor carry-ing out a government service obligation arealso severe—especially for the auditor. Aclient will often take an auditor to court,as will stockholders, creditors, and otherstakeholders. At best, it becomes a “he said,she said” confrontation; at worst, itbecomes an autopsy or malpractice case,where the client-patient is dead or injuredand the blame or fault is attributed to theauditor—after the lawyers have directedattention away from management. In somecases, a true professional failure hasoccurred; however, in many other situa-tions, the auditor did not know and couldnot have known—but in hindsight shouldhave or could have known. Client man-agement has every reason not to cooperatewith an auditor because failure and liabil-ity will inevitably accrue to the auditor.

One of the rubrics of auditing is to fol-low the money. Who pays for the audit?Company management. What do theyexpect for their money? Certainly not anegative report. IRS auditors, who alsoprovide an attest service to society, donot face this same pressure. They are pro-tected from both financial pressure andthe legal consequences of failure or dis-agreement.

Perhaps it is time to rethink the rela-tionship between the requirement for thestatutory audit and the ability of the pri-vate sector to perform it. Perhaps it istime to acknowledge that public account-ing firms can be providers of financial andaccounting services on many dimensions.But on the other hand, perhaps the attestfunction must be shifted to government,where the likelihood of expected perfor-mance can be monitored and enhanced,and where attestors can receive adequateand appropriate power and protection to dothe work, ask the questions, and write theassessments expected from them. ❑

William Bruce Schneider, PhD, CPA(retired)California State University and theMaastricht School of ManagementLos Angeles, Calif.

Perhaps it is time to rethink the

relationship between the

requirement for the statutory

audit and the ability of the

private sector to perform it.


By Thomas G. Calderon, Li Wang,and Edward J. Conrad

Section 404(a) of the Sarbanes-OxleyAct of 2002 (SOX) requires thesenior management of U.S. public

companies to issue a report assessing theeffectiveness of the company’s internalcontrol over financial reporting (ICFR).In addition, SOX section 404(b) requiresthe independent auditors of U.S. publiccompanies to attest to the effectiveness ofICFR, although smaller public companieshave been permanently exempted from thisprovision. Through these reporting require-ments, regulators have sought to improvethe quality of financial reporting and bol-ster investor confidence.

An entity’s ICFR is considered ineffectiveif a material weakness is identified. ThePublic Company Accounting OversightBoard (PCAOB) defines a material weaknessas “a deficiency, or a combination of defi-ciencies, in internal control over financialreporting, such that there is a reasonable pos-sibility that a material misstatement of thecompany’s annual or interim financial state-ments will not be prevented or detected ona timely basis” (Auditing Standard [AS] 5,An Audit of Internal Control over FinancialReporting That Is Integrated with an Auditof Financial Statements, Appendix A, A7,PCAOB, 2007).

Numerous studies have examined vari-ous issues related to material weaknessreporting, such as the following: ■ Characteristics of companies reportingmaterial weaknesses (e.g., Weili Ge and SarahE. McVay, “The Disclosure of MaterialWeaknesses in Internal Control After theSarbanes-Oxley Act,” Accounting Horizons,vol. 19, no. 3, pp. 137–158, 2005; Jeffrey T.Doyle, Weili Ge, and Sarah E. McVay,“Determinants of Weaknesses in InternalControl over Financial Reporting,” Journal ofAccounting and Economics, vol. 44, no. 1/2,

pp. 193–223, 2007; Hollis Ashbaugh-Skaife,Daniel W. Collins, William R. Kinney, Jr.,and Ryan LaFond, “The Effect of SOXInternal Control Deficiencies on Firm Riskand Cost of Equity,” Journal of AccountingResearch, vol. 41, no. 1, pp.1–43, 2009)■ Changes in corporate governanceafter reporting material weaknesses (e.g.,Karla M. Johnstone, Chan Li, and KathleenHertz Rupley, “Changes in CorporateGovernance Associated with the Revelationof Internal Control Material Weaknessesand Their Subsequent Remediation,”Contemporary Accounting Research, vol.28, no. 1, pp. 331–383, 2011)■ Capital market reactions to materialweaknesses (e.g., Ashbaugh-Skaife 2009;Messod D. Beneish, Mary B. Billings, and

Leslie D. Hodder, “Internal ControlWeaknesses and Information Uncertainty,”Accounting Review, vol. 83, no. 3, pp.665–703, 2008; Jacqueline S. Hammersley,Linda A. Myers, and Catherine Shakespeare,“Market Reactions to the Disclosure ofInternal Control Weaknesses and to theCharacteristics of Those WeaknessesUnder Section 302 of the Sarbanes-OxleyAct of 2002,” Review of Accounting Studies,vol. 13, no. 1, pp. 141–165, 2008)■ The relationship between materialweaknesses and earnings quality (e.g., JeffreyT. Doyle, Weili Ge, and Sarah E. McVay,“Accruals Quality and Internal Control overFinancial Reporting,” Accounting Review,vol. 82, no. 5, pp. 1141–1170, 2007; Kam C.Chan, Barbara R. Farrell, and Picheng Lee,

Material Internal Control Weakness ReportingSince the Sarbanes-Oxley Act

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

a u d i t i n g

“Earnings Management of Firms ReportingMaterial Internal Control Weaknesses UnderSection 404 of the Sarbanes-Oxley Act,Auditing: A Journal of Practice andTheory, vol. 27, no. 2, pp. 161–179, 2009;Ruth W. Epps and Cynthia P. Guthrie,“Sarbanes-Oxley 404 Material Weaknessesand Discretionary Accruals,” AccountingForum, vol. 34, pp. 67–75, 2010)■ The effects of material weaknesses on thecost of debt or equity (e.g., Maria Ogneva,Kannan Raghunandan, and K.R.

Subramanyam, “Internal Control Weaknessand Cost of Equity: Evidence from SOX 404Disclosures,” Accounting Review, vol. 82, no.5, pp. 1255–1297, 2007; Dan S. Dhaliwal,Chris E. Hogan, Robert Trezevant, andMichael S. Wilkins, “Internal ControlDisclosures, Monitoring, and the Cost ofDebt,” Accounting Review, vol. 84, no. 4, pp.1131–1156, 2011).

In contrast to prior studies, the analysisbelow reviews the trend and frequency ofreported material weaknesses from 2004 to

2010, examines how company size corre-lates with material weaknesses, discusseshow significant regulatory events alteredICFR reporting, describes the specific typesof material weaknesses that were mostprevalent during the 2004–2010 reportingperiod, and reports on the extent to whichdifferent types of material weaknesses per-sisted among companies. The conclusiondiscusses the implications of these materi-al weaknesses for auditors, management,and boards of directors.

21AUGUST 2012 / THE CPA JOURNAL

Organization Event Effective Date for Compliance with SOX Section 404 Reporting Requirements

Public Company Auditing Standard (AS) 2, An Audit of Internal Fiscal years ending after November 15, 2004Accounting Oversight Control over Financial Reporting Performed in Board (PCAOB) Conjunction with an Audit of Financial Statements

SEC Requirement (Press Release, February 24, 2004) ■ Accelerated filers: fiscal year ending after November 15, 2004

■ Nonaccelerated filers and foreign private issuers: fiscal year ending after July 15, 2005

SEC Extension (Press Release, March 2, 2005) Nonaccelerated filers and foreign private issuers: fiscal year ending after July 15, 2006

SEC Extension (Press Release, September 22, 2005) Nonaccelerated filers: fiscal year ending after July 15, 2007

SEC Extension (Press Release, August 9, 2006) ■ Nonaccelerated filers: SOX section 404(a), fiscal year ending after December 15, 2007; SOX section 404(b), fiscal year ending after December 15, 2008

■ Accelerated foreign private issuers: SOX section 404(b), fiscal year ending after July 15, 2007

PCAOB AS 5, An Audit of Internal Control over Financial Fiscal year ending after November 15, 2007Reporting That Is Integrated with an Audit of Financial Statements, superseded AS 2(June 12, 2007)

SEC Management Guidance (Press Releases, Management guidance for evaluating and assessing June 27, 2007) internal control over financial reporting (ICFR)

SEC Extension (Press Release, February 1, 2008) Nonaccelerated filers: SOX section 404(b), fiscal years ending after December 15, 2009

SEC Extension (Press Release, October 2, 2009) Nonaccelerated filers: SOX section 404(b), fiscal years ending after June 15, 2010

Congress Dodd-Frank Wall Street Reform and Consumer Permanently exempted nonaccelerated filers from Protection Act of 2010 SOX section 404(b) requirements

EXHIBIT 1Timeline of Significant Events Related to Internal Control Reporting

BackgroundOriginally, the SEC required larger pub-

lic companies (i.e., accelerated filers) to com-ply with SOX section 404 starting in 2004.To aid auditors in addressing the new require-ments, the PCAOB issued AS 2, An Auditof Internal Control over Financial ReportingPerformed in Conjunction with an Audit ofFinancial Statements, in 2004. The first two

years of implementation came with signifi-cant costs and challenges; in light of the timeand resources needed, the PCAOB releasedAS 5 in 2007, superseding AS 2, with thegoal of improving audit efficiency in this areathrough a top-down approach focusing onsignificant financial statement accounts. Inaddition, the SEC extended the compliancedates several times for nonaccelerated filers

(see Exhibit 1). Lastly, the Dodd-FrankWall Street Reform and Consumer ProtectionAct of 2010 permanently exempted nonac-celerated filers from the SOX section404(b) reporting requirements.

DataThis article’s analysis is based on data

obtained from Audit Analytics for 2004to 2010. Because nonaccelerated filers (i.e.,companies with a market capitalization lessthan $75 million) were eventually exempt-ed from SOX section 404(b) reportingrequirements, the analysis focuses on accel-erated (i.e., companies with a market cap-italization between $75 million and $700million) and large accelerated (i.e., com-panies with a market capitalization of atleast $700 million) filers. In addition,because external auditors are independentand their reports on ICFR effectiveness are probably more objective than those provided by management, the analysisfocuses on external auditors’ reports (SOXsection 404[b]).

Analysis Accelerated filers with material weak-

ness by year and filing category. Exhibit2 presents an analysis of both large accel-erated and accelerated filers with materialweaknesses by year and filing category.The result in Exhibit 2 indicates that thereis an overall downward trend in the num-ber of companies with material weakness-es over the 2004–2010 period. Public companies were first required to file SOX section 404(b) reports as ofNovember 15, 2004. Approximately 20%of accelerated filers reported material weak-


Number of Filers with Percentage of All Filers Year Material Weaknesses in the Filing Category

Panel A: Accelerated Filers

2004 246 20%

2005 281 15%

2006 234 13%

2007 205 11%

2008 123 7%

2009 80 5%

2010 76 5%

Panel B: Large Accelerated Filers

2004 161 12%

2005 179 9%

2006 146 6%

2007 105 5%

2008 45 3%

2009 32 2%

2010 28 1%

EXHIBIT 2Accelerated Filers with Material Weaknesses, by Year and Filing Category

EXHIBIT 3Top 10 Types of Material Weakness

MW1: Accounting documentation, policy, or proceduresMW11: Material or numerous auditor/year-end adjustments

MW2: Accounting personnel resources and competency/trainingMW20: Restatement of or nonreliance on company filings

MW19: Untimely or inadequate account reconciliationsMW7: Information technology, software, and security and access

MW12: Nonroutine transaction control issuesMW14: Restatement of previous SOX section 404 disclosures

MW17: Segregation of duties and design of controlsMW9: Journal entry control issues

97.4%60.9%

51.4%42.1%

24.8%20.2%19.4%

15.0%14.2%

10.7%

nesses in 2004, as opposed to only 12% oflarge accelerated filers. Although the num-ber of companies with material weakness-es increased in 2005 for both types ofaccelerated filers, the corresponding per-centages decreased for both types of filers.This is due largely to the fact that, in 2004,only accelerated registrants with fiscalyears ending after November 15 were sub-ject to the SOX section 404(b) requirement;on the other hand, all accelerated regis-trants, regardless of fiscal year-end, weresubject to the requirement in 2005.Interestingly, both categories of filers expe-rienced a sharp decline in reported mate-rial weaknesses in 2008. This sharp dropmay have resulted from the improved guid-

ance of AS 5, which became effective in2007. It is possible that public companiesexperienced the intended effect of AS 5more fully in 2008 than in 2007. In addi-tion, it is very likely that corporationsbecame more adept at designing effectiveinternal control structures and complyingwith sound internal control practices (i.e.,problems were fixed over time).

By 2010, only 1% of large acceleratedfilers and 5% of accelerated filers hadmaterial weaknesses, and material weak-nesses seem to have been significantlyremediated from 2004 to 2010. The resultreported in Exhibit 2 suggests thatmandatory reporting on ICFR led toimprovements in the quality of internalcontrol over financial reporting, particularlyamong large public companies.

Specific material weakness issues. Severalinternal control issues can give rise to a mate-rial weakness. Audit Analytics uses a 21-itemtaxonomy to identify these issues. Exhibit 3shows a ranking of the top 10 issues (collec-tively, over the 2004–2010 period). The rank-

ings for accelerated and large accelerated fil-ers were combined because only negligibledifferences between the two were observed.The predominant material weakness issue isaccounting documentation and policy, fol-lowed by material or numerous auditor/year-end adjustments, and then by accountingpersonnel resources and competency. On aver-age, 97.4% of all accelerated filers with mate-rial weaknesses had issues related to account-ing documentation and policy. Because thisis a critical part of the internal control struc-ture, the consistency and quality of financialstatements are likely to be significantly affect-ed by a lack of controls in this area. Many

other controls rely on the existence of prop-er documentation and policy.

Exhibit 4 shows the trend of the top fivematerial weakness issues from 2004 to2010, broken down by year. The exhibitreveals several salient patterns. The top twoissues from 2004 to 2010 have consistent-ly been the following:■ Accounting documentation, policy, orprocedures (MW1)■ Material or numerous auditor/year-end adjustments (MW11).

Accounting personnel resources andcompetency/training (MW2) and restate-ment of or nonreliance on company filings


Rank 2004 2005 2006 2007 2008 2009 2010

1 MW1 MW1 MW1 MW1 MW1 MW1 MW1

2 MW11 MW11 MW11 MW11 MW11 MW11 MW11




Note:MW1: Accounting documentation, policy, or proceduresMW11: Material or numerous auditor/year-end adjustmentsMW2: Accounting personnel resources and competency/trainingMW20: Restatement of or nonreliance on company filingsMW19: Untimely or inadequate account reconciliationsMW7: Information technology, software, and security and accessMW4: Inadequate disclosure controls

EXHIBIT 4 Rank of Material Weakness Issues by Year

EXHIBIT 5Persistent Material Weakness

Accelerated Filers

Large Accelerated Filers

Persistence 1 Persistence 2 Persistence 3 Persistence 4 Persistence 5 or more

50%31%

12%5%

2%

54%27%

12%5%

2%

Material weaknesses seem to

have been significantly remediated

from 2004 to 2010.

(MW20) have consistently appeared to beeither the third or fourth most prevalentissues from 2004 to 2010. MW2 rankedfourth in 2004 and 2005, but moved up tothird place after 2005; in contrast, MW20was third on the list until 2005, but droppedto fourth place from 2006 to 2010 (exceptfor 2008).

The increasing pressure on accountingpersonnel resources is evident in theseresults, which seems consistent with theemphasis in organizations on lean person-nel resources and deferred training due todiminishing personnel budgets. Inadequatedisclosure controls (MW4) rose into thetop five for the first time in 2010, possi-bly reflecting the greater monitoring of thisarea by the SEC.

Consecutive years of material weakness.Exhibit 5 identifies the percentage of compa-nies that experienced consecutive years ofmaterial weaknesses (although not necessar-ily the same issues). If a company had mate-

rial weaknesses in only one year, it is count-ed as Persistence 1; if a company had mate-rial weaknesses in two consecutive years, itis counted as Persistence 2; and so on. Asurprisingly large number of companies hadmultiple years of ineffective internal controlsand thus persistent material weaknesses.

Exhibit 5 shows that 50% of accelerat-ed filers and 46% of large accelerated fil-ers with material weaknesses reported themfor two or more years. Less than 20% ofcompanies had material weaknesses forthree or more years, and at least half of thelarge accelerated and accelerated filers hadthem for only one year. Thus, it seems thatthe majority of the companies were able toremediate identified material weaknesseswithin one or two years. The top threematerial weaknesses that persisted for threeor more consecutive years are MW1,MW11, and MW2. These are the samethree material weaknesses that occurredmost frequently among all accelerated fil-

ers and in each year examined from 2004to 2010.

Average number of material weak-nesses. Exhibit 6 reveals that the averagenumber of material weaknesses for accel-erated filers has been declining; this num-ber decreased from 2.5 in 2005 to 1.6 in2010 for accelerated filers. In contrast, theaverage number of material weaknesses forlarge accelerated filers started at 2.4 in2004, dropped to 2 in 2005, remained rel-atively constant through 2008, increased to2.8 in 2009, and eventually decreased againto 2.4 in 2010.

A closer look at material weaknessesreported in 2009 by large accelerated filers(Exhibit 7) reveals that the frequency of thepresence of MW1, MW11, and MW7 (infor-mation technology, software, and securityand access) increased in 2009. In addition,MW4 (inadequate disclosure controls)emerged among the top four issues in 2009for large accelerated filers. This is consistentwith the SEC’s increasing emphasis on dis-closure in recent years.

ImplicationsThe number of companies with reported

material weaknesses declined significantlyfrom 2004 to 2010. Companies are strength-ening their internal controls, and existing pro-fessional guidance has become more effec-tive. One practice that became fairly com-mon over the 2004–2010 period wasstrengthening the internal audit team; inter-nal auditors are now routinely reporting tothe audit committee of the board (RaymondElson and Michael Lynn, “The Impact andEffect of the Sarbanes-Oxley Act on theInternal Audit Profession: Chief AuditExecutives’ Perspectives,” Academy of


EXHIBIT 7Top Five Types of Material Weakness

for Large Accelerated Filers (2009)

MW1: Accounting documentation, policy, or procedures

MW11: Material or numerous auditor/year-end adjustments

MW2: Accounting personnel resources and competency/training

MW4: Inadequate disclosure controls

MW7: Information technology, software, and security and access

100%

81%

53%

34%

31%

EXHIBIT 6Average Number of Material Weaknesses

3.0

2.52.01.51.00.5

02004 2005 2006 2007 2008 2009 2010

Large Accelerated Filers Accelerated Filers

2.42.3

2.52.22.1

2.3

2.12.3

2.8

2.2 2.4

221.6

Accounting and Financial Studies Journal,vol. 12, no. 1, pp. 59–65, 2008; Lawrence J.Abbott, Susan Parker, and Gary F. Peters,“Serving Two Masters: The AssociationBetween Audit Committee Internal AuditOversight and Internal Audit Activities,Accounting Horizons, vol. 24, no. 1, pp. 1–24,2010).

Company size, as reflected by marketcapitalization, has a bearing on the num-ber of material weaknesses discovered.Large accelerated filers appear to havestronger internal control systems and, thus,fewer incidents of ineffective internalcontrols than accelerated filers. It seemsthat the level of resources that a companycan commit to internal controls has animportant effect on whether it will experi-ence a material weakness. Audit commit-tees should remain aware of the apparentrelationship between the resources com-mitted to internal controls and the effec-tiveness of those controls.

As noted above, MW1, MW11, and MW2in particular persist across years and acrossaccelerated and large accelerated compa-nies. Audit committees and internal auditorsshould be aware that several issues are theprime culprits in the assessment of internalcontrol effectiveness. Internal audit person-nel and management should stay vigilant inmonitoring and evaluating these areas.

It is not certain that internal controlsattestation will produce incremental cash flowbenefits as a result of process improvementsthat are normally associated with enhancedinternal controls. Yet, a large body of litera-ture suggests a direct correlation between theeffectiveness of internal controls and auditfees (Arnold Schneider, Audrey Gramling,Dana Hermanson, and Zhongxia Ye, “AReview of Academic Literature on InternalControl Reporting Under SOX,” Journal ofAccounting Literature, vol. 28, pp. 1–46,2009; Thomas G. Calderon, Li Wang, andTom Klenotic, “Past Control Risk andCurrent Audit Fees,” Managerial AuditingJournal, forthcoming). Thus, it seems plau-sible that audit committees and internal audi-tors could help reduce their companies’ auditand related professional fees by continuingto nurture their internal control systems.

Material weaknesses persist longer forsmaller accelerated filers; this is not surpris-ing, given the comparably limited resourcesavailable to such entities. Larger corporationsexhibit less persistent material weaknesses;

this is consistent with access to greaterresources. It is incumbent upon current andprospective boards of directors to be awareof likely areas of material weaknesses and

their overall implications for corporate gov-ernance. Board members and audit com-mittees should review all material weak-ness findings, but they should pay particu-lar attention to the three predominant inter-nal control issues that commonly challengecorporations of all sizes. In doing so, board

members should work closely with internalaudit units; a direct relationship betweenthe internal audit function and the audit com-mittee of the board enhances a corporation’scontrol structure and can minimize internalcontrol problems (Schneider 2009).

Internal auditors and a company’s auditcommittee must stay abreast of requirementsin the continuously evolving reportingenvironment. The PCAOB’s AS 5, theSEC’s guidance regarding management’sreport on ICFR, and the requirements ofthe Dodd-Frank Act illustrate the changingnature of this dynamic area. ❑

Thomas G. Calderon, PhD, is a professorof accountancy, Li Wang, PhD, CPA, CMA,is an assistant professor, and Edward J.Conrad, PhD, is an associate professor, allat the George W. Daverio School ofAccountancy, the University of Akron, Akron,Ohio. The authors wish to thank Diane Julesfor her feedback on this article.


It seems that the level of resourcesthat a company can commit to

internal controls has an importanteffect on whether it will experience

a material weakness.


By Josef Rashty

Earnings per share (EPS) is one ofthe most common and complex per-formance measurements that a pub-

licly held company presents in its quarterlyand annual reports. (See Josef Rashty andJohn O’Shaughnessy, “Restricted StockUnites and the Calculation of Basic andDiluted Earnings per Share,” The CPAJournal, June 2011, pp. 40–45.) AccountingStandards Codification (ASC) Topic 260,“Earnings per Share,” covers guidance forthe calculation and presentation of basic anddiluted EPS, and ASC Topic 718,“Compensation—Stock Compensation,” pro-vides guidance for certain unique character-istics of stock compensation awards thatimpact the EPS calculation.

In their July 2005 CPA Journal article,“The Two-Class Method for EPS: Theory,Rule, and Implementation,” Nathan Slavinand Steven Petra discussed the calculationof basic EPS under the two-class stockmethod for certain participating securities,based on Emerging Issues Task Force(EITF) Issue 03-6, Participating Securitiesand the Two-Class Method Under FASBStatement No. 128.

The discussion below is based on FASBStaff Position (FSP) EITF 03-6-1,Determining Whether Instruments Grantedin Share-based Payment TransactionsAre Participating Securities, subsequentguidance effective for fiscal years begin-ning after December 15, 2008. This FSPwas subsequently codified under ASC 260-10-45-61-A and 68-B, and ASC 260-10-55-76-A through D. The discussionbelow explains and illustrates the applica-tion of the two-class method in the calcu-lation of basic and diluted EPS for stockcompensation awards that are consideredparticipating securities under ASC 260, andit highlights the complexities surroundingsuch calculations and related disclosures.

The Two-Class MethodThe two-class method is an earnings

allocation formula that treats participatingsecurities as having rights to earnings thatotherwise would have been available onlyto common shareholders. Complicationsarise during the application of the two-classmethod in the calculation of basic anddiluted EPS, primarily because of the com-

plexity of the calculation and the limitedapplication guidance under ASC 260 andin related accounting literature.

Certain companies issue stock compen-sation awards that contain rights to receivenonforfeitable dividends prior to the awardsbeing vested. Under ASC 260, such unvest-ed stock compensation awards are consid-ered participating securities and, as such,


a c c o u n t i n g

Stock Compensation Awards as Participating Securities

The Two-Class Stock Method for CalculatingEarnings per Share

must be included in the two-class methodcalculation of basic and diluted EPS,regardless of a company’s intention todeclare or commit to pay any dividends.These awards are considered participatingsecurities because the holders of the awardsparticipate in the distributions of earningswith common shareholders from the datethat the awards are granted.

By contrast, unvested stock compensa-tion awards that contain rights to receivedividends only if the awards are fully vest-ed do not represent a participation right.These awards are not considered partici-pating securities because the holders of theawards do not have the right to retain div-idends unless the employees have renderedthe requisite service and the awards arefully vested.

In practice, however, most companiesdesign their employee compensationplans in such a way that stock compensa-tion awards will not be considered partic-ipating securities. In other cases, the impact

of stock compensation awards as partici-pating securities have not been material(e.g., Hewlett-Packard Company, Form 10-Q for the period ended January 31, 2012,http://www.sec.gov/Archives/edgar/data/47217/000104746912002476/a2207600z10-q.htm). Nevertheless, there are manyother publicly held companies that haveclassified their stock compensation awardsas participating securities and have report-ed their EPS under the two-class method(e.g., Helmerich & Payne Inc., Form 10-Q for the period ended March 31, 2012,http://www.sec.gov/Archives/edgar/data/46765/000110465912032962/a12-5931_110q.htm).

Participating SecuritiesA company should determine if it has

any participating securities and whether itshould allocate earnings to those securities.A participating security is a security otherthan common stock that may participate inthe distribution of earnings, together with

common stock, in its current form. Thisparticipation may even be conditioned uponthe occurrence of a specified event. Oneexample of a participating security is acompany’s preferred stock with dividendparticipation rights, whereby the holderwould receive a cash dividend when div-idends are declared on common stock.

Participation does not have to be in theform of dividends, however; any form ofparticipation in undistributed earnings con-stitutes participation. For example, partic-ipating securities may participate in theundistributed earnings of a companythrough a formula tied to the dividends paidon common stock, such as a warrant enti-tling the holder to a “yield right” equal toa certain percentage of the dividends paidon common stock, even though this yieldright is not labeled as a dividend.

Applicability of losses. Generally, loss-es are not applicable to participating secu-rities. A publicly held company allocateslosses to a participating security in the peri-



The following example reflects the computation of basic and diluted EPS when an entity has issued nonqualified stock options (NQSO). It reflects the calculation of basic anddiluted EPS both for NQSOs as nonparticipating securities and NQSOs as participating securities.

AssumptionsNet income (NI) $500,000Weighted average of common shares outstanding (WAS) 1,000,000Number of common shares outstanding at the end of the period (CSO) 1,000,000NQSOs granted at the beginning of the period1 100,000Grant price (exercise price) at the beginning of the period (EXP) $ 10Average stock price during the period (AVG) $ 15Black-Scholes-Merton valuation of NQSOs (FMV) $ 4Unrecognized stock compensation at the beginning of the period2 $400,000Stock compensation for the period $ 80,000Unrecognized stock compensation at the end of the period $320,000Average unrecognized stock compensation 3 $360,000Dividend declared and payable per common share $ 0.10Estimated forfeiture rate 20%Effective tax rate (ETR) 40%

1 NQSOs will be fully vested at the completion of four years; therefore, no options have been vested or exercised during the first year that EPS is calculated.2 Number of NQSOs grants (100,000) multiplied by the Black-Scholes-Merton valuation of $43 The simple average of unrecognized stock compensation at the beginning of the period for $400,000 and at the end of the period for $320,000

Calculation of basic and diluted EPS if NQSOs were not participating securities. In this scenario, the option holders do not have rights to participate in dividends with thecommon shareholders.

Basic EPS1 $0.5000Diluted EPS:

Assumed proceeds from the exercise of options 2 $1,000,000Average unrecognized compensation 360,000Excess tax benefits 3 40,000

Total assumed benefits $1,400,000Incremental diluting shares (IDS) 4 6,667Diluted shares outstanding (DSO) 5 1,006,667Diluted EPS 6 $0.4967

1 $500,000 (NI) ÷ 1,000,000 (WAS) = $0.50002 100,000 (NQSOs) × $10 (EXP) = $1,000,0003 ($15 [AVG] − $10 [EXP] − $4 [FMV] = $1 × 40% [ETR]) × 100,000 (NQSOs) = $40,0004 100,000 (NQSOs) − ($1,400,000 ÷ $15 [AVG]) = 6,6675 1,000,000 (WAS) + 6,667 (IDS) = 1,006,667 (DSO)6 $500,000 (NI) ÷ 1,006,667 (DSO) = $0.4967

Calculation of basic and diluted EPS if NQSOs were participating securities. In this scenario, the option holders have a nonforfeitable right to participate in dividends withthe common shareholders on a dollar-for-dollar basis.

Net income (NI) $500,000Less distributed income (DI)1 (108,000)Undistributed income (UI) $392,000

Average diluted shares outstanding (ADS) 1,100,000Average diluted expected-to-vest shares outstanding (AES) 1,080,000

1 1,000,000 (CSO) + (100,000 [NQSOs] × [80% or excluding the estimated forfeited awards]) = 1,080,000 × $0.10 (dividend) = $108,000

Common shares Basic EPS Diluted EPSDistributed earnings $0.10001 $0.09934

Undistributed earnings 0.35642 0.35425

Common shares EPS $0.4564 $0.4535

Unvested shares Basic EPS Diluted EPSDistributed earnings $0.08003 $0.08006

Undistributed earnings 0.35642 0.35425

Unvested shares EPS $0.4364 $0.4342

1 $0.10 dividend declared and paid to each common shareholder2 $392,000 (UI) ÷ 1,100,000 (ADS) = $0.35643 $80,000 of earnings distributed to 100,000 unvested NQSOs4 (1,000,000 CSO × $0.10 dividend declared) ÷ 1,006,667 (DSO) = $0.09935 $392,000 (UI) ÷ 1,106,667 (ADS plus IDS) = $0.35426 $80,000 dividend applicable to 80,000 NQSOs expected to vest ÷ 100,000 average unvested options outstanding

EXHIBIT 1An Illustration of the Two-Class Method

ods of net loss if, based upon the contrac-tual terms of the participating security,the security had not only the right to par-ticipate in the earnings of the issuer, butalso a contractual obligation to share in thelosses of the issuing entity on a basis thatwas objectively determinable. The compa-ny should determine whether the holder ofa participating security has an obligationto share in the losses of the issuing entityfor the calculation of EPS in a given peri-od, on a period-by-period basis.

Computing EPS Using the Two-ClassMethod

All securities, including stock compensa-tion awards, that meet the definition of a par-ticipating security—irrespective of whetherthe securities are convertible, nonconvertible,or potential common stock securities—should be included in the computation ofbasic and diluted EPS, using the two-classmethod. Under this method, a companyassumes that it distributes all of its earnings

to the holders of all outstanding participat-ing awards (not just those awards that areexpected to vest), which would ultimatelyreduce the earnings available for distributionto common shareholders. In other words, thetwo-class method is an earnings allocationformula that treats all participating securitiesas having rights to earnings that otherwisewould have been available only to com-mon shareholders.

The two-class method calculation, com-prising the sum total of EPS applicable todistributed and undistributed earnings, iscalculated as follows:■ Distributed earnings—First, the com-pany determines the amount of the divi-dends that it has declared in the currentperiod (dividends declared in the currentperiod should not include dividendsdeclared with respect to prior-year unpaidcumulative dividends) and is applicable toits common stockholders and its partici-pating securities. Second, the companyallocates the distributed earnings to an aver-

age number of common stock and an aver-age number of participating securities thatare expected to vest.■ Undistributed earnings—Third, thecompany reduces its income from contin-uing operations (or net income) by theamount of distributed earnings (calculatedabove). Fourth, the company allocates theundistributed earnings to an average num-ber of common stock and an average num-ber of participating securities.

It should be noted, however, that theamount of distributed earnings allocated tothe unvested stock compensation awardsequals the total dividends distributed toall stock compensation awards, minus thedividends applicable to awards that areexpected to be forfeited.

By contrast, the amount of undistributedearnings must be allocated to all outstand-ing awards, including awards that are expect-ed to be forfeited. This approach is basedon the assumption that, under the two-classmethod, an entity distributes its earnings to


all outstanding awards (not just the awardsexpected to vest). Generally, the applicationof the two-class method reduces the earningsavailable to distribute to common share-holders. Exhibit 1 illustrates this concept.

Stock Compensation AwardsASC 260 requires that all awards be

included in the computation of diluted EPSas long as the effect is dilutive. Dilutivestock compensation awards (e.g., stock

options and restricted stock units) will beincluded in the diluted EPS computationeven if employees are not able to exercisethe awards until some future date.Companies determine the dilutive effect of


EXHIBIT 2Computation of Basic and Diluted EPS by Helmerich & Payne Inc.

Three Months Ended Six Months EndedMarch 31, March 31,

2012 2011 2012 2011Numerator: Income from continuing operations $129,763 $98,961 $274,060 $203,326Loss from discontinued operations (44) (171) (55) (386)Net income 129,719 98,790 274,005 202,940Adjustment for basic EPS:Earnings allocated to unvested shareholders (530) (300) (1,009) (599)Numerator for basic earnings per share:From continuing operations 129,233 98,661 273,051 202,727From discontinued operations (44) (171) (55) (386)

129,189 98,490 272,996 202,341Adjustment for diluted EPS:Effect of reallocating undistributed earnings of

unvested shareholders 7 6 14 11Numerator for diluted EPS:From continuing operations 129,240 98,667 273,065 202,738From discontinued operations (44) (171) (55) (386)

$129,196 $98,496 $273,010 $202,352Denominator:Denominator for basic EPS—weighted-average shares 107,385 106,515 107,285 106,270Effect of dilutive shares from stock options and

restricted stock 1,657 2,080 1,640 2,105Denominator for diluted EPS—adjusted weighted-

average shares 109,042 108,595 108,925 108,375Basic earnings per common share:Income from continuing operations $1.20 $0.92 $2.54 $1.90Loss from discontinued operations — — — —Net income $1.20 $0.92 $2.54 $1.90Diluted earnings per common share:Income from continuing operations $1.18 $0.91 $2.51 $1.87Loss from discontinued operations — — — —Net income $1.18 $0.91 $2.51 $1.87

Figures in thousands, except per-share amounts Source: Helmerich & Payne Inc. Form 10-Q filed for the period ended March 31, 2012,http://www.sec.gov/Archives/edgar/data/46765/000110465912032962/a12-5931_110q.htm


the stock compensation arrangements usingthe treasury stock method (TSM).

The use of forfeiture rates in the calcu-lation of basic and diluted EPS is consis-tent with the provisions of ASC Topic 780,“Stock Compensation.” Therefore, anychanges in the estimated number of for-feited share awards must be reflected in theEPS calculation in the period that a changein estimate occurs.

Treasury Stock MethodThe TSM assumes that a company

uses the proceeds from the hypotheticalexercise of the stock compensation awardsto repurchase common stock at the aver-age market price during the period (Rashtyand O’Shaughnessy 2011). Therefore,higher assumed proceeds (the numerator)and a lower average market price duringthe reporting period (the denominator)increases the number of shares that a com-pany can hypothetically repurchase. Anincrease in the number of shares that acompany can hypothetically repurchaselowers the denominator and raises theamount of diluted EPS.

The assumed proceeds under the TSMinclude the following:■ The purchase price of the award thatthe grantee pays in the future (usually theexercise price of the stock compensationawards)■ The average compensation costs forfuture services that have not been recognized■ Any windfall tax profits (or shortfalls)due to the exercise of awards.

Unvested stock compensation awardsthat contain nonforfeitable rights to divi-dends (or dividend equivalents) are par-ticipating securities, and should be includ-ed in the calculation of basic and dilutedEPS under the two-class method.

Participating and NonparticipatingSecurities

ASC 260 considers unvested stock com-pensation awards as participating securi-ties, as long as they participate in distri-butions of earnings with common share-holders from the grant date, and the granteeis not required to render any service to earnsuch dividends. The unvested stock com-pensation awards that contain rights toreceive dividends only upon full vestingare not participating securities, because theholders of the awards do not have the rightto retain the dividend unless they completethe requisite service period.

Dividends or dividend equivalents mayalso be transferred to the holders of stockcompensation awards, in the form of areduction in the exercise price of theawards. This feature is not a participatoryright because the award does not repre-sent a nonforfeitable right to participate inearnings absent the exercise of the award—that is, a right to dividends or dividendequivalents in the form of a reduction inthe exercise price is a contingent transferof value. Similarly, if payment of dividendsor dividend equivalents is contingentupon vesting in the stock compensationaward, the awards are not considered par-ticipating securities.

DisclosuresFSP EITF 03-6-1 requires the presenta-

tion of basic and diluted EPS only for eachclass of common stock and not for partic-ipating securities; however, the guidancedoes not preclude the presentation of basicand diluted EPS for participating securities(e.g., stock compensation awards) as a noteto the financial statements. For example,Helmerich & Payne Inc., in its Form 10-Q filed for the period ended March 31,2012, made the following disclosureregarding the calculation of EPS underthe two-class method:

Accounting Standards Codification(“ASC”) 260, Earnings per Share,requires companies to treat unvestedshare-based payment awards that havenon-forfeitable rights to dividend or div-idend equivalents as a separate class ofsecurities in calculating earnings pershare. We have granted and expect tocontinue to grant restricted stock grants

to employees that contain non-forfeitablerights to dividends. Such grants are con-sidered participating securities underASC 260. As such, we are required toinclude these grants in the calculation ofour basic earnings per share and calcu-late basic earnings per share using thetwo-class method. The two-class methodof computing earnings per share is anearnings allocation formula that deter-mines earnings per share for each classof common stock and participating secu-rity according to dividends declared (oraccumulated) and participation rights inundistributed earnings.Basic earnings per share is computed uti-lizing the two-class method and is cal-culated based on weighted-average num-ber of common shares outstanding dur-ing the periods presented.Diluted earnings per share is computedusing the weighted-average number ofcommon and common equivalent sharesoutstanding during the periods utilizingthe two-class method for stock optionsand nonvested restricted stock (http://www.sec.gov/Archives/edgar/data/4676/000110465912032962/a125931_110q.htm).Exhibit 2 replicates Helmerich & Payne’s

computation of basic and diluted EPS.

Practical ImpactEPS is one of the most common and

complex performance measurements cal-culated by publicly held companies. Certaincompanies issue stock compensationawards that contain rights to receive non-forfeitable dividends prior to thoseawards being vested. These stock com-pensation awards could be considered par-ticipating securities and thus could beincluded in a company’s calculation ofbasic and diluted EPS—yet the inclusionof any provision that contains rights toreceive nonforfeitable dividends prior toawards being vested might have a negativeimpact on a company’s calculation of itsbasic and diluted EPS. The frameworkfor calculating EPS using the two-classmethod described above can be helpful toCPAs facing such a scenario. ❑

Josef Rashty, CPA, has held several man-agerial positions with publicly held tech-nology companies in the Silicon Valleyregion of California. He can be reachedat [email protected].

The inclusion of any provision

that contains rights to receive non-

forfeitable dividends prior to awards

being vested might have a negative

impact on a company’s calculation

of its basic and diluted EPS.


By Gaurav Kapoor and Michael Brozzetti

The field of internal auditing hastransformed significantly over thepast decade. Several factors have

contributed to this change, including theincreased complexity of a globalized mar-ketplace, high-profile fraud and corrup-tion scandals, new laws and regulations,and increased demand from stakeholdersfor greater assurance. (See Exhibit 1 forsome specific shifts that have occurred withrespect to internal auditing.) Within the pro-fession, internal auditing serves as a cor-porate conscience and guiding force thathelps to ensure that business decisions andmanagement operations remain consistentwith an organization’s mission, strategies,and goals.

Given the continually changing cli-mate, auditors must take on additionalresponsibility to aid organizations in man-aging risk. Exhibit 2 highlights key quali-ties that internal auditors should possess.Although internal auditing presents certainchallenges, businesses should strive toimplement an enterprise-wide internal auditsystem that takes advantage of the adviceprovided below.

Adding ValueThe Institute of Internal Auditors (IIA)

defines internal auditing as “an indepen-dent, objective assurance and consultingactivity designed to add value and improvean organization’s operations. It helps anorganization accomplish its objectives bybringing a systematic, disciplined approachto evaluate and improve the effectivenessof risk management, control and gover-nance processes” (http://www.theiia.org/theiia/about-the-profession/internal-audit-faqs/?i=1077).

Internal auditors would do well to fre-quently revisit this definition and ask them-

selves several related questions: Is ourinternal audit department designed to addvalue? Are our internal audit processes sys-tematic and disciplined enough to sustainthat value? Are we willing to change areasthat need change?

To truly add value to an organization’soperations, internal auditing has to remainrelevant to stakeholders, such as manage-

ment and the board of directors. Internalauditors are the eyes and ears of the orga-nization, and they can constructivelyimprove the entity’s risk management andinternal control processes, while also pro-viding assurances as to the effectivenessand efficiency of these processes and man-agement operations. When properlydesigned, internal audit activities can sig-nificantly improve the business as a whole.

Emerging ConcernsAlthough internal auditors often report

to management and the board of direc-

tors, they are generally accountable firstto their company’s audit committee. Thefollowing sections present some of the keyconcerns of audit committees that internalauditors should keep in mind.

Risk assurance and governance.Although the focus on risk management has,for some time, been a key trend in the fieldof internal auditing, audit committees con-

tinue to consider it a major area of concern.The IIA has issued guidance on how toprovide internal audit opinions regarding therisk management, internal control, and gov-ernance activities of an organization byupdating standards within its InternationalProfessional Practices Framework.

Enterprise risk management. With enter-prise risk management (ERM) becoming atop organizational priority, organizations’ inter-nal audit plans are being aligned with keyenterprise risk areas to provide assurancethat these risks are being managed effective-ly and kept in check by management.

The Transformation of Internal Auditing


a u d i t i n g

Challenges, Responsibilities, and Implementation

Fraud. Fraud has become a major areaof concern for organizations worldwide.Internal auditors are being asked to assessand monitor fraud risks and controls, detect and investigate vulnerabilities, andprovide advice on how to remedy theseweaknesses.

Governmental regulation and reform.The increasing complexity of compliancelaws and regulations has prompted internalauditors to help track regulatory changes andcompliance issues.

Aligning an organization’s internal auditplan to its strategic plan. Internal auditorscan play a significant role in assessing strate-gic risks and guiding the expansion of busi-ness plans. They can also aid in the acqui-sition of a new company, the launch ofnew products and services, or the modifica-tion of a business’ organizational structureto achieve operational excellence.

International Financial ReportingStandards. Although U.S. GenerallyAccepted Accounting Principles (GAAP)remains the standard for U.S. businesses,there is a good chance that InternationalFinancial Reporting Standards (IFRS) mightbecome the standard in the near future. Ingeneral, IFRS requires increase transparen-cy and greater disclosure around the meth-ods and reasons for the accounting treat-ment of certain transactions.

Ethics. Internal auditors are being calledupon to help maintain a high standard ofethical behavior in their organizations byassessing the design and operation of third-party services; whistleblower policies;and ethics and compliance programs,including the handling of reported viola-tions and subsequent disciplinary actions,when warranted.

IT security. The move toward cloud com-puting, mobile computing, and virtualiza-tion have raised serious concerns about thesecurity, integrity, and privacy of informa-tion. Internal auditors are being asked toaudit these risks and the controls used tomanage them, while also getting involvedin other IT areas, such as data analytics, dis-aster and data recovery, system access man-agement, change management, and softwaredevelopment life cycles.

Doing more with less. Risks might be infi-nite, but resources aren’t. Thus, the task ofimproving risk and control management whilealso minimizing costs continues to be at theforefront of every internal auditor’s mind.

Knowledge, skills, and abilities. Giventhe growing importance of internal auditsto the organization, much emphasis is beingplaced on the skills and qualificationsrequired by auditors, as well as on theirdevelopment, training, and retention. Manyorganizations are seeking a certified inter-nal auditor (CIA) at the same time thatmany professional practitioners are pursu-ing the CIA designation as a means ofdemonstrating their internal auditingknowledge, skills, and competence.

Challenges of Internal AuditingThe changing environment has created

numerous challenges that internal auditorsmust face while performing their duties.The following sections highlight three ofthese issues.

Coping with expanding responsibilities.Today, internal auditors are not only askedto assess financial controls, but also toenhance governance, risk management, andcontrol processes within an organization.Their responsibilities have expanded sig-nificantly to include strategy audits, ERMaudits, ethics audits, operational audits,quality audits, IT audits, supplier audits,and due diligence in mergers and acquisi-tions. Internal auditors also have an obli-gation to understand how and why certainassumptions have or have not been madewith respect to organizational strategyaudits. For example, if an entity’s man-agement wants to launch a new productand assumes that it will get 20% of themarket share within the first year, internalauditors need to question how such anassumption has been validated and how the

organization might be impacted if thosetargets are not met.

Managing information. In order toadd value to an organization, internal audi-tors need to efficiently integrate and dis-seminate information in various ways—vertically, with management and the boardof directors, and horizontally, with otherfunctions related to governance, risk, andcompliance. Sharing information and intel-ligence with the right people at the righttime is absolutely critical in decisionmaking. In other words, information is onlyas good as the hands it gets into and thetimeliness with which it gets there.

Keeping pace with changing businessrisks. The traditional model of creating anannual audit plan cannot be sustained anylonger; in light of ever-changing businessrisks, internal audit plans need to be flexi-ble. More importantly, internal auditors mustprioritize preimplementation activities overpostimplementation activities when an orga-nization undergoes transformational changes,such as establishing new goals, restructuringthe enterprise, implementing managementand personnel changes, engaging in mergersand acquisitions, and implementing new ITinnovations.

Implementing an Enterprise-wideInternal Audit Program

For an internal audit activity to be sup-ported across an enterprise in an effectiveand sustainable manner, it must meet theobjectives described below.

Act as a resource for risk information.Internal auditors should present informa-tion and discoveries in a way that allows


Then Now

■ Provided assurance over threats ■ Provides assurance over threats (i.e., the downside of risk) and opportunities (i.e., the downside

and upside of risk) ■ Performed discrete audits on ■ Performs integrated audits on compliance with internal controls governance, risk management, and

controls■ Acted as a back-office function ■ Acts as a front-office function■ Provided lagging indicators about risk ■ Provides leading indicators about risk■ Was the “cop” that management ■ Is the “expert” that management seeksavoided

EXHIBIT 1A Comparison of Internal Audits, Then and Now

decision makers to make good choices.Auditors can’t control the future, but theycan help control the likelihood of futuresuccess by advocating sound risk man-agement and internal control practices.

Balance a risk-based approach with anobjective-driven approach. The traditionalapproach to risk management—listing outand managing hundreds of risks—is nolonger an efficient one. With the growingneed for better risk management policies andlower costs, there needs to be a stronger focuson key business objectives that set bound-

aries for risk assessment. This helps relatedactivities remain relevant and manageable.

Get involved at the top. Internal auditorsmust collaborate with management and theboard of directors to ensure that an organi-zation’s mission, strategy, and goals alignwith its purpose and values. They shouldask relevant questions: Are the right peo-ple setting and approving strategy? Is theboard providing risk oversight in the strat-egy planning process? Do the proposedstrategies support the core values?

Maintain excellent talent. An internalaudit department requires a balanced mixof internal recruits, external recruits, andthird-party consultants. There should be anemphasis on training, including functionaland industry certifications. In addition, theinternal auditors’ Code of Ethics includes theprinciples of integrity, competence, objec-tivity, and confidentiality, which must be fol-lowed by internal auditors and supportedby management and the board of directorswith unwavering conviction.

Prioritize people. Many internal auditorsbelieve that people represent the mostimportant area of an internal control envi-ronment. But when it comes to auditing,more time is usually spent on processesand technology than on people. If internalauditors want to save costs and managerisks more effectively, they must leverage

an organization’s people in the process andensure that the right people have beenplaced in the right positions to do theright thing. (Exhibit 3 provides an exam-ple of an internal control system.)

Utilizing TechnologyFaced with multiple types of audits and

increasing responsibilities, internal auditorscan quickly find themselves overwhelmed.Fortunately, technology offers an advancedsolution—it helps streamline and simplifyaudit processes, organize data, and auto-mate time-consuming and resource-inten-sive workflows. The following sectionsaddress several ways that technology canenhance internal audits.

Integration. In a shift to simplify andimprove the efficiency of internalaudits, many companies opt for a single,integrated audit management platform.Such platforms extend across the enter-prise, transcending business and func-tional silos, facilitating collaboration, andminimizing redundant processes andeffort.

Audit workflows. An integrated auditmanagement system helps streamline thecomplete internal audit life cycle and estab-lishes the “systematic and disciplinedapproach” recommended by the IIA thatclosely maps each business objective tovarious compliance areas, business andfunctional areas, processes, risks, andcontrols. The end result is a structured,organized, and value-driven approach tointernal auditing, which is an essential partof the broader risk management concernsof an enterprise.

Risk assessments. Advanced audit man-agement systems are usually equipped witha centralized repository or library of all therisks and controls that might affect an orga-nization. This enables internal auditors tofacilitate a targeted, risk-based internalaudit that better supports business activi-ties and key business objectives.Automated systems can help internal audi-tors save substantial time and effort in theirrisk assessment and tracking process.

Risk prioritization. Internal audit sys-tems can support the quantification of rel-evant inherent risks and residual risks. Theyprovide an aggregate view of an organi-zation’s risk profile, enabling internal audi-tors to prioritize and plan their activitiesmore effectively.


1. Integrity and character2. Communication skills3. Technical skills and expertise4. Intelligence5. Business acumen6. Professional skepticism7. Inquisitiveness8. Self-starter skills9. IT knowledge10. Personality

EXHIBIT 210 Essential Qualities Sought

in Internal Auditors

EXHIBIT 3The Internal Control System

Ethics and

Governance

Internal

Adjudication

Internal

People

ProcessTechnology

ExternalSystems / Devices Information / Data

Source: Boundless LLC

Resource management. An integratedinternal audit system allows internal audi-tors to efficiently plan and scheduleaudits for an entire enterprise and to deployresources so that the most relevant and sig-nificant risks are addressed first. The sys-tem also helps standardize audit processesand methodologies for consistency in workquality; this, in turn, supports the qualityassurance and improvement programrequired by the IIA.

Reporting. Using a robust audit man-agement system, internal auditors canefficiently organize audit data to supporttheir recommendations and can gain man-agement support for taking action. Somesystems are equipped with powerful dash-boards that provide real-time visibility intoall the audit activities across the enterprise.This improves audit tracking and enablesaudit progress to be measured against keymilestones for timely execution.

Continual monitoring. Internal auditsystems help automate the monitoring of

risks and controls, provide alerts and warn-ings for risks that require attention, andtrack corrective actions recommended byinternal auditors and implemented by man-agement. Information from multiple auditscan be aggregated and easily plotted onmaps or graphs to track audit trends.

A Multifaceted RoleThe current generation of internal audi-

tors must strive to become as wise as an

organization’s board of directors, assavvy as an organization’s management,as diligent as its accountants, as intelli-gent as statisticians, and as persuasiveas attorneys. In other words, they mustplay a multifaceted role, while maintain-ing the highest levels of professionalintegrity in order to help their organiza-tions avoid harmful risks and seize ben-eficial opportunities. It is not only a tallorder but also a great responsibility. Thereis no doubt that audit competencies andskills will continue to be in high demand,especially as the IIA endeavors to turninternal auditing into a universally rec-ognized and accepted profession aroundthe world. ❑

Gaurav Kapoor is the chief operating offi-cer of MetricStream, Inc., Palo Alto, Calif.Michael Brozzetti, CIA, CISA, CGEIT, isthe president of Boundless LLC,Philadelphia, Pa.


There is no doubt that audit

competencies and skills will

continue to be in high demand.

Most tax professionals are familiar with the complex natureof the federal taxation of capital gains from the sale ofcommon stock, but there are also tax savings opportu-nities for shareholders of qualified small business stock:

the Internal Revenue Code (IRC) section 1045 capital gain rolloverprovision and the IRC section 1202 provision for the exclusionof capital gain. Moreover, the tax savings associated with theseIRC sections will increase in 2013 when the capital gains raterises to 20% and the 3.8% Medicare tax on investments com-

mences. Shareholders who have held shares for more than fiveyears can soon benefit from tax savings associated with the 75%and 100% exclusion under IRC section 1202.

The following discussion examines the expected future increas-es in tax savings and provides examples designed to quantify thetax savings as a percentage of the capital gain. This informationcan help individuals maximize their tax savings by decidingwhether to utilize IRC section 1045, IRC section 1202, or acombination of both, by first applying the capital gain rollover

Tax Savings from the Sale of QualifiedSmall Business Stock

T A X A T I O N

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


By Sidney J. Baxendale and Richard E. Coppage

provisions of IRC section 1045 and thenexcluding a percentage of the capital gainnot rolled over using IRC section 1202.

Rollover of Capital Gain If the sale of qualified small business stock

results in a capital gain, the seller can avoidtaxation of the gain by meeting the condi-tions under IRC section 1045. Qualifiedsmall business stock refers to stock in a C corporation that was issued after August 10, 1993, and acquired by the share-holder at its original issue in exchange formoney or other property (not includingstock), or as compensation for services pro-vided (IRC section 1045[b][1]). Stock in acorporation will not be regarded as qualifiedsmall business stock unless at least 80% ofthe assets of the corporation are used in anactive qualified trade or business—that is,any trade or business other than oneinvolving the performance of services inthe fields of accounting, actuarial science,architecture, athletics, brokerage services,consulting, engineering, health, law, per-forming arts, or any other trade or business

where the principal asset is the reputationor skill of one or more employees. Othertrade or business exclusions include bank-ing, farming, financing, insurance, investing,leasing, mining, and restaurant or hotel man-agement (IRC section 1202[e]).

The stock acquired by the shareholderwill not be considered qualified small busi-ness stock if, at any time during a four-year period beginning two years before theissuance of such stock, the corporationpurchased any of its stock from theshareholder or from a person related to theshareholder (IRC section 1202[c][3]). Inaddition to meeting the requirements forqualified small business stock, the stockmust have been held by a noncorporateshareholder for more than six months (IRCsection 1045[a]), and the qualified smallbusiness stock of another corporation mustbe purchased during a 60-day periodbeginning on the date of the sale. If thenecessary conditions are met, all or aportion of the capital gain may be rolledover; thus, the tax on the gain rolled overmay be postponed.

If the sale and purchase is accomplishedto permit a rollover, the taxpayer must rec-ognize the capital gain only up to the pro-ceeds from the sale of the stock, minus thecost of any qualified small business stockpurchased during the 60-day period (IRCsection 1045[a]). IRS Publication 550,Investment Income and Expenses, clari-fies the above rule by stating, “If thisamount is less than the amount of your cap-ital gain, you can postpone the rest of thatgain. If this amount equals or is morethan the amount of your capital gain, youmust recognize the full amount of yourgain” (p. 67, 2011). The “amount” refersto the proceeds from the sale of the stock,minus the cost of the newly purchasedstock, as stated under IRC section 1045(a).Any portion of the capital gain that is notrecognized is regarded as a rollover capi-tal gain. The basis of the newly pur-chased stock is the purchase price less therollover capital gain (IRS Publication550, 2011).

Any recognized gain would be taxed atthe capital gains tax rate, which is currently


Tax Rates Starting in 2013Capital Gain of $200,000

Rollover of No Rollover of Tax Advantage Capital Gain Capital Gain of Rollover

Proceeds from sale of 40,000 shares at $15 per share $ 600,000 $ 600,000Original cost of 40,000 shares at $10 per share 400,000 400,000Amount of capital gain on sale of stock $ 200,000 $ 200,000

Amount reinvested in qualified small business stock within 60 days $ 600,000 $ 0

Taxable capital gain in year of stock sale $ 0 $ 200,000Capital gains tax rate1 23.8% 23.8%Capital gains taxes in year of stock sale $ 0 $ 47,600 $ 47,600

Adjusted cost basis of newly purchased stock:Purchase price of new stock $ 600,000Less capital gain not taxed (rolled over) (200,000)Adjusted cost basis of newly purchased stock $ 400,000

1 Capital gain rate of 20% plus Medicare tax rate of 3.8%

EXHIBIT 1Federal Income Tax Advantages of Rollover of Entire Capital Gain


15%. Without congressional action extend-ing that rate, it is scheduled to increase to20% in 2013. In addition, recognized cap-ital gains will be subject to a 3.8%unearned income Medicare contribution taxin 2013 for high-income taxpayers. Theinvestment income subject to the 3.8%tax is the lesser of 1) the net investmentincome or 2) the excess of modified adjust-ed gross income over a threshold amount($250,000 for taxpayers filing jointly and$125,000 for taxpayers filing separately,per IRC section 1411).

Example: full rollover of capital gain.This example, which shows the federalincome tax advantages of the rollover ofcapital gain, relies on the followingassumptions:■ A taxpayer joins with anotherentrepreneur to start a company that man-ufactures accessories for golf carts. ■ The taxpayer (married or single) ishighly paid, with a marginal capital gainstax rate of 20% in 2013. He is also sub-ject to the 3.8% Medicare tax on invest-ment income starting in 2013.

■ The company was organized as a Ccorporation in the United States afterAugust 10, 1993, and each of the twoentrepreneurs was issued 40,000 shares inexchange for a cash investment of$400,000. ■ During all years of the corporation’sexistence, the assets of the corporation weredevoted solely to the manufacture of golfcart accessories, and the company was verysuccessful. The corporation has notredeemed any of the shares that wereissued to the two entrepreneurs.■ After owning the stock for severalyears, the shareholder sold his 40,000shares for $15 per share in 2013 ($5 pershare more than the original cost of theshares). Thus, the selling shareholder hasa capital gain of $200,000 ([$15 − $10] ×40,000) on the sale of the stock.■ The shareholder who sold the 40,000shares for $15 per share ($600,000) pur-chased $600,000 worth of shares of qual-ified small business stock in another C cor-poration within 60 days after selling the40,000 shares.

Exhibit 1 shows that the capital gain onthe sale of the 40,000 shares was $200,000($600,000 − [40,000 shares × $10]), and theentire $600,000 in proceeds from the saleare reinvested within 60 days after the sale.Because the proceeds from the sale minusthe cost of the purchased shares is zero($600,000 − $600,000), and zero is less thanthe $200,000 capital gain, the entire$200,000 may be rolled over; as a result,the entire $200,000 capital gain avoids tax-ation in the year of the sale. Using the taxrates effective for 2013, $47,600 ($200,000× [20% + 3.8%]) of capital gain tax wouldbe avoided. Of course, when the newlyacquired stock is sold at some future date,the $200,000 gain may be taxed at that time.If this sale of the shares had occurred in2012, the tax savings would be only $30,000($200,000 × 15%).

In addition, Exhibit 1 shows that becausethe $200,000 capital gain was not taxed,the cost basis of the newly purchased stockis reduced by the amount of the capitalgain. The cost basis of the newly purchasedshares is $600,000, but the adjusted cost


Rollover of No Rollover of Tax Advantage Capital Gain Capital Gain of Rollover

Proceeds from sale of 40,000 shares at $15 per share $ 600,000 $ 600,000Original cost of 40,000 shares at $10 per share 400,000 400,000Amount of capital gain on sale of stock $ 200,000 $ 200,000

Amount reinvested in qualified small business stock within 60 days $ 575,000 $ 0

Taxable capital gain in year of stock sale $ 25,000 $ 200,000Capital gains tax rate1 23.8% 23.8%Capital gains taxes in year of stock sale $ 5,950 $ 47,600 $ 41,650

Adjusted cost basis of newly purchased stock:Purchase price of new stock $ 575,000Less capital gain not taxed (rolled over) (175,000)Adjusted cost basis of newly purchased stock $ 400,000

1 Capital gain rate of 20% plus Medicare tax rate of 3.8%

EXHIBIT 2Federal Income Tax Advantages of Rollover of Portion of Capital Gain


basis of the newly purchased stock is$400,000 ($600,000 − $200,000). Theadjusted cost basis of $400,000 in thisexample is important because if thenewly purchased stock is ever sold, the$400,000 adjusted cost basis will be usedto determine the capital gain or loss onthe sale. For example, if the newly pur-chased shares were sold for $500,000 insome future year, the capital gain on thatsale would be $100,000 ($500,000 sellingprice, minus $400,000 adjusted cost basis).

There is a means by which the $200,000rollover capital gain and any future capi-tal gain rollovers can escape taxation entire-ly: the rollover process could continue untilthe death of the owner of the shares. Uponthe owner’s death, the stock could be inher-ited by the shareholder’s beneficiary, whowill receive a cost basis in the shares equalto the market price on the date of the share-holder’s death. Thus, in the case of thedeath of a shareholder who properly rolledover capital gains, these capital gains fromqualifying small business stock sales andpurchases over a period of years wouldcompletely avoid capital gains taxation andthe beneficiary would inherit the stock atthe “stepped-up” basis (IRC section1014[a]).

Example: partial rollover of capitalgain. Exhibit 2 shows a partial rollover ofcapital gains using the same basic assump-tions as those in Exhibit 1; the onlychanged assumption is the purchase priceon the newly acquired shares ($575,000rather than $600,000). If the sales proceedsfrom the stock sale minus the purchaseamount for the newly purchased shareswere less than the $200,000 capital gain,then a portion of the gain must be recog-nized. For example, if the purchase priceof the newly purchased shares was$575,000, then the $600,000 sales priceminus the $575,000 purchase price wouldyield $25,000. Thus, a capital gain wouldhave to be recognized up to the $25,000amount; the rolled-over capital gain wouldbe $175,000 ($200,000 − $25,000). Inthis case, the adjusted cost basis of thenewly purchased shares would be $400,000($575,000 purchase price, minus $175,000capital gain rolled over).

Comparing Exhibit 1 with Exhibit 2reveals that the tax savings associated withthe $175,000 rollover is only $41,650,rather than the $47,600 savings that results

from rolling over the entire $200,000 cap-ital gain. If the sale of the shares hadoccurred in 2012, the tax savings associ-ated with the $175,000 rolled-over capitalgain would have been only $26,250 (15%× $175,000), rather than the $41,650 shownin Exhibit 2.

The complex rule used in determining theamount of the capital gain that may be rolledover requires careful consideration. If thesales price of shares sold minus the purchaseprice of the newly purchased shares yieldsan amount that is equal to or greater than thecapital gain on the sale, then the entire cap-ital gain will be taxable. Therefore, oncethe taxpayer knows the proceeds from thesale and the capital gain on the sale, she mustcarefully choose the amount of stock thatmust be purchased within 60 days to max-imize the tax savings associated with therollover of capital gain.

Exclusion of Capital Gain IRC section 1202 contains another poten-

tial tax-saving opportunity when the share-holder of qualified small business stock real-izes a capital gain upon the sale of the shares.This tax-saving provision is available fornoncorporate shareholders who have a cap-ital gain from the sale or exchange of qual-ified small business stock owned for morethan five years (IRC section 1202[a][1]).“Qualified small business stock” is definedthe same way as in the IRC section 1045capital gain rollover provision.

To qualify under IRC section 1202,however, a corporation that issued quali-fied small business stock must be a qual-ified small business—that is, a domestic Ccorporation that, at all times on or afterAugust 10, 1993, and before the issuanceof the qualified small business shares, hadaggregate gross assets equal to or less than$50 million. In addition, the aggregategross assets immediately after the issuanceof the qualified small business shares mustnot exceed $50 million. All corporationsthat are members of the same parent-sub-sidiary controlled group are treated as onecorporation with respect to the aggregategross asset provision (IRC section1202[d][1]).

If the common stock sold is qualifiedsmall business stock issued by a qualifiedsmall business, then the capital gain fromthe sale of the stock can be reduced by aspecified percentage if the stock has been

held for more than five years (IRC sec-tion 1202[a]). The percentage of the exclu-sion is determined by the time period dur-ing which the shares were acquired, inaccordance with the following schedule:■ Shares acquired after August 10, 1993,but before February 18, 2009, have a50% exclusion percentage.■ Shares acquired after February 17,2009, but before September 28, 2010, havea 75% exclusion percentage.■ Shares acquired after September 27,2010, but before January 1, 2012, have a100% exclusion percentage. (If the 100%

exclusion is not extended or modifiedbeyond December 31, 2011, it will auto-matically revert back to the 50% exclusion.)

Although capital gains on the sale ofstock are typically taxed at a maximum taxrate of 15% in 2012 (and at 20% startingin 2013), the portion of the gains not exclud-ed in the case of an IRC section 1202 cap-ital gain is taxed at a higher 28% tax rateunder IRC section 1(h)(4)(A)(ii). In addi-tion, 7% of the excluded gain is consid-ered a preference item for alternative min-imum tax (AMT) purposes when the exclu-sion percentage is 50% or 75%. The AMTon 7% of the capital gain was eliminatedfor the 100% exclusion (IRC section57[a][7] and IRC section 1202[a][4][C]).Depending upon the taxpayer’s particularcircumstances, preference items have thepotential of being taxed at a 26% or 28%rate for AMT purposes (IRC 55[b][1][A]).

If a shareholder has an eligible gain forthe taxable year from sales of stock

To qualify under IRC section 1202,

however, a corporation that issued

qualified small business stock must

be a qualified small business.


issued by any qualified small business,the aggregate amount of such gain forwhich the exclusion is applicable may notexceed the greater of 1) $10 million,reduced by the aggregate amount of eligi-ble gain taken into account in prior years;or 2) 10 times the aggregate adjustedbasis of qualified small business stockissued by the qualified small business andsold by the shareholder during the taxableyear (IRC section 1202[b]).

Example: advantages of the capitalgain exclusion. This example makes thesame assumptions as the example above,with one modification and one addition. Inorder to examine the impact of the 50%,75%, and 100% exclusions on tax savings,this example makes three alternativeassumptions about when the shareholderpurchased the 40,000 shares that were sold.The one additional assumption is that theshareholder has owned the shares for morethan five years before the sale of the stock.

The 50% exclusion is applicable for qualified small business shares pur-chased from August 11, 1993, throughFebruary 17, 2009, and held for morethan five years. If the shareholder pur-chased the 40,000 shares on February 17,2009, he would have to wait until February18, 2014—one day more than five yearslater—to sell the shares in order to quali-fy for the 50% capital gains exclusion. The75% exclusion is only applicable to situa-tions where the shareholder purchased theshares from February 18, 2009, throughSeptember 27, 2010, and will haveowned the shares for more than five years(that is, at least until February 19, 2014).The 100% exclusion is applicable forshares purchased from September 28, 2010,through December 31, 2011 (unless furtherextended), and owned by the same share-holder for more than five years (that is, atleast until September 29, 2015). As dis-cussed above, the highest tax savings from

IRC section 1202 are the 75% and 100%exclusions that are not attainable until afuture date.

Exhibit 3 examines the situation in whichthe stock was sold at a gain of $200,000(40,000 shares × [$15 −$10]), and the taxsavings associated with the IRC section1202 capital gain exclusion are calculatedfor each of the 50%, 75%, and 100%exclusion alternatives. The tax savings andthe tax savings as a percentage of capitalgain for each of the three alternatives areshown in Exhibit 3.

Exhibit 3 reveals that the tax savings asso-ciated with the 50% exclusion, using thetax rates starting in 2013, are minimal.Without considering the AMT, the tax sav-ings is 7.9% of the capital gain. Althoughnot shown in Exhibit 3, the 50% exclusiontax savings are even less when the AMT isconsidered (6.99% at the lower 26% AMTrate; 6.92% at the higher 28% AMT rate).The tax savings is only 1% of the capital


50% Exclusion 75% Exclusion 100% ExclusionAmount of capital gain on sale of qualified small business stock $ 200,000 $ 200,000 $ 200,000Less gain excluded from gross income (100,000) (150,000) (200,000)Amount of capital gain included in gross income $ 100,000 $ 50,000 $ 0

Tax effect of capital gain exclusion:Amount of capital gain excluded $ 100,000 $ 150,000 $ 200,000Normal capital gains tax rate 23.8% 23.8% 23.8%Taxes saved as a result of exclusion $ 23,800 $ 35,700 $ 47,600

Amount of capital gain not excluded $ (100,000) $ (50,000) $ 0Excess tax rate for IRC section 1202 capital gain not excluded 8% 8% 8%(31.8%–23.8%)1

Extra tax on section 1202 capital gain not excluded $ (8,000) $ (4,000) $ 0

Net capital gains tax savings from exclusion $ 15,800 $ 31,700 $ 47,600Net tax savings as a percentage of total capital gain 7.9% 15.85% 23.8%

1 31.8% equals the 3.8% Medicare tax plus the 28% capital gains tax on gain not excluded.23.8% equals the 3.8% Medicare tax plus the 20% capital gains tax on gain not subject to IRC section 1202.

EXHIBIT 3Federal Income Tax Advantages of IRC Section 1202 Capital Gain Exclusion


gain when the AMT is ignored and the 2012tax rates are used to calculate the tax sav-ings; when the AMT is considered, the taxsavings percentage drops to .09% for thelower 26% AMT tax rate and to .02% forthe higher 28% AMT tax rate.

The tax savings percentages are muchmore attractive for the 75% and 100% exclu-sions, which will become available in the nextfew years. In the case of the 75% exclusion(using the tax rates starting in 2013), the taxsavings percentage is 15.85% of the capital

gain (Exhibit 3). Although not shown inExhibit 3, the tax savings for the 75%exclusion, as a percentage of the capital gain,is 14.49% at the lower 26% AMT rate and14.38% at the higher 28% AMT rate. In thecase of the 100% exclusion (using the taxrates starting in 2013), the tax savings is23.8% of the capital gain (Exhibit 3). Thereis no tax preference amount associated withthe 100% exclusion; thus, there is no AMTfor the 100% exclusion. A sensitivity analy-sis revealed that, for each of the exclusionpercentages, the tax savings as a percentageof the capital gain remained unchanged asthe capital gain amount changed.

Joint Application There is nothing in the IRC that prevents

a taxpayer from rolling over the capitalgain using IRC section 1045 and then, ifthere is a taxable portion that was not rolledover, applying IRC section 1202 to thatportion. Of course, this joint applicationis only possible if the capital gain involvedqualified small business stock issued by a

qualified small business and if the otherconditions required by both IRC sections1045 and 1202 are met.

In such a joint application of IRC sec-tions 1045 and 1202, the portion of the gainrolled over under IRC section 1045would be deducted from the purchase priceof the newly purchased stock to arrive atthe adjusted cost basis of the stock. Next,the portion of the capital gain that wasnot deferred would be eligible for exclu-sion from capital gains tax under IRCsection 1202. The amount of the gainexcluded from taxation under IRC section1202 would only be related to the stockthat was sold and would have no effecton the adjusted basis of the newly acquiredstock. Of course, those shareholders for-tunate enough to qualify for the 100% cap-ital gain exclusion should not even con-sider using the rollover capital gain provi-sions of IRC section 1045.

An Obscure OpportunityIt is essential to mention several

caveats related to the tax provisions andexamples described above. The tax ratesused here are based on the tax rates thatare expected to be in effect starting in 2013and those that are currently in effect in2012. If the stockholder is in a lower fed-eral income tax bracket and subject to thelower capital gains rate, however, the taxsavings could be less.

The focus here is on the salient taxprovisions related to IRC sections 1045 and1202. As is true with all generalized taxadvice, however, taxpayers should consultwith their advisors before taking action.Only a tax professional who understands ataxpayer’s precise situation and has a com-prehensive understanding of the relevanttax provisions is in a position to make thecorrect decision concerning the issues dis-cussed above.

These two rather obscure provisions ofthe IRC are often overlooked whenapplying the rules for capital gains taxa-tion. Both of these provisions representopportunities to reduce the capital gaintax due on the sale of qualified smallbusiness stock. These savings will increasesignificantly in 2013 because of the sched-uled increase in the capital gains tax rateand the new Medicare tax on investmentincome. The tax savings associated withIRC section 1202 are scheduled to increase

significantly in the next few years aswell; stockholders who will have held thequalified small business shares for morethan five years will be able to realize thetax savings associated with the 75% and100% capital gains exclusion.

Taxpayers can also jointly use both IRCprovisions to maximize the capital gainstax savings. Any remaining taxable capitalgains after applying the rollover provisionsof IRC section 1045 may be partiallyreduced by using the capital gain exclusionprovisions of IRC section 1202. A taxpay-er’s overall objective is to minimize the cap-ital gain tax, and CPAs can advise an indi-vidual of the right steps to take. ❑

Sidney J. Baxendale, PhD, CPA, CMA,CGMA, and Richard E. Coppage, PhD,CPA, CMA, are professors of accountan-cy in the college of business at theUniversity of Louisville, Louisville, Ky.

These two rather obscure

provisions of the IRC are often

overlooked when applying the rules

for capital gains taxation.

Multinational corporations use foreigncurrency strategies to reduce theimpact of foreign currency volatil-ity in the countries in which they

have business operations. Such strategiesoften produce unforeseen tax conse-quences, however; many tax issues arisewhen foreign currency options, contracts,hedges, or straddles are accounted for beforeor at settlement. This article analyzes anddiscusses these issues and their potential res-olution under the Internal Revenue Code(IRC) for CPAs who advise on structuringforeign currency positions.

The Nature of TradingA corporation (investor) may engage in

foreign currency trading using a wide vari-ety of derivative and cash instruments,including options, forwards, swaps, andleveraged spot positions. In addition to trad-ing in outright (also called “naked”) posi-tions in foreign currencies, a corporationmay engage in arbitrage trading. Arbitragetrading strategies typically call for thepurchase and sale of very large notionalamount derivative contracts, where the riskof loss is reduced—but not eliminated—by entering into positions in a mannerthat substantially reduces outright foreignexchange risks. Such positions are referredto in financial markets as “straddles.”

A corporation may execute its foreigncurrency arbitrage trading strategy in sev-eral major currencies, including the cur-rencies of the G-8 industrialized nations,for which there are regulated futures con-tracts, as well as currencies of smallernations. Currencies for which regulatedfutures contracts are available—such as theeuro, British pound, and Swiss franc—are

referred to as “major” currencies; anycurrencies for which there are no regulat-ed futures contracts traded on an exchangeare referred to as “minor” currencies.Seeking to profit and protect internationalbusiness operations from changes in rela-tive currency exchange rates and interna-tional interest rate movements, a corpora-tion develops its trading strategy. Prices forless widely traded currencies can be morevolatile than those of major currencies, and

this relative volatility presents tradingopportunities.

Example. A corporation engages in atrade comprising two “forward contracts”:one long forward contract to purchase a spec-ified amount of Indian rupees (INR) for aspecific amount of U.S. dollars (USD), andone short forward contract, of shorter matu-rity and a different strike price, to sell a spec-ified amount of INR for a fixed amount ofUSD. The short forward contract has a small-

Foreign Currency Strategies Can ProduceUnforeseen Tax Consequences

T A X A T I O N

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


By Lee G. Knight and Ray A. Knight


er notional amount than the long forwardcontract. Each pairing of short and longforward contracts is referred to as a “com-bined transaction.” This may require a rela-tively small capital commitment that willprofit handsomely if 1) INR increases invalue compared to the USD, 2) INR inter-est rates drop, or 3) the INR yield curve flat-tens relative to the USD yield curve.Conversely, if exchange rates or interest ratesmove in the opposite direction, the combinedtransaction will drop in value. The corpora-tion intends to trade its positions rapidly totake advantage of small price and interestrate movements. All the currencies in whichthe corporation will trade are actively trad-ed in the interbank currency markets. Thecorporation enters into forward contracts inthe over-the-counter market to execute thearbitrage strategy because that market ismore liquid and provides tighter bid-askedspreads compared to the foreign currencytransactions on regulated futures exchanges.

IRC Section 988IRC section 988(a)(1)(A) provides that

any foreign currency gain or loss will betreated as ordinary income or loss. To qual-ify as an IRC section 988 transaction, twoconditions must be met. First, theamounts that the taxpayer receives orpays in the transaction must either bedenominated in terms of a nonfunctionalcurrency or be determined by reference tothe value of one or more nonfunctional cur-rencies (IRC section 988[c][1][A]). Second,the transaction must be one of several spec-ified types of transactions. One category,“foreign currency derivatives,” includesforward contracts, futures contracts,options, or other similar financial instru-ments (IRC section 988[c][1][B][iii]). Anygain or loss attributable to a foreign cur-rency derivative (as described in IRC sec-tion 988[c][1][B][ii], such as a forwardcontract) is considered a foreign currencygain or loss and, as such, is treated as ordi-nary income or loss, unless an exceptionapplies (IRC section 988[b][3]).

IRC section 988(c)(1)(D)(i) excludes reg-ulated futures contracts that are marked-to-market under IRC section 1256 from the def-inition of a section 988 transaction. A reg-ulated futures contract is any contract trad-ed on or subject to the rules of a qualifiedboard or exchange, with respect to which theamount required to be deposited and the

amount that may be withdrawn depend ona system of marking-to-market. Qualifiedboards or exchanges include national secu-rities exchanges registered with the SEC, adomestic board of trade designated as a con-tract market by the Commodity FuturesTrading Commission (CFTC), and any othermarket determined by the TreasuryDepartment to have adequate rules (IRC sec-tions 1256[g][1],[7]).

Under Treasury Regulations section1.988-1(a)(2)(iii)(A), section 988 treatmentis limited, with respect to foreign currencyderivatives, to those instruments where theunderlying property itself is a nonfunction-al currency. The exceptions to ordinaryincome treatment are very narrow and pri-marily elective. A taxpayer may elect to treatany gain or loss attributable to any foreigncurrency derivative that is not part of a strad-dle (defined in IRC section 1092[c]) ascapital gain or loss if the foreign currencyderivative is a capital asset in the hands ofthe taxpayer (IRC section 988[a][1][B]). Asimilar elective rule is available to certainpartnerships that are “qualified funds” thattrade foreign currency derivatives (IRCsection 988[c][1][E]). A qualified fund mustbe a partnership with at least 20 unrelatedpartners during the entire taxable year. Inaddition, the partnership’s principal activitymust be the buying and selling of options,futures, or forward contracts with respect tocommodities (de minimis amount), and atleast 90% of its gross income must comefrom interest, dividends, gains from thesale or disposition of capital assets held forthe production of interest or dividends andincome, and gains from commodities,futures, forwards, and options, with respectto commodities (IRC section988[c][1][E][iii]).

A final, broader exception provides cap-ital treatment for foreign currency deriva-tives that are part of certain hedgingtransactions (Treasury Regulations sec-tion 1.988-5[a]). Under this exception, thedisposition of a foreign currency derivativethat is treated as a hedging transaction mayresult in a capital gain or loss under cer-tain circumstances, generally when thehedge relates to a capital asset. Section 988hedges are limited, however, to hedges ofqualifying debt instruments, certain execu-tory contracts, and certain stock or securi-ties purchases (Treasury Regulations sec-tions 1.988-5[a],[b],[c]). For these purpos-

es, an “executory contract” is an agreementto pay nonfunctional currency for proper-ty used in the ordinary course of the tax-payer’s business or for services, or toreceive nonfunctional currency for suchproperty or service. A section 988 trans-action, such as forward contract for anonfunctional currency, is not an executo-ry contract (Treasury Regulations section1.988-5[b][2][ii][A],[B]).

Forward Contracts in Major Currenciesand Minor Currencies

An IRC section 1256 contract is marked-to-market at the end of each tax year; thatis, each contract must be treated as if soldat the end of the year for its fair market value,and any gain or loss must be accounted forin that year. In addition, when a taxpayer ter-minates a “section 1256 contract” positionduring the year, the contract is marked-to-market. This treatment is required if a tax-payer 1) offsets a section 1256 position, 2)makes or takes delivery under a section 1256contract, 3) exercises or is exercised on asection 1256 option position, 4) makes or isthe recipient of an assignment under a sec-tion 1256 option, or 5) closes a position bylapse or otherwise (IRC section 1256[a][1],[c][1]).

IRC section 1256(b) encompasses anyof the following types of contracts: 1)regulated futures contracts, 2) foreign cur-rency contracts, 3) nonequity options, 4)dealer equity options, or 5) dealer securi-ties futures contracts. For this purpose, aforeign currency contract, by definition, isa contract—

(i) which requires delivery of, or the set-tlement of which depends on the valueof, a foreign currency in which positionsare also traded through regulated futurescontracts, (ii) which is traded in the inter-bank market, and (iii) which is enteredinto arm’s length at a price determinedby reference to the price in the interbankmarket. (IRC section 1256[g][2]). A forward contract based on any major

currency will meet these three criteria, andthus will constitute a section 1256 contract.A forward contract in any minor currencywill not be a section 1256 contract becauseno regulated futures contracts in any minorcurrency trade on any exchange; thus, it willnot be subject to any mark-to-market require-ment. Instead, the gain or loss will be rec-ognized only upon the sale, exchange, or ter-


mination of these forward contracts (IRC sec-tions 1001, 1234A).

Straddles Under IRC Section 1092A straddle is defined as two or more

“offsetting positions with respect to per-sonal property,” where one position pro-vides a “substantial diminution” of the riskof loss from holding the other position(IRC section 1092[c][2][A]). For the pur-poses of this definition, personal property

is limited to property of a type that isactively traded, and position means “aninterest (including a futures or forward con-tract or option) in personal property”(IRC sections 1092(d][1], 1092[d][2]).

The straddle rules describe six circum-stances under which two or more positionswill be presumed to be offsetting:

(i) the positions are in the same person-al property (whether established insuch property or a contract for suchproperty),(ii) the positions are in the same personalproperty, even though such propertymay be in a substantially altered form,(iii) the positions are in debt instrumentsof a similar maturity or other debt instru-ments described in regulations prescribedby the Secretary, (iv) the positions are sold or marketedas offsetting positions (whether or notsuch positions are called a straddle,spread, butterfly, or other similar name),(v) the aggregate margin requirement forsuch positions is lower than the sum of

the margin requirements for each suchposition (if held separately), or (vi) there are such other factors (or sat-isfaction of subjective or objective tests)as the Secretary may by regulations pre-scribe as indicating that such positionsare offsetting (IRC section 1092[c][3]).The prescribed regulations have not yet

been issued. For the purposes of theserules, two or more positions are treated asdescribed in subsections (i), (ii), (iii), or

(vi), only if the value of one or more suchpositions ordinarily varies inversely with thevalue of one or more other such positions.

If two or more positions qualify as a strad-dle, a loss realized by disposing of one ofthe positions cannot be deducted by thetaxpayer, to the extent that there is unrec-ognized gain in the position still owned bythe taxpayer (IRC section 1092[a][1]).Moreover, if a taxpayer has not held prop-erty that is part of a straddle for at least oneyear before establishing the straddle, theholding period for such property will be resetto zero and will not start until the propertyis no longer part of a straddle (e.g., when theoffsetting position is terminated). Finally, anycosts, such as interest, incurred to purchaseor maintain the positions constituting thestraddle cannot be deducted. Instead, suchcosts are capitalized and may only be usedto reduce the gain recognized when the prof-itable side of the straddle is sold (IRC sec-tion 263[g]). As noted above, forward con-tracts are positions in personal property;furthermore, foreign currencies for which

there is an active interbank market are pre-sumed to be actively traded (IRC section1092[d][7][B]).

Forward Contracts and the Timing RulesThe Treasury Regulations implementing

IRC section 988 provide specific timingrules for section 988 transactions, such asforward contracts, that confirm the appli-cation of the IRC’s general timing rules.Treasury Regulations section 1.988-2(d)(2)(i) states that, unless a forward con-tract subject to IRC section 988 is ahedge for its purposes, the general real-ization rules of the IRC govern the timingof the recognition of gain or loss on thecontract. Special provisions in the IRC andTreasury Regulations override the generalrule of realization-based timing. Forwardcontracts are also specifically excludedfrom the accounting method rules appli-cable to notional principal contracts(Treasury Regulations section 1.446-3[c][1][ii]). Finally, if forward contracts areinvestments, rather than hedges entered intoto manage the risks arising from a tradeor business, they are not subject to the tim-ing rules of Treasury Regulations section1.446-4 (IRC section 1221[b][2]; TreasuryRegulations section 1.1221-2[b], 2[c][3],1.446-4[a]).

Terminating one financial position ordi-narily has no impact for tax purposes on anyother position held by an investor. If thetermination of one position had any impacton any offsetting position, the numerouscases discussing tax-motivated straddleswould never have arisen; in addition, IRCsection 1092 would not be necessary. TheIRC, however, establishes one special cir-cumstance where terminating one financialinstrument will cause a deemed terminationof another financial instrument. IRC section1256(c)(2) provides that where two ormore section 1256 contracts are part of astraddle and “the taxpayer takes deliveryunder or exercises any of such contracts …each of the other such contracts shall be treat-ed as terminated on the day on which thetaxpayer took delivery.” The special termi-nation rule applies only where a taxpayertakes delivery of the underlying asset of asection 1256 contract. The legislative histo-ry concerning section 1256(c)(2) states:

The bill also requires, if a straddle includestwo or more regulated futures contracts,that all the contracts will be treated as

If two or more positions qualify as a straddle, a loss realized

by disposing of one of the positions cannot be deducted

by the taxpayer, to the extent that there is unrecognized

gain in the position still owned by the taxpayer.


terminated on the date the taxpayer takesdelivery under any of such contracts.Thus, section 1256(a) will apply … toall regulated futures contracts constitutingpart or all of a straddle when the taxpay-er takes delivery under any of such con-tracts. (S.Rep. No. 97-592, at 27, 1982).Under IRC section 1256(c)(2), where the

taxpayer receives the commodity pursuantto one of the contracts making up a strad-dle, the remaining contracts in the straddleare treated as terminated and immediatelyreestablished. This termination allowsinvestors to make a mixed-straddle electionunder IRC section 1256(d) for the new strad-dle, which would consist of the commodityand any related short section 1256 contractsremaining in the investors’ hands. The leg-islative history of this provision states:

The bill amends section 1256(d)(4)defining mixed straddles to require iden-tification of all positions constitutingsuch straddle not later than the close ofthe day on which the first regulatedfutures contract forming part of the strad-dle is acquired. This amendment clari-fies that an election as to whether sec-tion 1256 will apply to a regulatedfutures contract included in a mixedstraddle may not be deferred beyond thedate the contract is acquired. For thispurpose, when a short regulated futurescontract is treated as terminated on thedate the taxpayer takes delivery undera long regulated futures contract (underthe straddle amendment to section1256[c], the short position will be treat-ed as a new regulated futures contractacquired on that date.) (S.Rep. No. 97-592, at 27, 1982; Andrea Kramer,Financial Products: Taxation,Regulation and Design, 63.07(c), 3d ed.,2001 Supp.). A mixed straddle consists of at least one

IRC section 1256 contract and one posi-tion that is not a section 1256 contract. Ifa taxpayer makes the IRC section 1256(d)mixed-straddle election, the section 1256contract in the straddle will not be subjectto the mark-to-market and character rulesunder section 1256. The special rule of IRCsection 1256(c)(2) does not apply to otherterminations of section 1256 contractsthat are part of a straddle because otherforms of termination do not leave theinvestors with the underlying commoditythat automatically creates a new mixed

straddle (compare IRC section 1256[c][1]with IRC section 1256[c][2]).

The gain or loss attributable to a forwardcontract in a minor currency should be real-ized in accordance with the applicable sec-tion of the tax code (Treasury Regulationssection 1.988-2[d][2]). For example, a gainor loss should be realized when the con-tract is transferred, assigned, or terminat-ed (Kevin M. Keyes, Federal Taxation ofFinancial Instruments and Transactions,section 15.03[4][a], 1997). The terminationof a forward contract in a minor currencydoes not trigger tax consequences withrespect to the remaining forward contractforming part of a combined transaction.The tax treatment of the termination of aforward contract was discussed in Vickersv. Commissioner (80 T.C. 394, 1983).

Neutralizing Further Risk of Loss or Opportunity for Gain

Typically, one forward contract in acombined transaction will increase in valuewhile the second one will not. The com-bined transactions are designed so that ifan investor is correct in its assessment offuture currency and interest rate move-ments, the increase in value of one con-tract will substantially exceed the loss onthe second contract. The investor may ter-minate the profitable contract in exchangefor a termination payment from the coun-terparty; the investor would then hedge itsremaining exposure by entering into a newforward contract that perfectly hedges itsrisks. The two forward contracts willform a new straddle. To the extent thatgains on one forward contract exceed loss-es on the remaining forward contract in acombined transaction, terminating the prof-itable contract will yield funds beyondthose needed for collateral. The excessfunds are available for additional tradingactivities.

The new hedging forward contract doesnot terminate the initial forward contract;instead, it creates a new obligation betweenthe parties, reflecting current market condi-tions. Under general tax principles, merelyeliminating the risk of loss and the oppor-tunity of gain from one financial position byentering into a new position does not trig-ger recognition of gain or loss with respectto the first position. IRC section 1259 pro-vides an exception to this realization-basedtiming rule. IRC section 1259(a) requires tax-

payers to recognize gain on the “construc-tive sale” of an “appreciated financial posi-tion.” An appreciated financial positionmeans an interest, including a futures or for-ward contract, with respect to any stock, debtinstrument, or partnership interest (IRCsection 1259[b]). Because a forward for-eign currency contract is not an interest inany stock, debt instrument, or partnershipinterest, forward contracts do not constituteappreciated financial positions within themeaning of IRC section 1259. Generally, ataxpayer recognizes gain or loss only whena position is sold, otherwise disposed of, orterminated (IRC sections 1001, 1234A).

The Treasury Regulations implementingIRC section 988 provide specific timingrules for section 988 transactions, such asforward contracts, that conform to the gen-eral timing rules. Treasury Regulations sec-tion 1.988-2(d)(2)(i) states that, unless aforward contract subject to section 988 isa hedge for purposes of section 988, thegeneral realization rules govern the tim-ing of the realization of gain or loss onthe contract. Treasury Regulations section1.988-2(d)(2)(ii)(A) further states that“exchange gain or loss … shall not be real-ized solely because such transaction is off-set by another transaction (or transactions).”

The regulations do provide one circum-stance where entering into an offsettingposition will cause the recognition of gain(but not loss). If a taxpayer offsets a posi-tion, exchange gain is recognized to theextent that the taxpayer derives an eco-nomic benefit from the gain, such as apledge of the position (TreasuryRegulations section 1.988-2[d][2][ii][b]).Aside from terminating a profitable for-ward contract and receiving its cashvalue, the only means of accessing the con-tract’s value is through its use as collater-al—which, under these rules, wouldcause a deemed recognition event andresult in phantom income.

Additional special timing rules apply tosection 1256 contracts, such as forwardcontracts in major currencies. IRC section1256(c)(1) provides that the mark-to-mar-ket and character rules of IRC section 1256apply to any “termination (or transfer) dur-ing the taxable year of the taxpayer’sobligation (or rights) with respect to asection 1256 contract by offsetting, by tak-ing or making delivery, by exercise orbeing exercised, by assignment or being


assigned, by lapse or otherwise.” IRCsection 1256(c)(1) thus applies the mark-to-market regime to “all terminations andtransfers of futures contracts” (Greene v.U.S., 79 F.3d 1348, 1354, 2d Cir., 1996).

IRC section 1256 uses several terms ofart from the commodity futures market,including “offsetting.” In the regulated futuresmarketplace, offsetting is a means of legal-ly terminating an investor’s rights or obli-gations under a futures contract (Vickers v.Comm’r, 80 T.C. 394, 405, 1983). To ter-minate a futures contract via offsetting, theholder of a futures contract purchases theopposite type of contract on the sameexchange for the same delivery month as theexisting contract. For example, under therules of the commodity exchanges, the hold-er of a long contract can terminate the con-tract by acquiring a short contract on thesame exchange for the same deliverymonth (see Mertens Law of FederalIncome Taxation, para. 21A.05, no.85, 1997).In contrast, entering into a new forward con-tract to eliminate the risk of loss on one ofthe original forward contracts will not ter-minate any rights or obligations under theoriginal forward contract.

As used in IRC section 1256(c)(1), off-setting therefore refers to a specific meansof terminating a futures contract. Merelyentering into a forward contract that is nottraded on any exchange and that neutral-izes further gain or loss from another for-ward contract will not cause the latter con-tract to be terminated (see PLR 88-18-010,February 4, 1988). Because entering intothe new contract does not terminate the pre-existing contract, IRC section 1256(c)(1)does not cause a preexisting forward con-tract to be treated as terminated (TreasuryRegulations section 1.988-2[d][2][ii][C]).

Independent Economic SignificanceThe IRS could argue that the forward con-

tracts in a combined transaction should beintegrated, thereby deferring the tax conse-quences of closing out one contract of thestraddle until gains or losses are recognizedon the remaining contract. In analyzing thetreatment of financial transactions, howev-er, there has been a strong bias against inte-grating separate financial contracts. InBingham v. Comm’r (27 B.T.A. 186, 190,1932), the court held that the tax conse-quences of a short sale should be deferreduntil they are covered, even though the tax-

payer owned stock identical to stock that wassold short. IRC section 1259, added by theTaxpayer Relief Act of 1997, now providesthat under some circumstances such shortsales will be treated as a constructive saleof the stock held by the taxpayer. The IRShas occasionally attempted to require tax-payers to integrate financial instruments.

Prior to the enactment of IRC section 1092in 1981, the IRS took the position that tax-payers could not recognize the tax conse-quences of closing one leg of a straddle if anoffsetting leg remained open. In RevenueRuling 77-185, the taxpayer purchased andsold silver futures contracts on margin to gen-erate losses that could be used to minimizethe tax consequences of a short-term capitalgain realized from the sale of real estate. Thetransactions involved were as follows:

On August 1, 1975, the taxpayer soldsilver futures contracts for July 1976delivery and simultaneously purchasedthe same number of silver futures con-tracts for March 1976 delivery.

On August 4, 1975, the taxpayer soldthe March 1976 futures contracts at ashort-term capital loss. On the same day,the taxpayer purchased the same num-ber of silver futures contracts for May1976 delivery. On February 18, 1976, the taxpayer soldthe May 1976 futures contracts at a long-term capital gain and covered the shortposition established on August 1, 1975,by purchasing futures contracts for July1976 delivery, which resulted in a short-term loss.The commission on the closing of eachtransaction was minimal and because the

taxpayer consistently maintained aspread, the margin requirement tofinance these was minimal.In 1975, the taxpayer reported a short-

term capital loss on the sale of the March1976 futures that offset short-term gainsfrom real estate. In 1976, the taxpayerhad a net long-term capital gain on the May1976 futures and a short-term capital losson the sale of the July 1976 futures; thetaxpayer realized a small economic loss.The IRS concluded that the taxpayer wasnot entitled to deduct his short-term capi-tal loss on the closing of one position when,at the same time, a new position wasacquired. Moreover, the taxpayer was notentitled to deduct, in a later year when theentire transaction was closed out, the eco-nomic loss on the transactions.

In disallowing the short-term capital lossin 1975, the IRS relied on TreasuryRegulations section 1.165-1(b), whichstates that a loss is deductible only whena transaction is closed. According to theIRS, the taxpayer established a balancedposition with his initial long and short con-tract purchases. After the sale and purchaseof the silver futures contracts in 1975, thetaxpayer was in exactly the same bal-anced position as before these transactions;the only difference was the month of deliv-ery of the replacement contracts. Becausethe taxpayer continued to hold this bal-anced position, the IRS concluded thatthe transaction resulted in no real changein a true economic sense and was, there-fore, not a completed transaction. Becausethe transaction was incomplete, any deduc-tion of losses in 1975 was premature. TheIRS also disallowed the loss when all ofthe positions were closed in 1976, basedon IRC section 165, which states thatonly losses incurred in a “transactionentered into for profit” may be claimed tooffset tax liability. It asserted that taxpay-ers involved in offsetting position transac-tions had, as their dominant purpose, thecreation of an artificial short-term capitalloss, while ensuring that no real econom-ic effect resulted from such transactions.Thus, the taxpayer’s lack of a profit motivein trading its offsetting positions resultedin the disallowance of any deductions.

In Smith v. Commissioner (78 T.C. 350,1982), the position set forth in RevenueRuling 77-185 was challenged. While theIRS won the case, the court disagreed with

In analyzing the treatment of

financial transactions, there

has been a strong bias

against integrating separate

financial contracts.

many of the IRS’s arguments. Like the tax-payer described in Revenue Ruling 77-185,Smith had purchased and sold silver futurescontracts, which resulted in a short-term cap-ital loss in 1973, and a short-term capital lossand a long-term capital gain in 1974. The economic loss of the taxpayer withrespect to these transactions was approxi-mately $5,082 (which included $4,000 ofcommissions).

The IRS argued that the short-term capi-tal losses recognized in the first year shouldbe fully disallowed because 1) there were nogenuine losses realized; 2) the losses wereone step in a series of transactions, whichhad to be integrated and recognized only inthe year when all of the positions were closedout; 3) the transactions lacked economic sub-stance; and 4) the losses, if real, were notdeductible because they were not incurredin a transaction for profit.

The Tax Court first determined that theshort and long positions entered into by thetaxpayer were separate properties pos-sessing independent significance for taxpurposes. Furthermore, it determined thatthe close of one leg of a straddle was aclosed and completed transaction, andthat a gain or loss was sustained at thatpoint in time. (See also Valley Waste Millsv. Page, 115 F.2d 466, 468, 5th Cir., 1940).In analyzing whether the futures transac-tions should be integrated, the Tax Courtexamined the following three theories:■ A common law “wash sale” doctrine■ A nonstatutory straddle integration rule■ The step transaction doctrine.

In each case, the court determined thatsuch theories did not require integrationof the transactions. The Tax Court held,however, that the real loss sustained inthe first year was substantially less thanwhat was reported by the taxpayer. Afterreviewing the nature of the taxpayer’s trad-ing activity, the Tax Court held that thetaxpayer had exchanged existing contractsfor new contracts rather than for sold andpurchased contracts. Gain or loss on suchan exchange of property is determined bycomparing the taxpayer’s basis in the oldproperty to the cash plus fair marketvalue of property received. The court deter-mined that the fair market value of the newcontracts received was nearly equal tothat of the old contracts surrendered.Therefore, only a small loss was realized(Smith, 78 T.C. 381–84).

Based on prior case law, the Tax Courtfound clear authority that there was nocommon law wash sale doctrine withrespect to a continuous position in a com-modity future; the question was whether acommon law doctrine existed withrespect to straddles. The court noted thatprior case law supported a non-statutorywash sale doctrine where a party had notcompletely relinquished an economicinvestment in the same, or substantiallyidentical, investment. Because each of thepositions was neither the same asset norsubstantially similar under any wash saledoctrine, statutory or otherwise, the courtheld that such a doctrine could not forcethe integration of the losses.

The Tax Court also refused to create anew, nonstatutory straddle integration rule.The court cited the complexity of articu-lating a theory where investments in dif-ferent assets were to be integratedbecause their prices move on tracks thatare close to parallel. The complexity ofsuch a theory was evidenced by theenactment of IRC section 1092 and itsmyriad rebuttable presumptions. The courtleft open the possibility of ruling differ-ently if the taxpayer had been guaranteedan exact offsetting unrealized gain. Still,it noted that contracts with different deliv-ery months showed varying relative prices,and while the price variations were small,they were not de minimis.

In response to the argument that the steptransaction doctrine would be an appro-priate ground for disallowing the claimedlosses, the Tax Court stated that the gen-eral purpose of the step transaction doc-trine was to disregard unnecessary stepsundertaken to achieve a tax consequencedifferent from what would have occurredif a transaction were done directly. The TaxCourt stated that there was no authority forthe proposition that the step transactiondoctrine requires the integration of gainsand losses realized in different years, andacceptance of such a concept would under-mine the system of annual tax account-ing. In addition, because of the risk thatfuture offsetting gains might not material-ize—even though this result was “not prob-able”—the court distinguished the previ-ous case from situations where the steptransaction was applied, especially in thetaxation of transactions between corpora-tions and stockholders.

In evaluating the argument that the tax-payer’s real losses should not be allowedbecause the transaction was not entered intofor profit, the Tax Court stated that, if thetaxpayer had nontax profit motives forentering into a transaction involving off-setting positions, losses from the transac-tion would not be disallowed merelybecause the taxpayer also had strong taxavoidance reasons for entering into thetransaction. Likewise, the taxpayer’s hopeof profit did not necessarily have to be rea-sonable, just bona fide. In Smith, howev-er, the evidence presented indicated noapparent nontax profit motive for enteringinto the offsetting positions. Thus, theTax Court reasoned that the losses werenot incurred in any transaction entered intofor profit and disallowed the losses.

Other courts have come to the same con-clusion regarding similar transactions. InStarr v. Comm’r (T.C. Memo. 1991–610),the court held that a taxpayer failed to meetthe burden of proof in showing that heentered into a straddle transaction primar-ily for profit within the meaning of section108(a) of the Deficit Reduction Act of1984. In contrast, in Laureys v. Comm’r(92 T.C. 101, 130, 1989), the court allowedthe deduction of losses on straddles becausethe taxpayer’s primary purpose in engag-ing in the option, spread, butterfly, and spe-cialty transactions was consistent with hisoverall portfolio strategy for making a prof-it, and because the taxpayer was a mem-ber of the Chicago Board OptionsExchange (CBOE) and an appointed mar-ket maker in certain CBOE options.

Consider the Tax Implications A multinational corporation’s foreign

currency trading strategies should be struc-tured to minimize economic risk.Nonetheless, complex tax issues should beaddressed before the trading commences.Corporations and their tax advisorsshould have a working knowledge of therules for tax planning to overcome theIRS’s potential tax challenges and avoidunforeseen tax consequences. ❑

Lee G. Knight, PhD, is the HyltonProfessor of Accountancy at Wake ForestUniversity, Winston-Salem, N.C. Ray A.Knight, JD, CPA, is a visiting professorof practice, also at Wake Forest University.


The economic recession has highlighted the need for socioe-conomic reform. As businesses find themselves in the after-math of the housing crisis—accompanied by an ongoingcredit crunch with unprecedented unemployment rates, mas-

sive federal bailouts, plunging state revenues, and incomprehen-sible budget deficits—they are forced to reconsider and restruc-ture their traditional methods of doing business. Similar to for-profit enterprises, nonprofit organizations are now searching forways to generate a return. As the lines between the nonprofitand for-profit worlds blur, entrepreneurs worldwide continue tosearch for new legal structures that better suit the present eco-

nomic reality. Some are turning to hybrid entities, including thelow-profit limited liability company (L3C), which was specifi-cally designed to increase the number of program-related invest-ments that private foundations can make to such socially centeredbusinesses.

The discussion below focuses on limited liability companies (LLC)and the need for hybrid entities, specifically benefit corporations (Bcorporations) and L3Cs. Nonprofit organizations and program-relat-ed investment rules under the Internal Revenue Code (IRC) arealso addressed. CPAs should remain abreast of L3C legislation andcurrent developments in this area, as well as the intended use of

The Need for Hybrid Businesses

F I N A N C E

n o t - f o r - p r o f i t o r g a n i z a t i o n s


By Valeriya Avdeev and Elizabeth C. Ekmekjian

Examining Low-profit Limited Liability Companies and Benefit Corporations


L3Cs for program-related investments andother purposes.

An Overview of LLCsPrior to August 1988, only two states

had adopted LLC legislation: Wyoming in1977 and Florida in 1982. Before the IRSreleased Revenue Ruling 88-76 and itscheck-the-box regulations in 1997, anLLC—just like an L3C today—wasviewed as an unfamiliar and confusingbusiness structure.

Today, all 50 states have laws authoriz-ing LLCs; in fact, LLCs are becoming themost popular business structure in the UnitedStates. An LLC is a very flexible and effi-cient business entity. Unlike an S corpora-tion, an LLC has no limitation on the num-ber and the type of owners; unlike a corpo-rate entity, an LLC is not bound by complexstate compliance laws; and unlike limitedpartners in a partnership, members of anLLC are not subject to potential vicariousliability for acts committed by co-owners inthe ordinary course of business.

Tax-planning opportunities for individu-als interested in creating an LLC are almostendless. LLCs can take the form of almostany business type. Specifically, an LLC withtwo or more members may be treated as atax partnership; as a tax corporation, if itmakes the necessary election; or as a tax-exempt organization, with some limitations.In its Limited Liability Company ReferenceGuide Sheet, the IRS sets out the following12 conditions that an LLC must meet inorder to satisfy the tax-exempt status require-ments under IRC section 501(c)(3):■ The organizational documents mustinclude a specific statement limiting theLLC’s activities to one or more tax-exemptpurposes.■ The organizational language must spec-ify that the LLC is operated exclusivelyto further the charitable purposes of itsmembers.■ The organizational language must requirethat the LLC’s members be IRC section501(c)(3) organizations, governmental units,or wholly owned instrumentalities of a stateor political subdivision thereof.■ The organizational language mustprohibit any direct or indirect transfer ofany membership interest in the LLC to atransferee other than an IRC section501(c)(3) organization or governmentalunit or instrumentality.

■ The organizational language muststate that the LLC, interests in the LLC(other than a membership interest), orits assets may only be availed of or trans-ferred (directly or indirectly) to anynonmember, other than an IRC section501(c)(3) organization or governmentalunit or instrumentality, in exchange forfair market value.■ The organizational language must guar-antee that, upon dissolution of the LLC,

the assets devoted to the LLC’s charitablepurposes will continue to be devoted tosuch purposes.■ The organizational language mustrequire that any amendments to theLLC’s articles of organization and operat-ing agreement be consistent with IRCsection 501(c)(3).■ The organizational language mustprohibit the LLC from merging with orconverting into a for-profit entity.


■ The organizational language mustrequire that the LLC not distribute anyassets to members who cease to be IRCsection 501(c)(3) organizations or govern-mental units or instrumentalities.■ The organizational language must con-tain an acceptable contingency plan in theevent that one or more members cease, atany time, to be an IRC section 501(c)(3)organization or a governmental unit orinstrumentality.■ The organizational language must statethat the LLC’s exempt members will expe-ditiously and vigorously enforce all of theirrights in the LLC, and will pursue alllegal and equitable remedies to protect theirinterests in the LLC.■ The LLC must represent that all its orga-nizing document provisions are consistentwith state LLC laws and are enforceable atlaw and in equity. (http://www.irs.gov/pub/irs-tege/llc_guide_sheet.pdf)

The IRS established these 12 condi-tions to ensure that tax-exempt LLCs were

operated exclusively to further their socialpurpose, rather than generate net income.But some states—California, Indiana, Iowa,Maryland, Minnesota, New York, NorthDakota, Rhode Island, Texas, Utah,Virginia, and the District of Columbia—require in their respective statutes that anLLC be organized for a business profit.Thus, it is questionable whether an LLCorganized in those states will be respectedas a tax-exempt entity. In order to avoidthis predicament, entrepreneurs can orga-nize their entity as a tax-exempt LLC inother states and then operate in the stateslisted above. Finally, an LLC with onemember may be treated as a tax corpora-tion, if it makes the necessary election, oras a pass-through disregarded entity, whol-ly owned by a nonprofit organization.

Even under the elaborate variety oftoday’s business forms, it is likely thatone single entity cannot successfully oper-ate both a nonprofit and a for-profit struc-ture. If the entity has a for-profit purpose,

its managers will find themselves boundby the decisions of the board of directors,which will require an overriding for-prof-it motive in most of the entity’s under-takings. Likewise, if the entity’s purposeis to be a tax-exempt organization, itsmanagers will find themselves bound bystrict statutes that preclude any meaning-ful financial gain by the owners, regard-less of the social benefit accomplished.Combining a profit motive with a socialpurpose in a single entity requires theorganization of a new business form.There are two known methods of creat-ing such a hybrid entity—a B corporationand an L3C.

B CorporationsA B corporation is a new, purpose-

driven hybrid structure that creates bene-fits for all of its stakeholders: the businessitself, the community in which the businessoperates, and the environment. B corpora-tions are business organizations that electto obtain certification from B Lab, a non-profit organization dedicated to using thepower of business to achieve a sociallydesirable business purpose and address sys-temic problems. B Lab’s stated goals areto build a community of certified B cor-porations with a social purpose and pro-mote legislation creating new corporateforms that meet “higher standards of cor-porate purpose, accountability, and trans-parency” (http://www.benefitcorp.net/for-attorneys/legal-faqs).

In order to obtain certification from BLab, a B corporation must abide by certainrequirements, such as meeting comprehen-sive and clear social and environmental per-formance standards, institutionalizing stake-holder interests, and building a collectivevoice through the power of a unifying brand.Only after meeting those requirements willan entity obtain the right to use the certifi-cation as a B corporation. This allows theentity to network with similar organiza-tions and to use the B corporation designa-tion for marketing purposes.

Unlike the name suggests, B corporationstatus is not limited to corporations only;B corporations can take a corporate form,but they can also be LLCs or even limit-ed liability partnerships.

New York legislation. In December 2011,New York became the seventh state to passlegislation to allow businesses to organize as

CASE STUDY

MOOMilk, a recently formed L3C, is a perfect example of an L3Cused for purposes other than PRIs. Vaughn Chase, an owner ofone of 10 small farms in Maine, and other farmers created acompany to process and distribute organic milk locally under

their own brand, Maine’s Own Organic Milk Company, or MOOMilk. MOOMilkwas organized as an L3C under Vermont’s statute because, at that time, Mainehad not yet passed similar L3C legislation. Chase, an organic dairy farmer, had received a notice from his processor, H. P.Hood, that it would no longer be taking milk from Chase’s farm. The refusal toprocess Chase’s milk came just after he had invested substantial personal fundsto convert his 600-acre family farm to meet the U.S. Department of Agriculture’sorganic certification standards. Unable to find another organic processor, Chasethought that he would be forced out of business. Because an L3C is a for-profit entity that is eligible for regular investments, however,Chase and the other farmers were able to create a new business and attract thenecessary capital to MOOMilk. The company’s operating agreement specified thatthe farmers receive 90% of the profits each month, as well as a predetermined pricefor their milk. Furthermore, the agreement specified that investors would onlyreceive a return upon exiting the enterprise. One attorney who worked on structur-ing MOOMilk commented, “Nobody’s going to get rich investing in this L3C. But ifthe goal is to save family farms, that is going to happen” (Malika Zouhali-Worrall,“For L3C Companies, Profit Isn’t the Point,” CNNMoney, http://money.cnn.com/2010/02/08/smallbusiness/l3c_low_profit_companies).The case of MOOMilk illustrates how an L3C can serve as a catalyst forincreased investment in socially beneficial enterprises.


B corporations. Prior to the adoption of thislegislation in New York, some uncertain-ties still existed regarding B corporations andtheir organizational structure. For example,even if the original investors were in agree-ment with the limitation on a for-profit moti-vation inherent in a B corporation, it wasunclear whether, under corporate law, anysuccessor investor would be bound by thelimitation on management’s obligation tomaximize profit.

Under the Silver-Squadron legislation(A.4692-A/S.79-A) that was signed intolaw, companies organized as B corpora-tions in New York must pursue a generalpublic benefit, measured by “material pos-itive impact on society and the environ-ment, taken as a whole, assessed against athird-party standard” (http://benefitcorp.net/selecting-a-third-party-standard).

B corporations in New York do nothave to follow the B Lab certificationprocess; according to the legislation, anindependent third-party standard is suffi-cient. The legislation defines a third-partystandard as a “recognized standard fordefining, reporting and assessing generalpublic benefit” that is developed by anindependent person, is transparent, and ispublicly available (http://benefitcorp.net/selecting-a-third-party-standard). In addi-tion, section 1707 of the law mandates thatdirectors and officers of B corporationsconsider the effects of their actions on theirshareholders, employees, workforce, andthe interests of their customers.

Nonprofit Organizations and Program-Related Investment Rules

The following three types of organiza-tions are not organized for profit: ■ Those organized for public benefitunder IRC section 501(c)(3), known ascharities or public benefit organizations,including private foundations■ Those organized for the mutual bene-fit of other owners, such as businessleagues or homeowners associations■ Religious organizations.

Each of these organizations is exemptfor federal income tax purposes—that is,except for unrelated business taxableincome, such entities are not subject totax on the income that they derive pursuantto IRC section 501(a).

A private foundation is a domestic or aforeign organization described in IRC sec-

tion 401(c)(3), other than organizationsdescribed in IRC section 509(a)(1) through(4), and is exempt from income tax underIRC section 501(a). Private foundations arenot considered public charities under IRCsection 501(c)(3) or supporting organizations;however, private foundations nonethelessqualify as IRC section 501(c)(3) organiza-tions and are required to maintain charitable,

educational, religious, or other social pur-poses. In the United States, private founda-tions primarily engage in grant-making activ-ities to other nonprofit organizations.

In order to qualify as a private founda-tion under IRC section 501(c)(3) and IRCsection 509, an entity must be organizedand operated exclusively for one or moreexempt charitable purposes. If more than


an insubstantial part of the organization’sactivities is in furtherance of a for-profitmotive, the organization will lose its tax-exempt status. As such, any private foun-dation must—■ be organized and operated so that nopart of its net earnings benefits a privateshareholder or individual, and ■ not confer more than an incidentalprivate benefit on any such individual.

Moreover, under IRC section 4944(a), ifa private foundation invests in another enti-ty in such a manner as to jeopardize thecarrying out of any of its exempt purpos-es, a tax equal to 10% of the jeopardizinginvestment will be imposed on the foun-dation. The foundation will be charged anadditional tax of 25% if the jeopardizinginvestment is not corrected in a timely fash-ion. An exception does exist, if such aninvestment was program related. Pursuantto IRC section 4944(c) and TreasuryRegulations section 53.4944-3, the tax isnot imposed on a private foundation if theprogram-related investment (PRI) meets allthree of the following requirements:■ The primary purpose of the investmentis to accomplish one or more of the pur-poses described in IRC section170(c)(2)(B).■ No significant purpose of the invest-ment is the production of income or theappreciation of property.■ No purpose of the investment is toaccomplish one or more of the purposes

described in IRC section 170(c)(2)(D).IRC section 170(c)(2)(D), in turn,

restricts activities that involve influencinglegislation and participating in politicalcampaigns. By enacting the PRI exception,

Congress recognized that private founda-tions’ exempt activities were not limited tomere grant-giving activities.

PRIs are much more attractive to privatefoundations than grant distributions. Mostoften, PRIs are repaid and can even earna profit. Moreover, under IRC section4940, capital gains on PRIs are excluded

from gross investment income calculations.PRIs also qualify as an exception to theexcess business holdings rule under IRCsection 4943. Lastly, PRIs require greateraccountability to the foundation becausethey will likely be repaid.

As of today, most private foundations donot engage in PRI arrangements. In order fora private foundation to be confident that itsspecific PRI meets the applicable IRSrequirements and will not be subject to the10% tax or cause the entity to lose its tax-exempt status, it must seek a costly and time-consuming private letter ruling from the IRS.But another hybrid entity—the L3C—wasspecifically designed to overcome theseobstacles and meet the PRI requirementsunder the IRC.

L3C LegislationIn April 2008, Vermont became the first

state to enact legislation creating a new formof business entity—the L3C. An L3C is asubset of LLCs and was intended to bridgethe gap between for-profit and nonprofitenterprises. As a for-profit entity, an L3C isneither tax-exempt nor eligible to receive tax-deductible charitable contributions.Moreover, an L3C is required, by law, tohave as its primary purpose the advancingof a charitable or educational social goal,rather than the maximizing of profits.

The Vermont Limited LiabilityCompany Act defines L3Cs as follows:

(27) L3C or low-profit limited liabilitycompany means a person organizedunder this chapter that is organized fora business purpose that satisfies and isat all times operated to satisfy each ofthe following requirements:(A) The company:(i) significantly furthers the accomplish-ment of one or more charitable or edu-cational purposes within the meaningof Section 170(c)(2)(B) of the InternalRevenue Code of 1986, 26 U.S.C.Section 170(c)(2)(B); and(ii) would not have been formed butfor the company’s relationship to theaccomplishment of charitable or educa-tional purposes.(B) No significant purpose of the com-pany is the production of income or theappreciation of property; provided, how-ever, that the fact that a person pro-vides significant income or capital appre-ciation shall not, in the absence of

ADDITIONAL RESOURCES

“2011 Instructions for Form 990-PF,” IRS, p. 3, www.irs.gov/pub/irs-pdf/i990pf.pdf

Benefit Corporation Information Center, www.benefitcorp.net

“B Lab: The Nonprofit Behind B Corps,” B Lab, www.bcorporation.net/The-Non-Profit-behind-B-Corps

“Limited Liability Company,” IRS, www.irs.gov/businesses/small/article/0,,id=98277,00.html

Richard A. McCray and Ward L. Thomas, “Limited Liability Companies as ExemptOrganizations—Update,” pp. 3–6, www.irs.gov/pub/irs-tege/eotopicb01.pdf

“Tax Information for Private Foundations,” IRS, www.irs.gov/charities/foundations/index.html

“What Is the Difference Between a Private Foundation and a Public Charity?”Foundation Center, www.foundationcenter.org/getstarted/faqs/html/pfandpc.html

PRIs are much more attractive

to private foundations than grant

distributions. Most often, PRIs are

repaid and can even earn a profit.


other factors, be conclusive evidence ofa significant purpose involving the pro-duction of income or the appreciation ofproperty.(C) No purpose of the company is toaccomplish one or more political or leg-islative purposes within the meaning ofSection 170(c)(2)(D) of the InternalRevenue Code of 1986, 26 U.S.C.Section 170(c)(2)(D).(D) If a company that met the definitionof this subdivision (23) at its formationat any time ceases to satisfy any one ofthe requirements, it shall immediatelycease to be a low-profit limited liabili-ty company, but by continuing to meetall the other requirements of this chap-ter, will continue to exist as a limited lia-bility company.The Vermont Limited Liability

Company Act further provides:(a)(2) The name of a low-profit limitedliability company as defined in subdivi-sion 3001(23) of this chapter shall con-tain the abbreviation L3C or l3c.The Vermont statute discussed above is

a mirror image of the IRC section4944(c) PRI requirements. Since L3Cswere specifically designed to qualify forthe PRI exception, such resemblance is nota coincidence; the drafters of L3C legisla-tion are hopeful that the IRS will soon issuea corresponding revenue ruling acceptingL3Cs as a suitable mechanism for usingPRIs, thus eliminating the need for pri-vate foundations to request private letterrulings each time they wish to enter into anew PRI arrangement.

Along with Vermont, L3Cs can beformed in eight additional states: Illinois,Louisiana, Maine, Michigan, NorthCarolina, Utah, and Wyoming. A new L3Cformed in any of these states can legallyoperate in any state. Legislation allowingthe formation of L3Cs is also being con-sidered in numerous other states, includingArizona, Arkansas, Hawaii, Indiana, Iowa,Kentucky, Maryland, Montana, New York,Oklahoma, Oregon, and Rhode Island.

The states that have enacted L3C legis-lation have adopted language very similarto that used in the Vermont LimitedLiability Company Act. Similar toVermont, all of the other states requirethe following basic elements: ■ The entity must further the accom-plishment of a charitable or educational

purpose within the meaning of IRC sec-tion 170(c)(2)(B).■ The entity would not have been formedbut for its relationship to the accomplishmentof a charitable or educational purpose.■ Neither the production of income northe appreciation of property is a significantpurpose of the entity.■ The entity has no political or legisla-tive purpose within the meaning ofIRC170(c)(2)(D).

Furthermore, in some states, such asVermont and Utah, the educational or char-itable purpose requirement for an L3C is

included in the definition provisions ofthe state’s LLC act, and no specific lan-guage is expressly required to be containedin the L3C’s articles of organization. Inother states, such as Michigan, the educa-tional or charitable purpose, together withthe prohibition on lobbying and politicalcampaign activity, is required to beexpressly stated in the L3C’s articles oforganization. Because the articles of orga-nization are public and the operating agree-ment is not, the IRS would presumably pre-fer to have the requirements specificallystated in the articles of organization.

All of the states that passed L3C legis-lation did so by supplementing their exist-ing LLC statutes to permit the creation ofthis new social-purpose business entity.Because an L3C is a subset of an LLC, itshould similarly be treated as a pass-through entity for income tax purposes,assuming that the L3C does not elect to betreated as a corporation. Similar to an LLC,an L3C provides its members with limit-

ed liability protection against the actionsand debts of the L3C business. Likewise,there are no limitations on who can be amember of the L3C.

Additional Uses of L3CsAs mentioned above, an L3C is a hybrid

type of business that combines the strengthsof the LLC structure with the social bene-fits of an exempt entity. The primary pur-pose of an L3C is to promote charitable oreducational purposes, whereas earning aprofit is a secondary objective. Moreover, anL3C allows its investors the flexibility toaccount for different investment objectives,as well as varying financial considerations.

An L3C has the potential to increase theflow of capital from exempt organizations,beyond private foundations interested inPRIs. For example, L3Cs might be particu-larly well-suited for joint ventures with tax-exempt hospitals or similar operating chari-ties. L3Cs could also be used as sub-sidiaries of an exempt organization in orderto provide limited liability protection to itsparent and segregate different charitableactivities. For a real-life example of how anL3C was used, see the sidebar, Case Study.

Looking ForwardThe arrival of hybrid entities, such as B

corporations and L3Cs, represents apotential breakthrough for individuals andorganizations that are dedicated to achiev-ing social change. L3Cs are especially like-ly to cause a substantial increase in theavailability of both private and nonprofitcapital to entities that need it most—thosedesigned to further charitable and educa-tional purposes. CPAs can help such enti-ties by understanding the scope of theseorganizations, the rules that govern theiruse, and continual developments in thisarea. For more information, readersshould visit the links in the sidebar,Additional Resources. ❑

Valeriya Avdeev, JD, LLM, and ElizabethC. Ekmekjian, JD, LLM, are professors inthe department of accounting and law atCotsakos College of Business, WilliamPaterson University, Wayne, N.J. The authorswould like to acknowledge Ann Thomas,AB, JD, at New York Law School, and JohnWilcox, PhD, at Manhattan College, for theircontinued guidance and support.

An L3C allows its investors the

flexibility to account for different

investment objectives, as well as

varying financial considerations.

It has been said that it is wise to keepyour friends close and your enemiescloser. In these challenging economictimes, accounting firms are increasing-

ly following this maxim when it comes topostemployment restrictions for departingprofessionals. In fact, growing numbersof accounting firms are making certain thatthey have the right form of non-competeand protective covenant agreements inplace with their employees, managers, andpartners in order to ensure that accountantscannot leave the firm and take their booksof business and client relations to a com-petitor. More and more well-known NewYork accounting firms are going to courtto enforce their rights under such agree-ments when once-loyal accountants leavethe firm and then seek to service formerclients or hire employees from their for-mer firm.

Many accounting firms recognize theimportance of including the correct andupdated form of a protective covenant intheir employment agreements. Others,however, rely on covenants drafted manyyears ago, neglecting to revise agree-ments to reflect changes in an employee’sseniority, market conditions, or the law.Even accounting firms that periodicallyupdate their protective covenants oftenimplement them on a forward-looking basisonly. Thus, these firms fail to require exist-ing employees to agree to the updated pro-visions and are left without complete pro-tection.

The discussion below explores some ofthe best practices for designing andupdating protective covenants, as well aspractical tips for implementing revised

agreements with existing staff and for hir-ing accountants with preexisting contrac-tual obligations. It will also focus on lead-ing and recent court cases involving NewYork accounting firms.

Leading New York Court CaseThe leading New York court case con-

cerning the enforcement of postemploy-ment protective covenants concerned anational accounting firm. The case—BDO Seidman v. Hirschberg, 93 N.Y.2d382 (1999)—demonstrates why account-ing firms should include carefully draftedprotective covenants in their employment,partnership, and shareholder agreements.

In BDO Seidman , the defendantHirschberg was an accountant whose localBuffalo firm had been acquired by BDO.

When Hirschberg was promoted to man-ager at BDO, he signed an agreement thatprohibited him from servicing BDO’sclients for 18 months after the terminationof his employment. In addition, itrequired that if Hirschberg violated theagreement, he would have to pay BDO150% of a particular client’s fees fromthe fiscal year prior to his departure fromBDO. When Hirschberg resigned fouryears after his promotion, he then provid-ed accounting services to several BDOclients—the equivalent of $138,000 in rev-enues to BDO in the year prior to hisdeparture.

The New York Court of Appeals exam-ined BDO’s agreement with Hirschberg todetermine whether it was enforceable. Thelaw is clear that, regardless of the actual lan-

The Increased Importance of Non-CompeteAgreements for Accounting Firms

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 Michael C. Lasky and David S. Greenberg

guage in the covenant, only reasonablerestrictions will be enforced. A “restraint isreasonable only if it: (1) is no greater thanis required for the protection of the legiti-mate interest of the employer, (2) does notimpose undue hardship on the employee, and(3) is not injurious to the public” (BDOSeidman, pp. 388–389).

The court emphasized that restrictionsof this type are more likely to be enforce-able against learned professionals who pro-vide specialized services, such as accoun-tants. It also scrutinized Hirschberg’scovenant to determine whether BDO wasindeed protecting a legitimate interest,and whether the covenant was tailored onlyas restrictively as necessary to protect thatinterest. The court ultimately held that thecovenant was overly broad because itprohibited Hirschberg from servicing allBDO clients—even those Hirschberg him-self recruited prior to joining BDO andthose with whom Hirschberg had notdeveloped any relationship as the result ofhis employment (BDO Seidman, p. 393).

Rather than simply discarding the overlybroad covenant, however, the court next con-sidered whether the covenant should havebeen enforced to the extent that it was rea-sonable. It found no evidence of BDO’sdeliberate overreaching, bad faith, or coer-cive abuse of superior bargaining power.Because of this, the court rewrote—that is,“blue-penciled”— the covenant to effectivelynarrow it by precluding Hirschberg onlyfrom servicing those clients with whom hehad developed a relationship as a result ofhis employment with BDO (BDO Seidman,pp. 394–395). The court then sent the caseback to the trial judge to determine whetherBDO was entitled to receive damages basedon the formula of 150% of the client’sprior year’s revenue, as specified in thecovenant (BDO Seidman, p. 397). This casedemonstrates how valuable protectivecovenants can be in guarding an account-ing firm’s business interests. But BDOSeidman also highlights the importance ofchoosing appropriate covenants for givenemployees and carefully drafting suchcovenants so that they contain reasonableand clearly defined terms.

Types of Protective CovenantsProtective covenants come in a variety

of forms, and selecting the right covenantis the first step in protecting a business.

The following sections examine five dif-ferent types of covenants.

Noncompetition provision. The mostrestrictive covenant is the blanket noncom-petition provision, which prevents employ-ees from working in competition with theirformer firm for a specified period of timefollowing the termination of employment.Because this type of covenant imposes thegreatest restraints on an employee’s abilityto earn a living, courts are most reluctant toenforce it. A blanket noncompetition provi-sion is appropriate for only the most seniormembers of an organization—if at all—and it is often utilized in the context of alarger firm’s buyout of a smaller firm andthe hiring of that smaller firm’s principals aspartners or senior executives. Blanket non-competition provisions might also beappropriate for senior-level employees withwide-ranging access to sensitive confidentialinformation, which would necessarily be dis-closed if the employee were to go to workfor a competitor.

Nonsolicit/nonservice provision. Thisprovision is less restrictive than the blan-ket noncompetition provision; it prohibitsformer employees from soliciting or pro-viding services to firm clients for a speci-fied period of time. Because non-solicitprovisions are narrower in scope than non-competes, they are relatively easier toenforce when properly drafted. Non-solic-it/nonservice provisions are appropriate fora broader range of employees than blanketnoncompetition provisions, and firms com-monly use them for both senior- and mid-level employees. These covenants can beappropriate even for junior employees whowill have ongoing contact with firm clients.Moreover, such covenants can sometimesbe expanded in scope for more senioremployees who join the firm in the con-text of a buyout or merger, such that thecovenants protect even those employees’preexisting clients brought to the firm—acategory that is generally not protectable.(See Weiser LLP v. Coopersmith, 74A.D.3d 465, 467 [1st Dep’t 2010].)

Nonraid/nonhire provision. A non-raid/nonhire provision bars an employeefrom soliciting other firm employees for aperiod of time after departure. A nonraidprovision can be useful when a givenemployee has few direct or exclusiverelationships with firm clients, but worksclosely with other employees who do. Like

nonsolicit/nonservice provisions, non-raid/nonhire provisions are commonly usedfor a wide range of employees at variouslevels of seniority.

Extended notice provision. This type ofprovision simply requires employees togive advanced notice of their resignation.The long lead time gives the firm a betterchance to retain a client by introducingother personnel into the relationship, andit can assist the firm in retaining clients thatthe departing employee brought to thefirm—a category of client that a nonsolic-it/nonservice provision might not reach.Extended notice provisions can be appro-priate for employees at all levels, regard-less of whether those employees have con-tact with clients. The amount of noticerequired before resignation should be tai-lored to the employee’s level of seniority,with longer periods appropriate for moresenior employees.

Employment agreement. Last, employ-ment agreements can contain an agreementthat employees will not use the firm’s con-fidential or proprietary information afterdeparture. While the law itself prohibitsdeparting employees from improperlyusing confidential information, a contrac-tual provision can broaden the definitionof confidential information and can elim-inate disputes about whether specific typesof information are protected from anemployee’s use. Such covenants are appro-priate for employees at all levels.

Choosing and Drafting a CovenantIt often makes sense to use several of

the provisions described above in combi-nation in order to protect a company’sinterests. Firms should take a close lookat the types of services being rendered bya given category of employees, the close-ness of the employees’ relationships withclients and other employees, and the natureof information to which the employeeshave regular access. Next, firms shouldselect the appropriate blend of covenantsto fit a situation; different types of employ-ees might require different covenants, andfirms might impose greater restrictions onpartners or owners because of their con-tractual and fiduciary relationships with thefirm and its other partners or owners.

Once a firm has chosen the appropriatecovenants, it must refine them to makethem more effective by not only defining



the firm’s protective covenants carefullyand completely, but also by reasonably lim-iting their scope. The sections belowdescribe the key strategies that accountingfirms should use in working with legalcounsel to draft protective covenants andavoid common pitfalls.

Leave nothing to guesswork. A protec-tive covenant that fails to adequately definewhat it seeks to protect and prevent couldfall short when put to the test—in otherwords: when in doubt, spell it out. By assum-ing that everyone knows what a given termmeans, firms run the risk that a court willend up defining that term for them—and theresults might not work in favor of the firmseeking to enforce the covenant.

For example, the New York Court ofAppeals recently decided a case definingwhat “solicitation” of a client means. InBessemer Trust Company v. Branin, 16N.Y.3d 549 (2011), an executive sold hiswealth management company, began work-ing for the buyer of his company, and thenlater resigned and joined a competitor.While the executive had not agreed toany specific protective covenants pur-suant to the deal, New York law imposescertain nonsolicit obligations on the sellerof a business because the purchaser is con-sidered to be buying the seller’s goodwilland ongoing client relationships.

Despite these obligations, the court heldthat the executive was still permitted 1) toanswer a former client’s questions aboutthe competitor’s business, 2) to assist thecompetitor in creating a pitch strategy for theformer client, and 3) to even attend a meet-ing between the competitor and the formerclient (Bessemer, pp. 559–560). In the court’sview, none of these constituted impropersolicitation under the implied covenant inher-ent in the sale of a business.

Bessemer illustrates several importantlessons. First, firms should not leave defin-ing the terms in protective covenants or fill-ing in missing provisions to the courts.An employment agreement should specif-ically define critical terms, such as whatconstitutes solicitation and who qualifies asa client subject to protection. Second, firmsshould examine their existing covenants toensure they prohibit departing employeesfrom not only soliciting clients, but alsofrom servicing them. Otherwise, depart-ing employees might find it easy to cir-cumvent their protective covenants.

Defining the scope of protections: keepit reasonable. In addition to being clearlydefined, a firm’s protective covenants mustbe reasonable in scope. As BDO Seidmanillustrated, courts will not enforce overlybroad covenants. Thus, firms must be rea-sonable in defining their protected interestsand their employees’ prohibited conduct.Firms should not overreach; if a courtsees overreaching, coercion, or bad faithby a firm, it will decline to partially enforcethe agreement and will simply throw outthe protective covenant in entirety. It is truethat the New York Court of Appealsblue-penciled the protective covenant inBDO Seidman and that, more recently,another appellate court blue-penciled anoverly broad covenant entered into betweenaccounting firm Weiser LLP and its part-ners (Weiser LLP, p. 469).

Other New York courts, however, haverefused to blue-pencil agreements betweenaccounting firms and their employees;instead, they struck down the covenant inentirety. For example, in Scott, Stackrow& Co., CPAs, P.C. v. Skavina, 9 A.D.3d805 (3d Dep’t 2004), a New York appel-late court refused to partially enforce anoverly broad protective covenant that theaccounting firm sought to impose on a staffaccountant who joined the firm when itacquired her previous firm. The court notedthat that the accounting firm had deliber-ately imposed the overly broad covenanton the accountant, prohibiting the defen-dant from servicing the firm’s entireclient base (regardless of whether she hadany dealings with these clients), and hadinsisted that she sign the covenant eachyear despite offering her no promotion orincrease in responsibilities (Scott, Stackrow,pp. 807–808).

Notably, the Scott, Stackrow decision illus-trates the importance of routine “checkups”for a firm’s protective covenants. The courtspecifically mentioned that the firm hadcontinued to impose the overly broadcovenant, even though the BDO Seidmandecision had explained the reasonable limitsof such covenants only a few years prior.

Good protective covenants impose clearbut reasonable limits and conditions on whata departing employee can do. In the caseof a blanket noncompetition covenant—which might be appropriate only for seniorpartners or key executives involved in firm-wide strategy who have access to specific

types of highly confidential information—the agreement should define “competi-tion.” Where possible, the covenant shouldalso specify those competitors for whom theemployee may not work, and it shouldappropriately limit the period of time andthe geographic area, if applicable, in whichthe employee may not compete. This typeof covenant will more likely be enforced ifthe departing employee receives some con-tinued compensation during the term of thenoncompetition period.

A nonsolicit/nonservice provision shouldset forth a reasonable, definite time periodof effect and should specifically defineclients to include only actual or prospec-tive firm customers that the firm last ser-viced within a specific, limited period priorto the employee’s departure. The covenantshould define clients to include only cus-tomers that the employee personally ser-viced or pitched.

As with the term competition, the terms“solicitation” and “service” should be clear-ly defined. Service should list the variety ofservices performed by the employee oroffered by the firm (e.g., accounting, audit-ing, tax, management, consulting services).Similarly, solicitation should include director indirect efforts, such as assisting anotherperson, to cause a firm client not only toengage the employee’s new firm, but also toreduce, in any way, the amount of businessthe client does with the original firm. A non-raiding provision concerning the recruitmentof other employees should likewise explic-itly prohibit indirect efforts to recruit, suchas assisting a new employer in doing so.

Put a price tag on a violation. Finally,when drafting clear and well-defined pro-tective covenants, it can be advantageous forfirms to set forth specific remedies in theevent that departing employees violate theircovenants. Because the damages arising fromclient loss can be difficult to quantify,accounting firms now commonly include liq-uidated damages provisions in their protec-tive covenants. Such provisions require theexiting employee to pay a set sum (or a sumderived from a set formula) in the event ofa violation of the agreement.

Courts will enforce a liquidated-damagesclause if it does not result in the employ-ee paying a sum that is considered gross-ly disproportionate to the harm anticipat-ed at the time the parties signed theagreement. For example, in BDO Seidman,


the court approved, in theory, a liquidated-damages formula based on 1.5 times theprior year’s billings of the lost client, wherethe protective covenant lasted 18 months(BDO Seidman, p. 396). More recently, aNew York court required a currency trad-er who competed with his former employ-er in violation of his covenant to pay anamount equal to the trader’s averagemonthly commissions, multiplied by thenumber of months remaining in hiscovenant (GFI Brokers LLC v. Santana,2008 WL 3166972 [S.D.N.Y 2008]).Likewise, a New York court approved aliquidated damages payment amounting toa consultant’s contractual share of oneyear’s estimated annual billings to a clientlost to the consultant’s subcontractor(Crown It Services Inc. v. Koval-Olsen, 11A.D.3d 263 [1st Dep’t 2004]). In all ofthese situations, the accounting firmsdesigned the covenants to provide therevenue stream of the lost client, rather thantrying to stop a once-trusted employee fromservicing an unhappy client.

Another common and powerful reme-dy for breach of a protective covenant isan injunction—that is, a court order com-manding the departed employee to stopworking in violation of the covenant. Thekey to obtaining an injunction is a firm’sdemonstration that it will suffer irrepara-ble harm if the employee continues vio-lating the covenant. Courts generally rec-ognize that the loss of client relationshipsand goodwill constitutes irreparable harm(e.g., Ticor Title Ins. Co. v. Cohen, 173F.3d 63, 69 [2d Cir. 1999]). While thelaw itself provides for injunctive reliefwhen the proper conditions have been met,protective covenants nonetheless ofteninclude an employee’s explicit acknowl-edgement that a violation of the covenantwould result in irreparable harm and thatthe firm, therefore, has the right to seekan injunction in the event of a breach; how-ever, this acknowledgment would not nec-essarily prevent a court from finding thatmonetary damages would be sufficient tocompensate the former employer for itsloss, which could serve as an obstacle tosecuring the injunction.

There are at least two other difficultieswith relying on injunctive relief. First, theaccounting firm seeking to enforce thecovenant has a very high burden of proofand needs to prove its case (typically on

an emergency basis) before pretrial dis-covery. Meeting this high burden at suchan early stage can be daunting. For exam-ple, in April 2011, a New York courtrefused to issue a preliminary injunctionagainst J.H. Cohn LLP in a case involv-ing several managing directors and part-ners who had departed RSM McGladrey,and who had allegedly violated covenantsprohibiting their solicitation or servicing ofMcGladrey clients and their hiring of otherMcGladrey personnel (RSM McGladreyInc. v. J.H. Cohn LLP, No. 650523-2011,slip op. at 14 [Sup. Ct. N.Y. County, April 8, 2011]). Despite the fact thatMcGladrey was able to secure injunctiverelief against the managing directors andpartners themselves in other state courts,the New York court found that McGladreycould not demonstrate a likelihood ofsuccess on the ultimate merits of its claimsagainst J.H. Cohn and did not find thatMcGladrey would actually suffer irrepara-ble harm in the absence of an injunction(RSM McGladrey, pp. 11–12).

Second, former employees are likely toargue that it was their former firm’s fail-ure to service a client’s business properlythat caused the client to terminate his busi-ness relationship with the firm—rather thanthe employee’s violation of the covenant.In other words, a departing employee willtypically decide that the best defense is togo on offense and put the conduct of hisformer accounting firm on trial. This isanother reason why preset contractualremedies, such as liquidated damages, havebecome increasingly common in account-ing firms’ restrictive covenants.

Updating Covenants and Due Diligencein Hiring

Unlike some other jurisdictions, NewYork law recognizes that continuedemployment in an “at will” relationshipis sufficient consideration to supportnew protective covenants. Thus, from apurely legal standpoint, an accountingfirm does not need to offer employees anyadditional compensation in exchange fortheir agreement to sign new (and morestringent) protective covenants. As a prac-tical matter, however, many accountingfirms find that the best time to implementnew covenants is in the third quarter,when many firms begin to consider salaryincreases for the following year and

bonuses for the current year. The firm canpresent its new covenants to the employ-ees and ask that the employees sign andreturn the new covenants by a date priorto the announcement of salary increasesand bonuses.

In addition, accounting firms must con-sider any preexisting obligations that candi-dates have to their previous firms. Firmsshould always ask potential new hires if theyare subject to protective covenants, confi-dentiality agreements, or any other agree-ments with their former firm; they shouldalso insist on receiving and reviewing copiesof such covenants during the interview pro-cess, ideally along with the firm’s employ-ment counsel. When possible, accountingfirms should also make new accountants’employment contingent on their representa-tion that they have provided the firm withall prior protective covenants, and that noprior agreements prevent them from work-ing in the new position. This process ensuresthat an accounting firm’s investment in anew accountant is protected not only againstfuture loss of its client relationships, but alsoagainst claims by another firm seeking toprotect its own such relationships.

The Bottom LineProtective covenants offer accounting

firms a powerful means of protectingtheir most valuable assets: their client rela-tionships and their employees. It is criti-cal for a firm to make sure its profession-als agree to protective covenants thatreduce the likelihood of losing clients oremployees. With the right combination ofprotections—and provisions that clearlydefine those protections—savvy managingpartners and executive committees ofaccounting firms can ensure that theirfirm’s covenants will preserve the value oftheir business and include the latestindustry trends and legal developments.These proactive measures can be the dif-ference between the minimal disruptionof losing one accountant and waving good-bye to a substantial book of business, rev-enues, and employees. ❑

Michael C. Lasky is a senior partner andcochair of the litigation department at Davis& Gilbert LLP, New York, N.Y. David S.Greenberg is an associate in the litigationdepartment at Davis & Gilbert LLP.

Nearly one decade ago, most of the large accounting firmsdivested their advisory services business. The divestitureswere motivated not only by business and management rea-sons, but by regulatory pressures as well. In particular, reg-

ulators were concerned that audit quality could suffer if advisoryservices threatened auditor independence. As a result of the divesti-tures and the adoption of the Sarbanes-Oxley Act of 2002 (SOX),advisory services revenue represented only a small share of account-ing firms’ revenues circa 2007. In recent years, however, adviso-ry services revenue has risen again, renewing concerns of its poten-tial effects on audit quality. But auditor independence is no longer

viewed as the primary threat to audit quality; instead, concernsrevolve around the audit firm’s culture and the quality of theresources allocated to advisory versus assurance services. The fol-lowing is an examination of the rise and fall—and rise again—ofadvisory services within public accounting firms.

BackgroundAdvisory services revenue grew rapidly at public accounting firms

during the late 1990s; yet, by the early 2000s, all but one of thethen–Big Five had spun off or sold these business lines. Three fac-tors drove these divestitures: 1) internal management tensions because

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

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


By R. Mithu Dey, Ashok Robin, and Daniel Tessoni

Like a Phoenix, Revenues Reborn amid Renewed Concerns

Advisory Services Rise Again at Large Audit Firms

of the faster revenue growth and perceivedhigher margins of advisory services as com-pared to assurance services; 2) the opportu-nity to unlock higher values and raise capi-tal through sales to publicly traded corpora-tions or via an initial public offering (IPO);and 3) the pressure applied, and regulationsadopted, by policymakers aimed at ensuringauditor independence.

Beginning in the early 2000s, advisoryservices revenue shrank due to divestituresand the adoption of SOX. At the sametime, assurance services revenue soared asSOX fueled rapid increases in the demandfor assurance services from clients. As aresult, advisory services played a diminishedrole in accounting firms beginning in theearly 2000s to about 2007. Since 2007, how-ever, advisory services have represented arising share of revenue for accounting firms,triggering renewed concerns.

Over the years, observers have raised man-agement and policy concerns about the rolethat advisory services play in the accountingindustry. Arthur Wyatt, a former FASB andInternational Accounting Standards Board(IASB) board member and Arthur Andersensenior partner, has discussed concerns aboutinternal conflict in accounting firms that mayadversely affect audit quality (“AccountingProfessionalism—They Just Don’t GetIt!”Accounting Horizons, March 2004;“Accounting Professionalism: A FundamentalProblem and the Quest for FundamentalSolutions,” The CPA Journal, March 2004).According to Wyatt, such internal conflictmight have a bearing on the allocation ofresources and talent, and might result in ashift in client focus from the investing pub-lic (audit realm) to company managers (advi-sory realm). On the policy front, most of theconcerns in the late 1990s and early 2000sfocused on auditor independence, which wasviewed as a contributing factor in the col-lapse of major corporations such as Enron,WorldCom, and Adelphia. These policy con-cerns about auditor independence appearedto be largely addressed through SOX,which essentially prohibited the primary audi-tors from also providing advisory services.

Recently, however, advisory services haveagain become important to accounting firms.These firms have found ways to sell adviso-ry services to clients for which they are notthe primary auditor. This rebirth of advisoryservices has generated renewed policy andmanagement concerns. A Treasury report

(Final Report of the Advisory Committee onthe Auditing Profession [ACAP] to the U.S.Department of the Treasury, October 2008)on the auditing industry raised concerns aboutthe adverse role advisory services might beplaying in public accounting firms. Althoughthe ACAP report was silent in its recom-mendations about the firms’ scope of servicesbecause the issue was not part of the com-mittee’s charge, the co-chairs commented onthe scope of services issue in their transmit-tal letter accompanying the report.Specifically, they expressed concern that asnon-audit services grow at a faster rate thanaudit services, fewer resources will be allo-cated for audit work. Their concern shiftedfrom the issue of independence (alleviated bySOX) to that of resource allocation inaccounting firms and the potential implica-tions for audit quality. Other commentators(Dana R. Hermanson, “How ConsultingServices Could Kill Private-Sector Auditing,”The CPA Journal, January 2009) have

expressed concern that talent and resourcesmight be diverted from auditing toward thefaster- growing, and apparently more lucra-tive, advisory side of the business. If advi-sory services growth continues on its cur-rent trajectory, these concerns are likely tobecome more important in the very nearfuture, potentially leading to some kind ofpolicy or management response. The authorsbelieve that it is in the best interest of theaccounting profession to take a proactiveapproach in addressing that potential policyresponse.

The fact that the Big Four are deliver-ing value for their advisory services clientsis indisputable. The markets clearly rec-ognize their prowess as consultants. In anApril 2010 Gartner report of all consultingproviders, the Big Four are included inthe list of “Top 10 Consulting ServiceProviders’ Revenue, Growth and MarketShare, 2008–2009” for North America(http://www.gartner.com/id=1362249). At


EXHIBIT 1Advisory Services Revenue from All Clients, 1996–2010

$ in Millions

5,000

4,500

4,000

3,500

3,000

2,500

2,000

1,500

1,000

500

-1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

E&Y Advisory Services Revenue PwC Advisory Services Revenue

Deloitte Advisory Services Revenue KPMG Advisory Services Revenue


issue, however, is not whether the Big Fourare doing a good job of consulting, butwhether strong consulting businesses insideaudit firms pose a threat to audit qualityand firm culture. The authors’ focus is onwhether the return to consulting is harm-ful to audit quality—an issue of significantconcern to investors and regulators.

Prior Round of Divestitures Around 2000, all of the then–Big Five,

with the exception of Deloitte, divestedtheir advisory services practices. Thedivestitures were driven by one or more ofthe factors described earlier: managementtension, opportunity for unlocking value,and pressure from regulators. Each of theBig Five’s experiences is described below.

Arthur Andersen. Management tensioncaused the breakup at Andersen Worldwide,the parent company of Arthur Andersen (AA),and Andersen Consulting (AC). A formalprofit-sharing agreement between AA and ACwas struck in 1989, just before the IT boomcontributed to the lucrative environment foradvisory services during the 1990s. The agree-ment required that the more profitable firm

share profits with the less profitable one;fueled by IT, AC grew much faster and wasmore profitable than AA. Thus, this agree-ment caused a great deal of tension betweenAC and AA management. The conflict, asreported in the press, lasted for about threeyears, until AC finally split off by paying AA$1 billion and foregoing the rights to theAndersen name (Brown, “AndersenConsulting Wins Independence: ArbitratorTells Firm to Pay Auditing Arm $1 Billion;Parent’s Role Criticized,” Wall Street Journal,August 8, 2000), with AC becomingAccenture. Subsequent to the split, AA restart-ed its advisory arm, often competing for thesame clients as Accenture.

Ernst & Young. Ernst & Young (E&Y)sold its advisory group for $11.1 billion toFrench IT firm Capgemini in March 2000,at the very peak of the Nasdaq stock marketboom. According to interviews with leadingexecutives at E&Y, the advisory servicesbusiness was sold for financial, regulatory,and strategic reasons (Malhotra andPierroutsakos, “An Assessment of CapGemini’s Cross-Border Merger with Ernst &Young Consulting, Multinational Business

Review, summer 2005). Financially, the offerof 2.75 times the advisory services unit’sannual revenue allowed E&Y partners tomonetize the advisory services asset invest-ments of the 1990s. Regulatory pressurebrought to bear by the SEC to separateaudit from non-audit functions in order toensure auditor independence also motivatedthe sale. A final reason given for the divesti-ture was that it allowed management to focusmore closely on its audit practice: E&Y’sCEO claimed this was an important reasonE&Y outperformed other large audit firms.

On March 26, 2001, Chairman JamesTurley noted, “The year after we announcedthe sale of our advisory business, we won threeand a half times more revenue than the restof the Big Five combined! I am not sayingthat our sale of advisory directly led to that,but I really do believe that the focus that weare now putting on the core businessesplayed a part in that” (http://newman.baruch.cuny.edu/digital/saxe/saxe_2001/turley_2001.htm). In spite of the proclamation that focusingon core business was a key competitive advan-tage, E&Y started to build its advisory prac-tice soon after its non-compete agreement with

Total Assurance Advisory Tax Top 100 Revenues (Percentage of Total) (Percentage of Total) (Percentage of Total)1996 $21,221.90 $7,910.99 37% $8,302.14 39% $5,008.62 24%1997 25,469.80 8,393.81 33% 10,903.39 43% 6,148.38 24%1998 31,665.80 9,550.72 30% 14,847.70 47% 7,267.38 23%1999 36,739.69 10,920.39 30% 17,695.50 48% 8,123.80 22%2000 34,772.60 12,872.10 37% 12,824.03 37% 9,076.48 26%2001 35,362.33 13,176.18 37% 11,270.82 32% 10,915.33 31%2002 28,422.61 11,517.70 41% 7,144.62 25% 9,760.29 34%2003 30,643.26 13,871.01 45% 5,893.86 19% 10,878.39 36%2004 33,154.08 15,594.98 47% 6,690.24 20% 10,868.86 33%2005 38,010.71 19,003.03 50% 7,658.91 20% 11,348.76 30%2006 41,795.83 22,792.29 55% 8,511.31 20% 10,492.22 25%2007 40,854.65 21,544.75 53% 8,538.60 21% 10,771.30 26%2008 44,600.48 22,978.19 52% 9,389.17 21% 12,233.12 27%2009 42,638.90 19,001.83 45% 11,225.05 26% 12,412.02 29%2010 42,500.06 18,351.48 43% 12,252.89 29% 11,895.69 28%

All amounts in millions of dollars Source: 1997 to 2011 Accounting Today “Top 100 Firms” published annually

EXHIBIT 2Top 100 Accounting Firm Revenues


Capgemini expired in 2005. Ironically, therebuilding of advisory capabilities was per-formed under Turley, who earlier had arguedfor an increased focus on assurance services.

KPMG. In 2001, KPMG spun off its advi-sory practice, which it named Bearing Point,through an IPO. KPMG disclosed its IPOplan in May 2000, two months after theNasdaq peaked. The IPO was delayed dueto the turbulent market conditions.Nevertheless, management pushed ahead inthe belief that the IPO would provide theadvisory practice greater freedom in part-nering with and investing in the equity ofclients. Such opportunities are severely lim-ited for advisory units affiliated with anaccounting firm because of the potential con-flicts of interest concerning audit clients(“IPO Still On For KPMG Consulting,”Larry Greenemeier, InformationWeek,January 8, 2001). Subsequent to the expira-tion of its non-compete agreement withBearing Point in 2006, KPMG beganrebuilding its advisory practice.

PricewaterhouseCoopers. A similar storyunfolded at PricewaterhouseCoopers (PwC),where the primary reason for the divestiture

appeared to be pressure from the SEC. PwCexperienced at least two failed attempts indivesting its advisory unit. In 2000, nearthe peak of the IT bubble, computer giantHewlett Packard (HP) offered PwC $18billion in cash and stock for its advisory unit,but HP later dropped the offer because anagreement could not be reached. PwC alsoattempted an IPO, named “Monday,” in thesummer of 2002, but the market for newissues had collapsed at that time. Subsequentto these two failed attempts, and with theadoption of SOX, many of PwC's largestclients decided to either cut their advisoryrelationship with PwC or to reduce it. In2002, for example, 22 of the 100 largest auditclients did not want to hire PwC for advi-sory services, and 16 wanted to reduce theamount of advisory services sourced fromPwC (“Goodbye Monday,” Economist,August 1, 2002). Eventually, in October2002, PwC sold its advisory services to IBMfor $3.5 billion in cash and stock, less thanone-fifth the amount HP had offered just twoyears earlier. Like the other firms, once itsnon-compete agreement expired in 2006,PwC began rebuilding its advisory practice.

Deloitte. The sole member of the BigFive not to “successfully” divest its advi-sory practice was Deloitte. Deloitte’sattempt to divest through a management-led buyout fell through in March 2003.Borrowing costs for the capital needed tofinance the buyout skyrocketed in thewake of Andersen’s closure, and revenuesank as cautious audit clients cancelednon-audit contracts. On March 31, 2003,the firm scrapped its divesture plans; inhindsight, the firm’s management viewedthis as a blessing in disguise. “In a strangekind of way, we’re very fortunate,” saidBarry Salzberg, CEO of Deloitte &Touche USA. “By serendipity, we endedup with a strategy that is unique” (NanetteByrnes, “The Comeback of Consulting,”BusinessWeek, September 3, 2007). Interms of absolute advisory revenue, as wellas a percentage of total revenue, Deloitte’sadvisory services are significantly largerthan those of the other large accountingfirms.

The Big Four accounting firms havereentered the advisory services market bytargeting non-audit clients. In addition, they

Total Assurance Advisory Tax E&Y Revenues (Percentage of Total) (Percentage of Total) (Percentage of Total)1996 $3,570.00 $1,392.30 39% $1,392.30 39% $785.40 24%1997 4,416.00 1,589.76 36% 1,810.56 41% 1,015.68 23%1998 5,545.00 1,885.30 34% 2,384.35 43% 1,275.35 23%1999 6,375.00 2,231.25 35% 2,805.00 44% 1,338.75 21%2000 4,270.00 2,433.90 57% 213.50 5% 1,622.60 38%2001 4,485.00 2,601.30 58% 134.55 3% 1,749.15 39%2002 4,515.00 2,663.85 59% 135.45 3% 1,715.70 38%2003 5,260.00 3,261.20 62% 157.80 3% 1,841.00 35%2004 5,511.36 3,692.61 67% 165.34 3% 1,653.41 30%2005 6,330.64 4,558.06 72% 63.31 1% 1,709.27 27%2006 6,890.00 4,960.80 72% 68.90 1% 1,860.30 27%2007 7,561.00 5,292.70 70% 75.61 1% 2,192.69 29%2008 8,232.10 5,597.83 68% 164.64 2% 2,469.63 30%2009 7,620.00 3,124.20 41% 1,981.20 26% 2,514.60 33%2010 7,100.00 2,982.00 42% 1,846.00 26% 2,272.00 32%


EXHIBIT 3Ernst & Young: Breakdown of Total Revenues


are able to offer nonprohibited advisoryservices to audit clients with advanced auditcommittee approval under SOX section201(a). The current barrier to entry nowappears to be lower for accounting firms.The significant brand recognition andrecruiting strength of the Big Four pro-vide them access to large clients andqualified advisory services candidates. Asthe growth in advisory services accelerates,will regulatory pressure force the publicaccounting firms to replay the divestituresof the early 2000s?

At the present time, the advisory busi-ness is thriving among the Big Four, withrevenues exceeding $1 billion at each firm.The rebirth of advisory services appearsto have been a fairly easy undertaking,inhibited only by non-compete agreementsin certain cases. Of course, audit firms arealso delivering advisory services that arehighly valued by their clients. With auditrevenues flat or declining, due to greaterstandardization since SOX, advisory ser-vices are beginning to play an increasing-ly important role in driving accounting firmrevenue and profit growth.

The Increasing Role of Advisory Services in Recent Years: Understanding the Trend

The authors’ analysis shows that adviso-ry services revenue has grown since 2007,both in absolute terms and also as a shareof total revenue for public accounting firms.The data are compiled from surveys pub-lished by Accounting Today in its annual“Top 100 Accounting Firms” from 1996to 2010. The survey instrument requestsfirms to provide data on their net U.S. rev-enues and their fee split as a percentage oftotal revenue. Total revenues (U.S. publicand private clients) are disaggregated intothree components: assurance, tax, and theremainder as advisory. Starting with the2002 “Top 100 Accounting Firms,” a fourthrevenue component, “other,” was added,including elements such as financial plan-ning, litigation support and valuation work,payroll, and benefit plan administration. Toprovide consistency over time, advisory ser-vices are defined as “other” and “manage-ment advisory services.”

Exhibit 1 shows the changes in advisoryservices revenue for the Big Four from 1996

to 2010. During the late 1990s and early2000s, advisory services revenue increasedrapidly for all of these firms. Advisory ser-vices revenue then dropped significantly forthree of the Big Four, due to the aforemen-tioned divestitures. And even in the case ofDeloitte, which did not divest, revenuedeclined beginning in 2001. From 2005onwards, advisory services revenue began toincrease again for most of these firms. In 2010,advisory services revenue, as a percentage oftotal revenue, accounted for a significant shareof Big Four revenues: 19% for PwC, 26% forE&Y, 28% for KPMG, and 45% for Deloitte.If the Big Four (Five) are eliminated from theTop 100 accounting firms, one finds thatrevenue from advisory services was close to30% from 2000 to 2005 and has been near20% since 2006. This may indicate that theBig Four are taking advisory services busi-ness away from non–Big Four firms.

In the early 2000s, the assurance busi-ness took center stage while the advisorybusiness declined. As discussed earlier, mostof the Big Four divested their advisorybusinesses and SOX increased demand foraudit services. From 2003 to 2005, in spite

Total Assurance Advisory Tax KPMG Revenues (Percentage of Total) (Percentage of Total) (Percentage of Total)1996 $2,530.00 $1,012.00 40% $1,037.30 41% $480.70 19%1997 3,000.00 1,230.00 41% 1,020.00 34% 750.00 25%1998 3,800.00 1,368.00 36% 1,520.00 40% 912.00 24%1999 4,656.00 1,629.60 35% 2,002.08 43% 1,024.32 22%2000 5,400.00 1,890.00 35% 2,322.00 43% 1,188.00 22%2001 3,400.00 1,496.00 44% 612.00 18% 1,292.00 38%2002 3,400.00 1,496.00 44% 680.00 20% 1,224.00 36%2003* 3,793.00 2,541.31 67% –* 0% 1,251.69 33%2004* 4,115.00 2,962.80 72% –* 0% 1,152.20 28%2005* 4,715.00 3,630.55 77% –* 0% 1,084.45 23%2006 4,801.00 2,448.51 51% 1,296.27 27% 1,056.22 22%2007 5,357.00 2,571.36 48% 1,553.53 29% 1,232.11 23%2008 5,679.00 2,725.92 48% 1,533.33 27% 1,419.75 25%2009 5,076.00 2,436.48 48% 1,269.00 25% 1,370.52 27%2010 4,889.00 2,248.94 46% 1,368.92 28% 1,271.14 26%


* For 2003, 2004, and 2005, KPMG’s advisory revenues are included in assurance revenue.

EXHIBIT 4KPMG: Breakdown of Total Revenues


of the drop in advisory services revenue,increases in assurance services revenue morethan made up the difference, resulting inoverall revenue increases for all of the firms.Assurance services revenue increases weredriven by increases in liability risks for audi-tors and clients alike, as well as increases inengagement hours. With the passage of SOXand the implementation of SOX section 404,assurance revenues soared. Due to SOX sec-tion 404 compliance, audit fees nearly dou-bled from 2003 to 2004, and remained highin 2005, according to several studies (e.g., aFinancial Executives Institute member sur-vey report, March 2006). The PublicCompany Accounting Oversight Board’s(PCAOB) Auditing Standard (AS) 2 alsocaused an increase in audit hours. In addi-tion, top executives of publicly traded corporations are now required to take morepersonal responsibility for their financialstatements, leading to greater reliance onauditors for assistance.

From 2006 to 2007, several factors—including a backlash from clients over highengagement fees—impacted assurance rev-enues of the Big Four (Freeman, “Who’sGoing to Fund the Next Steve Jobs?” WallStreet Journal, July 18, 2008). Auditorsreduced their hours and audit revenuesdropped (Reilly, “Audit Fees Rise, But ata Modest Pace,” Wall Street Journal.March 27, 2006). A primary catalyst forthis was AS 5, which allowed auditors totake a more risk-based approach in theaudit and place more reliance on thework of others, such as internal auditors.In addition, by this time auditors and clientshad progressed along the learning curve ofSOX section 404, thereby reducing audithours and audit fees. Furthermore, thefinancial crisis and recession of 2007likely contributed to a reduction in aggre-gate audit revenue. The recession may havealso led clients to negotiate more force-fully with auditors to reduce prices.Companies were likely capturing agreater share of the savings generated bythe regulatory shift to AS 5 and the learn-ing curve cost reductions resulting fromSOX section 404. Other competitive pric-ing pressure came from second-tier audi-tors who had become more serious com-petitors to the Big Four; this competition,of course, was limited to certain sectorsof the markets in which the second tier wasmost capable of auditing. Because of these

developments, there was increased eco-nomic pressure on the Big Four to seekadditional nonassurance revenues (Byrnes2007).

During this same 2006–2007 period, mostof the non-compete agreements on adviso-ry services expired. Thus, as assurance rev-enues started to stagnate or decline, auditfirms had a strong motivation to make up

those revenues through other businesslines; thus, managers recultivated advisoryservices. Deloitte’s success in maintainingand growing its advisory services, even withthe strong regulatory constraints in place,provided a blueprint for the other firms toresuscitate their advisory services. The yearsfollowing 2007 clearly indicate that adviso-ry services are on the rise.

Since 2008, advisory services revenueshave continued to grow for the Big Four,while assurance services revenues have stag-nated. Based on this rapid growth, it seemsclear that firms are focusing their growth strat-egy on advisory services. For example, advi-sory services revenue for PwC grew as ashare of total revenue from 14% to 19%between 2008 and 2010, and Deloitte’s advi-sory services grew from 34% to 45%.

The 1996–2010 timeframe can be divid-ed into four periods. The first period, in thelate 1990s, was one of rapid growth inadvisory services. The second period,2000–2005, was characterized by divesti-tures in advisory services coupled with apost-SOX boom in auditing services. Thethird period, 2006–2007, saw stagnation inaudit revenues and an opportunity to recon-sider advisory services. The final period,since 2007, has seen a full-blown rebirthof advisory services.

Exhibit 2 takes a big picture look at rev-enue components of the Big Four. The threeprimary components of revenues for auditfirms are assurance, advisory, and tax, and

each has taken a different path over the1996–2010 timeframe. Assurance servicesrevenues were $7.9 billion in 1996, account-ing for 37% of overall revenues. Its shareof revenue peaked at 55% in 2006, but hasdeclined to just 43% by 2010 as assurancerevenues stagnated over that period.Advisory services revenues, on the otherhand, were $8.3 billion in 1996, slightly high-er than assurance services revenues andaccounting for 39% of overall revenue.Advisory services revenues peaked in 1999at $17.7 billion and 48% of overall revenues,before declining to a mere $5.9 billion, or19% of revenues, in 2003. Since 2003, advi-sory services revenues have been increas-ing—first slowly and, more recently, rapid-ly—to account for 29% of overall rev-enues. Tax services revenues more than dou-bled between 1996 and 2001 to $10.9 bil-lion, growing its share of overall revenuesfrom 24% to 31%. Since 2001, tax revenueshave been relatively flat, fluctuating in a narrow range between $9.8 billion and $12.4 billion. Tax revenues accounted for28% of overall revenues in 2010.

A Closer Look at Each of the Big FourErnst & Young. E&Y sold its advisory

services to Capgemini in 2000 and wasexcluded from the advisory market for fiveyears due to a non-compete agreement(Commission of the European Communities,“Regulation [EEC] No. 4064/89 MergerProcedure,” May 17, 2000). As shown inExhibit 3, total revenue for the firm peakedat $6.4 billion in 1999 before the sale, anddecreased to $4.3 billion in 2000; however,total revenue has steadily increased since then,to $7.1 billion in 2010. The steady increasein total revenue from 2000 to 2010 wasonly partially due to increases in advisoryrevenues. Advisory revenues stood at $2.8billion in 1999, dropped after the Capgeminisale to marginal levels, and remained thereuntil 2009 when it increased to $2.0 billionin 2009. The increase in total revenues from2000 to 2008 came from steady increases inboth assurance and tax services revenues. Inthe case of assurance services, revenuesincreased each year after the Capgemini sale,to peak at $5.6 billion in 2008. And tax ser-vices revenues increased steadily each year,


Total Assurance Advisory Tax PwC Revenues (Percentage of Total) (Percentage of Total) (Percentage of Total)1996* $4,135.00 $1,656.85 37% $1,569.40 40% $908.75 23%1997* 4,844.50 1,819.16 36% 2,009.65 42% 1,015.70 22%1998 5,862.00 1,055.16 18% 4,103.40 70% 703.44 12%1999 6,750.00 2,362.50 35% 3,037.50 45% 1,350.00 20%2000 8,878.00 2,903.11 33% 4,439.00 50% 1,535.89 17%2001 8,057.00 2,819.95 35% 3,625.65 45% 1,611.40 20%2002 5,174.00 3,000.92 58% 620.88 12% 1,552.20 30%2003 4,850.00 3,007.00 62% 242.50 5% 1,600.50 33%2004 5,189.50 3,373.18 65% 259.48 5% 1,556.85 30%2005 6,167.00 3,885.21 63% 678.37 11% 1,603.42 26%2006 6,922.38 4,153.43 60% 969.13 14% 1,799.82 26%2007 7,463.77 4,403.62 59% 1,044.93 14% 2,015.22 27%2008 7,578.30 4,243.85 56% 1,060.96 14% 2,273.49 30%2009 7,369.44 3,979.50 54% 1,105.42 15% 2,284.53 31%2010 8,034.00 4,097.34 51% 1,526.46 19% 2,410.20 30%


* For 1996 and 1997, data for Price Waterhouse and Coopers & Lybrand are merged to be consistent with the following years’ data.

EXHIBIT 5PricewaterhouseCoopers: Breakdown of Total Revenues


from $1.6 billion in 2000 to a peak of $2.5billion in 2009. As E&Y CEO Turleynoted, the firm was able to focus on its corebusiness after the sale of its advisory services.In 2009, advisory services revenues grewby more than an order of magnitude, to$2.0 billion or 26% of overall revenues, upfrom a mere 2% in 2008.

KPMG. As previously mentioned,KPMG spun off its advisory arm, namedBearing Point, in an IPO in 2001. Its non-compete agreement expired in 2006.Exhibit 4 shows that total revenues peakedat $5.4 billion in 2000, before the spin-off, and decreased to $3.4 billion in 2001,immediately after. Since then, total rev-enues have steadily increased to a newpeak of $5.7 in 2008. The increase intotal revenue from 2002 to 2005 wasentirely due to increases in assurance ser-vices. Advisory services were reintroducedin 2006 and promptly accounted for 27%of revenue. Tax revenues have remainedrelatively unchanged at nearly $1.2 billionduring the entire decade. Accounting formore than one quarter of its revenues, advi-sory services have been a critical source ofbusiness for KPMG for the past five years.

PricewaterhouseCoopers. PwC’s adviso-ry business accounted for 40% of its revenuesin 1996. PwC sold its advisory arm to IBMin October 2002, shortly after the passage ofSOX. Exhibit 5 shows that before the salein 2001, total revenue was $8.1 billion butdropped to $4.9 billion in 2003. It has steadi-ly increased back to the pre-sale level of $8.0billion in 2010. All three business segments—assurance, advisory, and tax—have con-tributed to the increase in total revenues.Assurance services revenues increased from$2.8 in 2001 to a peak of $4.4 billion in 2007,and they now stand at $4.0 billion. Tax ser-vices revenues have grown steadily from $1.6billion in 2002 to $2.4 billion in 2010.Advisory services revenues grew from a lowof $242 million to a peak of $1.5 billion in2010, accounting for nearly one-fifth oftotal revenues.

Deloitte. Deloitte is the outlier amongthe Big Four because it never divested itsadvisory services business. Its overall rev-enue increased more than threefold, from$2.9 billion in 1996 to $10.9 billion in 2010,as shown in Exhibit 6. Assurance servicesrevenues grew at a slightly slower rate, from$1.2 billion to $3.7 billion, during thatspan. But like the other firms, Deloitte’s

assurance services got a big boost from SOX,peaking at $4.8 billion in 2008 andaccounting for 44% of total revenue.Compared to the other Big Four, its adviso-ry services are a larger source of revenue.Advisory services revenue was $1.2 billion(41% of revenue) in 1996 and increased to$4.9 billion (45% of revenue) in 2010. Theshare of revenue contribution from each of

the business lines has changed little sinceSOX. And in absolute terms, Deloitte’s advi-sory services revenue is larger than the otherBig Four combined.

Policy and Management Concerns:Framing the Debate

Policymakers were especially concernedabout the outsized role advisory services were


playing at the large accounting firms duringthe late 1990s and early 2000s. In particular,they questioned whether auditors could beindependent if a large share of a firm’s rev-enue—and an even larger share of its prof-its—came from its non-assurance work.Could a client use the leverage of advisorybusiness to impair the objectivity of the auditand threaten auditor independence?Policymakers promulgated increasingly stringent regulations, culminating in SOX, which prohibited primary auditors fromperforming a wide range of non-assuranceservices.

Title II of SOX says in very clear languagethat “it shall be unlawful for a registeredpublic accounting firm (and any associated person of that firm, to the extentdetermined appropriate by the Commission)that performs for any issuer any audit requiredby this title … to provide to that issuer, con-temporaneously with the audit, any non-audit service,” including nine prohibited advi-sory services activities. The justification forlimiting advisory work performed by the pri-mary auditor was to ensure that auditors wereboth independent in fact and in appearance

with respect to their audit clients. Accordingto an analysis of fees paid to primary auditorsin the Audit Analytics database, auditorsserved as both auditor and consultant to90% of their public clients before the passageof SOX. For clients who received bothauditing and advisory services, advisory ser-vices accounted for 65% of total revenue.As a result of SOX, at least until 2006, auditfirms appeared to refocus their efforts onassurance services and deemphasized theiradvisory services. In recent years, advisoryservices accounted for only 10% of totalrevenue from clients where the auditor pro-vides both audit and advisory services. Thus,as expected from SOX compliance, advisoryrevenue from audit clients is relatively low.

The criticism that was leveled at auditorsregarding independence softened after SOXwas implemented. SOX was successful atenforcing audit independence at the prima-ry auditor level, but now a new issue—auditquality—has risen. Auditors are not con-strained from providing advisory servicesto non-audit clients, and the large firms haveincreased these services. The Big Four rankamong the top 10 consulting firms, reflect-

ing their ability to successfully deliverthose services (Gartner Dataquest ResearchNote G00200370, April 2010).

As noted above, concerns about thegrowth in non-audit services have beenexpressed by others recently (Wyatt 2004,ACAP 2008, Hermanson 2009). Thecochairs of the ACAP committee expressedthe following concern in their statementin the beginning of the report:

The rate of growth for non-audit services,especially advisory services offered to non-audit clients, now exceeds the rate ofgrowth for audit services. We realize thatthe allocation of investment dollars andprofessional talent is in many cases inter-changeable, and that some auditing firmsare working a delicate balance in allocat-ing resources amongst their various prac-tices. As Co-Chairs of this Committee, westrongly believe that the audit practiceshould always be the highest priority.Hermanson, who served on the

American Accounting Association com-mittee that commented on ACAP’s rec-ommendations, expressed concern that thisissue was not part of ACAP’s agenda and

Total Assurance Advisory Tax Deloitte Revenues (Percentage of Total) (Percentage of Total) (Percentage of Total)1996 $2,925.00 $1,170.00 40% $1,199.25 41% $555.75 19%1997 3,600.00 1,260.00 35% 1,620.00 45% 720.00 20%1998 4,700.00 1,457.00 31% 2,350.00 50% 893.00 19%1999 6,750.00 2,362.50 35% 3,037.50 45% 1,350.00 20%2000 5,838.00 1,809.78 31% 2,919.00 50% 1,109.22 19%2001 6,130.00 2,022.90 33% 2,819.80 46% 1,287.30 21%2002 5,933.00 2,135.88 36% 2,551.19 43% 1,245.93 21%2003 6,511.00 2,539.29 39% 2,343.96 36% 1,627.75 25%2004 6,876.00 2,750.40 40% 2,337.84 34% 1,787.76 26%2005 7,814.00 3,438.16 44% 2,656.76 34% 1,719.08 22%2006 8,769.00 3,946.05 45% 2,893.77 33% 1,929.18 22%2007 9,850.00 4,334.00 44% 3,349.00 34% 2,167.00 22%2008* 10,980.00 4,831.20 44% 3,733.20 34% 2,415.60 22%2009 10,722.00 3,967.14 37% 4,181.58 39% 2,573.28 24%2010 10,938.00 3,718.92 34% 4,922.10 45% 2,296.98 21%


* 2008 total revenue is an Accounting Today estimate.

EXHIBIT 6Deloitte: Breakdown of Total Revenues


that future waves of audit failures couldlead to government-run audits.

Audit quality has clearly become the cen-tral focus of the debate. Building on Wyatt’sdiscussion of advisory services and audit firmculture (2004), Hermanson (2009) describedfive negative effects of advisory serviceson audit firm culture. First, the culture of thefirm might no longer be consistent withaccounting professionalism. Second, the rea-son for the firm’s existence—audit—mightbecome diluted by advisory work. Third, the“identity of the client” might shift from theinvesting public (audit realm) to companymanagers (advisory realm). Fourth, as evi-denced in the pre-divestiture environment byAndersen and others, internal managementtensions might arise. Auditors and consul-tants might expend considerable effort arriv-ing at an agreement about compensation andprofit sharing, based on the perception thatadvisory services are often a higher marginbusiness. Such internal squabbles might takeenergy away from providing high-qualityauditing services. Auditors might feel pres-sure to cut costs on their audits in order tomake their margins and profits more com-parable to those of the consultants. Finally,the reward system within the firm mightfocus too much on revenue and profit gen-eration, and not enough on technical abilityand accounting professionalism.

The authors are concerned that auditquality might be impaired as firms refocuson advisory services. Specifically, how willthis affect the focus of CPA firm employeesand clients—for example, when it comes toresource allocation, will audit or advisory ser-vices garner the larger share of the most qual-ified talent in the firm? As advisory servicesexpand, it’s very likely that the competitionfor high-quality performers will increase.There are several reasons for believing thattop accounting graduates might choose advi-sory over the assurance arm, includinghigher compensation, better opportunities foradvancement, more potential clients, declin-ing revenues in the assurance segment, anda broader range of work experience to placeon a resume. Of course, even if the BigFour were not actively providing advisoryservices, top students might choose to workfor an advisory-only firm. Finally, high-qual-ity candidates might be more likely to shyaway from auditing, given the riskier auditenvironment and their greater individual lia-bility exposure.

The route to a partnership and what fol-lows differs for an advisory partner, ver-sus an assurance partner; the legal andfinancial risks from SOX and the PCAOBare greater in the assurance field. Someaudit firms also extract financial penaltiesfrom audit partners for errors in judgment.This could contribute to assurance person-nel constantly second-guessing their workand looking over their shoulder, creating anuncomfortable work environment.

In addition, the authors question howauditors will view prospective clients: asa potential audit client, or an advisoryclient? If advisory services are more prof-itable, will auditors only become the client'sprimary auditor when the probability ofdoing advisory work is low? Reviewingads in the popular press, the authors notethat marketing ads appear to focus on theoverall firm, or individually on tax andadvisory services, but rarely on assuranceservices. It would appear that the largefirms are leading with their non-assuranceservices in targeting potential clients. Theconstraints placed by the PCAOB haveincreased the risk profile of audit engage-ments and of auditors, whereas such bur-dens and oversight are not apparent in theadvisory arena.

A Public Discussion Advisory services have once again

become a significant share of the BigFour’s overall revenues. Observers of theauditing profession have expressedrenewed concerns about the adverse effectsthis may have on audit quality. While audi-tor independence does not appear to bethreatened, other concerns have been raisedabout firms’ allocation of key resources,especially talent. The data show very clear-ly that advisory services have been grow-ing, and given that assurance revenues haveremained relatively flat, the professionought to begin a public discussion on therole of advisory services and its possibleimpact on audit quality. Paraphrasing E&YCEO James Turley, jettisoning its adviso-ry services helped E&Y improve its assur-ance and tax offerings; bringing advisoryservices back on a large scale may nowcause assurance and tax services to suffer.

The lucrative nature of advisory serviceshas been, and likely will continue to be, amajor draw for accounting firms. In theearly 2000s, when the role of advisory ser-

vices was last debated within the profes-sion, prominent observers predicted that itwould play a significant role at audit firms.Robert K. Elliott, AICPA chairman andKPMG partner, predicted that, in the longrun, “all the public accounting firms willbe in advisory,” (“After Andersen War,Accountants Think Hard AboutConsulting,” by Reed Abelson, New YorkTimes, August 9, 2000).

Wyatt (2004) discussed the culturalchanges that have occurred within the largeaccounting firms—which might still domi-nate the firm culture—since the last roundof advisory services growth. Since the 1960s,firms’ culture started to change from anemphasis on professionals with technicalskills, experience, and knowledge aboutdiverse accounting issues to an emphasison growing revenues, profitability, and hir-ing staff without accounting degrees. Successin generating high-margin advisory feesoffered consultants an increasing voice infirm management that slowly started tochange the culture of the firms. Specifically,Wyatt stated that pleasing the client anddoing what was necessary to retain the clientreached a prominence unseen prior to therise of the successful advisory services arms.A cultural shift was occurring within theaccounting firms, and the recent return offirms to advisory services may indicate thatSOX did not reverse the behaviors and cul-ture that once existed.

A change is observable in the structureof the large accounting firms’ revenuestreams. Clearly, advisory services arebecoming a more important source ofrevenue for the Big Four. The authorsbelieve that this raises legitimate concernsabout the possible impact on the quality ofaudits performed by these firms. Theseconcerns are unlikely to go away. It wouldthus be beneficial for the accounting pro-fession to publicly recognize these con-cerns—and to develop a framework foraddressing them. ❑

R. Mithu Dey, PhD, CPA, is an assis-tant professor of accounting, AshokRobin, PhD, is a professor of finance,and Daniel Tessoni, PhD, CPA, is anassistant professor of accounting, all atthe Saunders College of Business at theRochester Institute of Technology,Rochester, N.Y.


By John Ruhnka and Windham E. Loopesko

E-mail is the predominant method ofcommunication used by most busi-nesses today. But companies can

suffer liabilities from the improper use of e-mail, as amply demonstrated in relevant caselaw. The presence of lengthy legal dis-claimers in business e-mails has increased—for example: “Our organization accepts noliability for the content of this e-mail, orfor the consequences of any actions takenon the basis of the information provided,unless that information is subsequently con-firmed in writing. If you are not theintended recipient, you are notified thatdisclosing, copying, distributing, or takingany action in reliance on the contents of thisinformation is strictly prohibited.”

Such disclaimers, addressed to recipientsof business e-mails, are intended to limitthe potential liability that a sender can face.Some disclaimers, such as the IRS federaltax advice disclaimer, are required by law.

But disclaimers have generally not beenas effective as their users have hoped, andtheir use is best seen as one part of a broad-er proactive policy for proscribing or limit-ing unauthorized or inadvertent e-mails.For example, no U.S. court case yet hasallowed a company to rely on a disclaimerto avoid liability for breach of a duty of con-fidentiality or for workplace sexual harass-ment in an e-mail transmission. While cur-rent case law has indicated that such dis-claimers are of limited value, the law is like-ly to evolve as courts continue to rule on theeffectiveness of disclaimers for specific typesof liabilities. The discussion below examinesthe impetus for the growing use of dis-claimers in business e-mails, and it explainstheir role in a company-wide e-mail use pol-icy, which can minimize improper or unau-thorized e-mail communications that mightresult in liability.

Areas of Potential LiabilityUnder the doctrine of vicarious liability,

a business can be liable for its employees’or agents’ communications with third par-ties if it is reasonable for the recipient tobelieve that the sender was acting on thebusiness’ behalf, even if the communica-tion was not authorized or not specificallyprohibited. In addition, under the doctrine ofrespondeat superior, a business can be heldliable for its employees’ wrongful or crim-inal acts—such as defamation, sexual harass-

ment, or gender discrimination—if they arecommitted within an employee’s scope ofemployment.

Vicarious liability means that the employ-ee or agent committing the harmful or illegalact is primarily liable to the injured party,but the business—as the employer—is sec-ondarily liable as well. To reduce unautho-rized or inadvertent e-mail communicationsthat might result in vicarious liability, manycompanies turn to employee policies gov-erning e-mail use and the safeguarding of con-

Business E-mails and Potential Liability

T E C H N O L O G Y

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

Protecting Privilege and Confidentiality Through Disclaimers and Prudent Use Policies

fidential information. When such preventivepolicies fail to prevent accidental, unautho-rized, or harmful employee communicationsthrough the company’s e-mail system, busi-nesses rely on disclaimers for the content insuch e-mails as an additional line of defensein order to try to reduce liability claims.

Although not an exhaustive list, the fol-lowing are important areas of potential lia-bility that could result from inadvertent orunauthorized business e-mail communications.

Accountant-client confidential informa-tion. Rule 301 of the AICPA ProfessionalStandards provides that a member “shall notdisclose any confidential client informationwithout the specific consent of the client.”The exception to this rule occurs when aCPA must respond to a “validly issuedand enforceable subpoena or summons” oris complying “with applicable laws and gov-ernment regulations.”

Furthermore, 24 states have enacted var-ious rules protecting accountant-client con-fidential communications to varyingdegrees. Texas, for example, has a privi-lege rule that prohibits CPAs from volun-tarily disclosing information communicat-ed by a client in connection with anengagement without the client's prior con-sent. Some state protections do not applyto criminal proceedings; others do not pre-vent disclosures to law enforcement if anaccountant has a reasonable basis forbelieving that a client violated federal, state,or local laws.

While federal law does not recognize anaccountant-client privilege, it creates acriminal offense (arising from a very nar-row confidentiality requirement imposedby Internal Revenue Code [IRC] section7216) for tax return preparers who know-ingly or recklessly disclose or use tax returninformation obtained or generated in thepreparer-client relationship, unless the pre-parer has express client consent or a courtorder has been issued. The IRS defines “taxreturn preparers” as individuals participat-ing in the preparation of tax returns for tax-payers, including—but not limited to—individuals practicing or presenting them-selves as preparers, compensated casualpreparers, electronic return originators,electronic return transmitters, intermediateservice providers, software developers, andreporting agents. Whereas the AICPA rulesare professional standards, the IRS prohi-bition is statutory, and a failure to comply

can create criminal liability. Both anaccountant and client must treat the taxreturn information as confidential in orderfor the privilege to apply. If this informa-tion is divulged to third parties, then it isnot considered confidential.

Accordingly, CPAs must ensure thatthey have appropriate taxpayer consent forthe disclosure of confidential client and taxpreparation information; they must alsokeep clients fully informed if they areserved with a subpoena to release the

client’s accounting or tax records or sub-mit to a deposition or interview regardingtax matters. State regulations sometimesimpose additional confidentiality require-ments. CPAs can ordinarily meet both theIRS and AICPA rules by receiving aclient’s written permission to release theinformation. If the party seeking clientrecords is not the client, the CPA shouldask the requestor to obtain the client’s writ-ten consent before complying.

Federal tax practitioner privilege. A fed-eral tax practitioner privilege, established bythe IRS Restructuring and Reform Act of1998, applies to CPAs and protects “tax-relat-ed communications” between federally autho-rized tax practitioners (FATP) and their clientsfrom government use against them in non-criminal IRS or federal court tax proceedingsif the communication would be consideredprivileged if it had been between a taxpayerand an attorney. Both the FATP and the clientmust treat the tax advice as confidential inorder for the FATP privilege to apply. FATPsinclude nonattorneys authorized to practicebefore the IRS—specifically CPAs,enrolled agents, and enrolled actuaries.Promoters of a tax shelter may not assertthe tax practitioner privilege.

Does a general confidentiality privilegeexist for tax return preparation communica-

tions, aside from the very narrow FATP priv-ilege? Most case law predates the FATP, andthe U.S. Court of Appeals for the NinthCircuit has ruled that communications per-tinent merely to preparing a tax return do notinvolve giving or receiving legal adviceand thus are not privileged (United Statesv. Gurtner, 474 F.2d 297 [9th Cir. 1973]).The Eighth Circuit, meanwhile, has held thattax returns are not privileged because theyare intended for disclosure to a third party(the IRS) and, thus, no expectation of con-

fidentiality is justified. A minority opinionholds that a tax practitioner privilege mightcover communications about what to claimon a return if such communications wouldconstitute legal advice.

IRS-required tax advice disclaimer.Treasury Department Circular 230,Regulations Governing Practice Before theInternal Revenue Service, requires tax prac-titioners to caution their clients with the fol-lowing: “any U.S. federal tax advice con-tained in this communication, including allattachments, is not intended or written tobe used, and cannot be used, for the purposeof (1) avoiding penalties under the InternalRevenue Code or (2) promoting, marketingor recommending to another party any tax-related matter(s) addressed herein.”

Attorney-client confidentiality, privilege,and work product. The American BarAssociation’s Model Rules of ProfessionalConduct, adopted by most states, imposesa general duty of confidentiality on attor-neys for discussions with potential clients,even if no attorney-client relationshipsubsequently ensues. But not all state rulesare adaptable to the Internet, where noreadily apparent jurisdictional boundariesexist. In a Ninth Circuit case, a law firmposted a questionnaire on its website solic-iting information for a potential class action


While federal law does not recognize an accountant-client

privilege, it creates a criminal offense for tax return preparers

who knowingly or recklessly disclose or use tax return information

obtained or generated in the preparer-client relationship.

from persons who had taken the drug Paxil(Barton v. U.S. Dist. Court for theCentral Dist. of Cal., 410 F.3d 1104 [9thCir. 2005]). The e-mail solicitation con-tained a disclaimer that filling out the ques-tionnaire created no attorney-client rela-tionship. When the drug manufacturer sub-sequently tried to get the law firm to dis-close the online questionnaire answers touse at trial, the Ninth Circuit held thatbecause the e-mail solicitation disclaimer

did not specifically address confidentiali-ty, prospective class action clients com-pleting the questionnaire could assume thata duty of confidentiality existed; this, inturn, enabled them to claim attorney-client privilege for their answers. The NinthCircuit indicated that a clear statement“written in plain English,” providing thatthe solicited information would not be heldconfidential and that respondents werenot being solicited as potential clients,might have prevented the duty of confi-dentiality from arising and the subsequentformation of attorney-client privilege.

The attorney-client privilege under com-mon law is a narrower rule protecting con-fidential attorney-client communicationsmade to secure legal advice from subse-quent discovery or use by opposing coun-sel at trial. The client—not the attorney—holds the legal privilege, and only the clientmay waive it. Inadvertent disclosure ofconfidential information to a third partywill not normally constitute a waiver if aclient did not intend to waive the privilege;however, a waiver may occur withoutintent if, for example, the client carelessly

allows the information to be disclosed toothers or fails to object to a disclosuredemand in litigation. While the attorney-client privilege does not cover accountants,an attorney may, in some instances, extendprotection over an accountant by retainingthe accountant as an expert (U.S. v.Kovel, 296 F2d 918 [2d Cir 1961]).

In assessing whether disclaimers areeffective, courts look to the totality of thecircumstances. In Charm v. Kohn, 27 Mass.L.R. 421 (2010), an attorney sent an e-mailto opposing counsel (with no confiden-tiality notice) and with a blind copy to hisclient. The client, replying to his attorneywith additional privileged information,inadvertently used “reply all” and copiedthe opposing counsel as well. The attorneyrealized the mistake and immediatelyphoned the opposing counsel to notify himthat the client’s transmission was in errorand that the information was confidential.The Massachusetts Superior Court ruledthat no waiver of the attorney-client priv-ilege occurred, due to these immediatesteps to protect the privilege; however,the court warned that blind-copying a clienton a message to opposing counsel “gaverise to a foreseeable risk that (the client)would respond exactly as he did.”

Negligent misstatement. If an employ-ee gives unauthorized or unintended pro-fessional advice in an e-mail, the employ-er can be liable for any advice that therecipient, or even a third party, reason-ably relies upon. Companies can addressthis risk with a disclaimer stating that noprofessional advice is offered or impliedunless specifically identified as such.

Entering into web-based contracts.Written business communications, includ-ing e-mails, can form legally binding con-tracts if a sender has actual or apparentauthority to offer or accept a contract ona company’s behalf. To limit or preventthis possibility, a statement should beincluded in the e-mail that notes that anyoffer or acceptance requires writtenapproval by a specifically identified com-pany officer in order to bind the companyto a contract.

Defamation. No disclaimer can protectagainst e-mails that contain actual libelousor defamatory content. A disclaimer againstunauthorized defamatory or harmful personalcomments can help show that a defamatorycommunication was expressly prohibited and

thus not within the scope of employment;however, companies still need to take promptaction responding to and remedying suchharmful acts as soon as they become awareof them. Business can also reduce liabilityby linking disclaimers to specific companye-mail use policies, codes of conduct, andtraining programs prohibiting employeesfrom providing employment references;requiring employees to avoid personal orpotentially defamatory references; and tak-ing prompt remedial actions as soon as thecompany learns of such prohibited orharmful communication.

Transmission of viruses. An employeesending or forwarding an e-mail contain-ing a computer virus can expose a com-pany to liability. In addition to imple-menting software to block viruses enteringand leaving the company’s e-mail system,some companies use a disclaimer statingthat an e-mail might contain viruses andthat the recipient is responsible for check-ing messages.

Internal and External E-mail Disclaimers

Businesses should include disclaimerson internal e-mails as well as external e-mailsbecause both can produce potential legal lia-bility if disclosed. Required statutory warn-ings and professional advice issues applymainly to external e-mails, but potentialdefamation, sexual harassment, and impliedcontract claims can be just as relevant forinternal e-mail. In numerous cases, for exam-ple, employees have successfully sued theiremployers for internal e-mails containingsexual, discriminatory, or other offensivecontent. Internal e-mails can also constitutea greater risk for breaches of employeeconfidentiality because it is more probablethat a colleague will accidentally read a con-fidential e-mail or that an insider will rec-ognize the importance of confidential infor-mation sooner than an outsider.

Disclaimer Specificity and LocationCompanies should not indiscriminately

attach specific disclaimers to all e-mailcommunications; in such a case, a com-pany runs the risk of not being able to subsequently argue that the disclaimer rep-resented a focused effort to prevent unin-tended liability. Businesses should only useconfidentiality warnings on messages thatcontain confidential information.


The court warned that blind-

copying a client on a message to

opposing counsel “gave rise to a

foreseeable risk that (the client)

would respond exactly as he did.”

The question of whether to place sucha disclaimer before or after the main textof the e-mail depends upon the confiden-tiality level of the e-mail communicationand the importance of its contents. A lawfirm sending privileged information or aCPA firm providing tax advice might wantto place disclaimers at the top of e-mailsin order to ensure that they meet statutorynotice requirements. For most companies,however, placing disclaimers at the endof e-mail messages is probably sufficient.

Recommended Features of Business E-mail and Internet Use Policies

Using unilateral (i.e., sender-generated)e-mail disclaimers that are not statutorilymandated will generally not eliminatepotential liability for harmful e-mailtransmissions. Targeted disclaimers can,however, help reduce vicarious liability forimproper or unauthorized e-mail disclo-sures if a company can demonstrate thatits company-wide e-mail and Internet usepolicy informs employees of proper use ofcompany e-mail, establishes prohibitionsor prior authorization requirements for spe-cific e-mail activities, safeguards confi-dential and client information, and limitsand monitors employees’ e-mail andInternet activities.

Companies should require all employeesto sign and return such policies before grant-ing them e-mail access and password autho-rization. E-mail use policies should containsanctions up to and including suspension,termination, and referral for criminal prose-cution for policy breaches. In addition, acompany should link e-mail use policies withstandards under a corporate employee codeof conduct, similar to those prohibiting sex-ual harassment or workplace discrimination,disclosure of proprietary or confidential infor-mation, and conflicts of interest.

Business e-mail and Internet use poli-cies often include the following features: ■ They require employees to check theire-mail in a consistent and timely mannerand manage their mailboxes.■ They prohibit employees from usingcompany e-mail in any way that violatesthe company’s employee code of con-duct, policies, or rules.■ They prohibit inappropriate uses ofcompany e-mail for unlawful purposes,including libel and slander, defamation,fraud, sexual harassment, obscenity, intim-

idation, impersonation, copyright infringe-ment, or political campaigning.■ They prohibit viewing, altering, forward-ing, or deleting e-mail accounts or filesbelonging to the company or other employ-ees without permission or authorization.■ They include warnings to exercise cau-tion when transmitting company or clientconfidential or proprietary informationvia e-mail.■ They limit personal use of companye-mail and Internet access with respect toconducting or soliciting for noncompanycommercial activity and to downloadingmaterials for nonbusiness use.■ They include warnings about safeguard-ing the company e-mail system against virus-es by not opening attachments fromunknown or unverified sources, and by nottampering with the computer system.■ They notify employees that the com-pany retains the right to monitor all e-mail traffic passing through or stored in thesystem to ensure compliance with e-mailuse policies, including review of employ-ee e-mails by the legal department.Companies often require that employeesconsent to the monitoring of their e-mailand Internet usage. A company should noti-fy employees that it might keep archivaland backup copies of all e-mails (regard-less of whether they have been deleted bythe employee) in order to meet electronicrecords discovery requests for litigationor governmental inquiries.

A number of specialized corporate com-pliance consulting companies can assistbusinesses and organizations in establish-ing or updating e-mail and Internet usepolicies (e.g., Info-Tech Research Group),as well as employee and Internet use mon-itoring (e.g., InterGuard, Spector Soft,GlobalITSecure, SoftActivity). In addition,information technology providers offersoftware systems that can automaticallyadd specific e-mail disclaimers to compa-ny e-mail messages or e-mail signaturesusing Microsoft Exchange and Outlook;this can help companies comply with reg-ulatory requirements and reduce potentialliability for business e-mails (e.g.,Exclaimer, Policy Patrol, Symprex).

An Ongoing TrendUnder current law, disclaimers alone are

not enough to protect a company from lia-bility brought about by unauthorized or inad-

vertent e-mails; they need to be part of amuch broader e-mail use policy that the com-pany not only announces but actively imple-ments. An article in The Economist, dis-cussing the increasing use of e-mail dis-claimers, concluded that disclaimers “areassumed to be a wise precaution. But theyare mostly, legally speaking, pointless.Lawyers and experts on Internet policy sayno court case has ever turned on the pres-ence or absence of such an automatic e-mail

footer in America” (April 7, 2011,http://www.economist.com/node/18529895).

But just as the requirements for whatconstitutes a binding international salescontract are evolving to adapt to new elec-tronic technologies, the growing dominanceof e-mail in business communications isexpected to produce legal changes in thisarena that will limit liability from clearlyunauthorized and unintended business e-mails. This trend suggests that targeted e-mail disclaimers in specific critical areasof business operations, used in conjunctionwith a comprehensive and actively policedbusiness e-mail use policy, are prudentbecause such policies can potentially helpto reduce—if not eliminate—liabilityresulting from unauthorized or improperbusiness e-mail communications. ❑

John Ruhnka, JD, LLM, is a professor oflaw and ethics, and Windham E. Loopesko,JD, is a member of the international busi-ness faculty, both in the business school atthe University of Colorado Denver.


The growing dominance of e-mail

in business communications is

expected to produce legal changes

in this arena that will limit liability

from clearly unauthorized and

unintended business e-mails.


By Susan B. Anders

Accountability Central, at www.accountability-central.com, is a col-lection of resources that address

corporate governance, globalization, ethics,and other related topics. Sponsored by theGovernance & Accountability Institute Inc.,whose mission is to provide education and guidance to leaders to do the rightthing for the right reasons, the website is pre-sented as a central resource for many freematerials, such as news, research papers,external links, and commentary, as well as customized services and subscription-basedpublications.

Accountability Central is organizedaround three major categories: environ-mental and energy issues, social issues andconcerns, and corporate governance. Eachcategory houses specific topics, or chan-nels, that are detailed in the main menuand consistently appear on the left side ofthe home and main pages. The center ofthe homepage presents a rather busy selec-tion of featured resources. The main pagesfor each topic, however, are easier to nav-igate; the content is categorized under newsand updates, research and insights, andcommentary and opinion. Users can accessrelevant links in the upper right-hand cor-ner of the page. Another menu bar, run-ning along the top of every webpage, pro-vides links to special features that includecommentaries, blogs, and a navigationaldashboard.

The website brings together resourcesfrom a large number of original sources thatwould be very difficult for an individual userto gather. Current events, news, articles, andreports are collected from a variety ofInternet sources, such as USA Today, theWashington Post, and the Journal ofAccountancy, as well as international sourcesand Governance & Accountability Institutestaff. Although frequent overlap between the

content and topic groupings can be over-whelming, it does increase the likelihood oflocating desired materials. The resources areupdated daily, and several years ofarchives are also accessible.

Because one of the Governance &Accountability Institute’s missions is edu-cational, many topic pages provide brief background information on the sub-ject at hand. For example, the accounting/

disclosure/financial reporting webpagesprovide an interesting introduction to thehistory of accounting and accountability.The shareholder activism section includesan introduction that discusses its origins;the concept of corporate ownership; cur-rent actors, such as faith-based investors;and comments on the topic from severalsources, including MarketWatch and CNNMoney.

Website of the Month: Accountability Central

T E C H N O L O G Y

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

Corporate GovernanceThe corporate governance section, as a

whole, addresses policies and practices ofcorporate boards and executives, as well astheir relationships with stakeholders. Thecorporate governance section includes sub-categories for general corporate gover-nance; government/political governance;accounting, disclosure, and financial report-ing; shareholder activism; capital mar-kets; enterprise risk management; andinvestor relations. Under the corporate gov-ernance subsection, a brief overview,“News and Updates on CorporateGovernance,” discusses historical infor-mation, the current state of corporate gov-ernance, burning issues, and commentariesfrom a variety of sources.

Recent corporate governance resources,under the research and insights subcate-gory, include an article from the Wall StreetJournal’s MarketWatch that addressedthe release of an Ernst & Young LLP studythat reported strengthened corporate gov-ernance and improved audit quality in the10 years following the passage of theSarbanes-Oxley Act of 2002 (SOX). AJournal of Accountancy article summarizedthe impact of SOX section 404 on the inter-nal control environment, and a USA Todayarticle followed up on security failures atLinkedIn and eHarmony; the article rec-ommended updating passwords, along withseveral specific password guidelines.

The capital markets section features a NewYork Times article summarizing a FinancialStability Oversight Council report thatidentifies several threats to the United States’market stability and calls for money marketfund reforms, greater consumer protectionstandards, and regulation of high-speed trad-ing. A summary of a U.S. TreasuryDepartment survey of foreign portfolio hold-ing of U.S. securities, located under theresearch and insights category, includestables of holdings by type of security andcountry, along with links to the originalreport. The capital markets connection cen-ter, found in the navigation box in theupper right-hand corner, provides readerswith a useful collection of links to mem-bership organizations, such as the CharteredFinancial Analyst Institute and FinancialExecutives International, as well as links tomajor stock and mercantile exchanges.

The enterprise risk management sec-tion features articles that cover a wide

range of topics, including natural disasters,financial disasters, and hydraulic fractur-ing. Under the commentary and opinionsubcategory, an interesting article on sup-ply chain sustainability summarized lessonsfrom the past—for example, companiesbeing held accountable for suppliers’ laborpractices must look beyond the first tierof vendors. The author recommends thatsupply chain sustainability should bealigned with an organization’s goals andobjectives. A Washington Post articleexamined the recent debates concerningoutsourcing, the reasons behind the trends,and the benefits and detriments. The rele-vant web links tab, located in the upperright-hand corner, offers a collection ofsites for business continuity and disasterrecovery planning, emergency manage-ment, family disaster planning, and hurri-cane preparedness.

Articles featured in the investor relationssection encompass the specific corporatefunction of that name along with the rela-tionship between the corporation and keystakeholders. Located under the news andupdates subcategory, the Fox BusinessNews article, “What to Do with Proxiesthat You Get in the Mail,” explainedwhat proxy statements are, how share-holders can vote or submit proxy ballots,how shareholders can submit their own ini-tiatives, and why shareholder participa-tion matters. “Climate Spectator: SeparatingGood Companies from Bad,” fromBusiness Spectator, discussed evidence thatenvironmental, social, and governance indi-cators positively correlate with stockprice and return on equity. Several arti-cles make connections between sustain-ability and profits, performance, andgrowth as well.

Social Issues and ConcernsThe ethics subcategory, under the social

issues and concerns section, offers a collec-tion of current events items; articles; andreports on business ethics, fraud, tax evasion,and other similar topics. Several articles—such as those from AccountingWeb,Law.com, and MarketWatch—summarizethe findings of a joint AICPA and CharteredInstitute of Management Accountants study on global business ethics. TheAccountingWeb piece even adds actualaccounting firm ethical policies. In theresearch and insights subcategory, a summary

of the most recent Ethics Resource Center’sbiannual survey is available and reports somedisturbing findings, such as an increased per-centage of employees suffering negative con-sequences from reporting violations and anincreased percentage of companies with weakethics cultures. The list of relevant weblinks is extensive and covers a variety of insti-tutions, organizations, and publications.

The globalization section focuses onworld trade issues and current events, withChina and Europe receiving significant cov-erage. A summary of a World Bank study,from the Toronto Globe and Mail, underthe research and insights subcategory,reports that more than half of all globalgrowth is expected to come from six emerg-ing economies by the year 2025: Brazil,China, India, Indonesia, Russia, and SouthKorea. Furthermore, the relevant web linkscontain a small, but useful, selection thatincludes the U.S. Department of Commerce,Federal Reserve banks, United Nationsresources, and China.org.

Special FeaturesThe featured commentators and bloggers

sections of the website, accessed from thetop menu bar, collect and organize columnsauthored by nearly two dozen commenta-tors, making it easier for users to follow aparticular author. The special sections drop-down menu, also located along the top bar,provides access to the Accountability Mattersblog and the Sustainability HQ website. Hottopics are news articles and commentariesflagged as emerging, controversial, andthought provoking on areas such as execu-tive compensation, global warming, andhealthcare.

Another useful feature in the special sec-tions tab is the news and information dash-board. It provides links to groupings ofwebsite news and articles beyond the mainmenu categories, as well as connectionsto external news media websites. The dash-board also offers links to outside organi-zations, such as the Brookings Institution,found under the think tanks subcategory,and U.S. government agency the newspages, including the Department of theTreasury and the SEC. ❑

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



PROFESSIONAL OPPORTUNITIES

NASSAU COUNTY / NEW YORK CITYCPA FIRM

Established firm with offices in NYC and LongIsland, which has successfully completed transac-tions in the past, seeks to acquire or merge witheither a young CPA with some practice of hisown or a retirement-minded practitioner and/orfirm. Call partner at 516.328.3800 or212.576.1829.

WALL STREET CPA looking for right indi-vidual to share and merge into my office space.Move in ready with ultra high tech hardwareand software built in. [email protected].

Are you an entrepreneurial CPA with qualitypublic accounting, audit and tax experience?Would you like to acquire a $500,000 Long Island practice from a retiring CPA ratably over the next five years? If so, provide background for consideration [email protected].

Rotenberg Meril, Bergen County’s largest independent accounting firm, wants to expand its New York City practice and is seeking merger/acquisition opportunities in Manhattan.Ideally, we would be interested in a high qualityaudit and tax practice, including clients in thefinancial services sector, such as broker dealers,private equity and hedge funds. An SEC auditpractice would be a plus. Contact Larry Meril at [email protected], 201-487-8383, to furtherdiscuss the possibilities.

Rockland County CPA firm (3 Partners) seek-ing energetic dynamic sole proprietor CPA withsmall practice to presently rent open officespace and share services with the primaryobjective of a long term association withpotential buyout and transition. Contact LanceMillman at: [email protected].

Two retirement-minded partners looking to affili-ate with energetic sole practitioner for futurebuyout. Our firm is well established in PutnamCounty, with a diversity of clients. Contact:[email protected].

PROFESSIONAL OPPORTUNITY l SPACE FOR RENT l SITUATIONS WANTED l FINANCIAL ACCOUNTING & AUDITING l PRACTICE WANTED l PRACTICE SALES l HOME OFFICE FOR SALE l BUSINESS SERVICES l TAX CONSULTANCY

PEER REVIEW l PROFESSIONAL CONDUCT EXPERT l EXPERIENCED TAX PROFESSIONALS WANTED l POSITIONS AVAILABLE l EDUCATION

M A R K E T P L A C ECLASSIFIED

Young, energetic and dynamic husband and wifeaccounting team seeks retirement-minded practitionerwith write-up and/or tax preparation practice in NewYork City area for merger and eventual buy-out.Contact: [email protected].

Full service midtown CPA firm w/ 12 profes-sionals, providing personalized services to close-ly held businesses and successful individuals,seeks growth through acquisition or merger.Professional, congenial environment. Modernoffices and procedures. [email protected].

Growing North Jersey CPA firm seeks CPA withstrong audit and tax experience looking to transi-tion into a near term partnership opportunity. E-mail resume to: [email protected].

Established Long Island CPA firm seeks toexpand. We are interested in acquiring a retire-ment-minded small to medium-size firm in theNY Metro Area. We have a successful trackrecord of acquiring practices and achieving clientretention and satisfaction. Please contact AndrewZwerman at [email protected].

Westchester CPA with boutique high net worth,

high quality, tax and financial planning practice

seeks to acquire or merge with similar minded

professional. Cash available.

Contact [email protected].

Small NYC CPA firm is looking for per diem

CPA, taxes, F/S [email protected].

Nassau County peer reviewed sole practitioner

with Masters in Taxation has available time to

assist overburdened practitioner. Open to merger,

buyout or other arrangements.

[email protected].

Successful Midtown NYC Firm (founded 1958)

with $3M+ practice seeks a firm grossing $500K

- $1M with retirement minded owners for merg-

er and eventual transition. Contact in confidence.

212-901-6114.

Small, long established Great Neck CPA firm

seeking energetic solo practitioner CPA with

existing business. Potential partnership a strong

possibility. [email protected].

Synergy for GrowthI run a single partner firm with audit and tax

practices and wish to share facilities, staff,

expertise and potentially combine with one or a

few compatible CPAs. I will take on a major

technology initiative soon or use yours if well

established. I am located in Grand Central area

and larger space is available in same building.

Please reply to [email protected].

Highly successful, $3.5 million, midtown CPA

firm seeks merger with firm/practitioner grossing

$1-7.5 million for continued growth and prof-

itability. Steady growth and attractive offices

make for unique opportunity.

E-mail [email protected].

SALE OF YOUR PRACTICE. If you have a

small (100K - 200K) practice and would like to

assure continuity and give you and your clients

the chance to experience a successful transition,

please write to us in confidence. We are a mid-

town firm with lots of experience with small and

medium-sized businesses and have successfully

acquired practices with excellent results for all.

Give us the opportunity to help you. Write to

NYSSCPA, Box 220, Horsham, PA 19044.

Three-Partner CPA Firm in Rockland County

seeking a young practitioner with a small prac-

tice to presently rent open office space and share

resources with the primary goal of partnership,

merger and succession. Contact us at rockland-

[email protected].

Long Island CPA with solid diversified practice

of $175,00 - $200,000 seeks affiliation with

eventual buyout. Open to any agreement that is

mutually beneficial. Practitioner to retire within

10 years. Practitioner has the available to work

for form. If interested contact: [email protected].

SPACE FOR RENT

OFFICE SPACE AVAILABLETHROUGHOUT MANHATTAN 300 square feet to 15,000 square feet. Elliot Forest, Licensed Real Estate Broker,212-447-5400.

AAA PROFESSIONAL OFFICES FOR RENT.NASSAU COUNTY. 1-, 2-, 3-room suites facing Hempstead Tpke. FREE UTILITIES.FREE FRONT PARKING. 516-735-6681.


Peer ReviewIf you need help, the first step is

Nowicki and Company, LLP716-681-6367

[email protected]

CPA FIRMS OR PARTNERS

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

For further info: please contact: Len Danonat D&R Associates Inc.212-661-1090 ext 14

SERVING THE CPA COMMUNITYSINCE 1939

Goldstein Lieberman & Company LLCone of the region’s fastest growing CPAfirms wants to expand its practice and isseeking merger/acquisition opportunitiesin the Northern NJ, and the entire HudsonValley Region including Westchester. Weare looking for firms ranging in size from$300,000 - $5,000,000. To confidentiallydiscuss how our firms may benefit fromone another, please contact PhillipGoldstein, CPA at [email protected] or (800) 839-5767.

CPA – Partner Opportunity in smallbusiness tax firm Nassau County. Two

Partners with million dollar practice seek

another CPA with small tax practice for

employment- partnership opportunity.

Must be experienced a-z with small busi-

ness, individual tax, Lacerte, Quickbooks.

Experience in Certified Audits, Reviews

also required. Location: South Shore

Nassau Compensation: package and

benefits to be discussed. Principals only.

[email protected] [email protected]

Fax 516-783-1720.

TAX ADMINISTRATOR WANTED

The U.S. Securities and Exchange

Commission seeks tax compliance and

administrative services for settlement

funds/Qualified Settlement Funds under

Section 468B(g) of the Internal Revenue

Code (IRC), 26 U.S.C. § 468B(g), and relat-

ed regulations, 26 C.F.R. §§ 1.468B-1

through 1.468B-5. A statement of require-

ments describing the work to be performed

and the procedures for submitting proposals

is available at http://www.sec.gov/nb/tax_

admin.pdf. Proposals must be submitted by

email to: [email protected] no later than

11:00 p.m. on Friday August 31, 2012.

Melville Long Island on Rte 110Two windowed offices in a CPA Suite; Full service building with amenities including use of a conference room. Cubicles also available.Contact Lenny at 212-736-1711 [email protected].

Windowed Office in CPA Suite, Plainview.Includes Secretary/Bookkeeping [email protected].

Midtown CPA firm has nicely decorated officesto sublet/share with us, fully furnished and computerized, for up to 20 people. All or partavailable. Convenient and cost effective. Merger possible. [email protected].

PREMIUM OFFICES FOR RENT (Merrick)Multiple Professional Suites516-623-9409 [email protected].

650 rsf on 5th Avenue @ 34th St. $50 sf. 2 offices. Avenue views. 24/7 access. Elliot @ 212-447-5400.

WALL STREET CPA looking for right indi-vidual to share and merge into my office space.Move in ready with ultra high tech hardwareand software built in. [email protected].

Bergen County. CPA firm has two furnishedwindowed offices with all services. 201-871-0033.

SITUATIONS WANTED

New York City Metro TechnicalAccounting/Auditing Pro seeks issues-oriented

and financial statements completion-type work,

such as draft footnotes and statement format,

on a project or other basis at a reasonable pro-

fessional rate for CPAs in need of this type of

temporary help. Also available for audit, reviews

or compilations workpaper or report review.

Can serve in SOX/PCAOB concurring partner

review function or independent monitoring func-

tion under new Engagement Quality Review(EQR) in years between smaller firm AICPA

Peer Reviews. Call 516-448-3110.

Need assistance answering SEC comment letters?SEC/GAAP reporting expert will help research/respond to comment letters; prepare filings/financial statements. 516.526.2085.

Sr. Accountant, Duluth, GA: Master's degree

in Accountancy plus at least 2 yrs. of public

accounting and audit exp. req'd. Resume to

W. Alex Choi, CPA, PC, 2550 Pleasant Hill Rd.,

Ste. 421, Duluth, GA 30096.

BUSINESS OPPORTUNITIES

Westchester CPA firm seeks to acquire accountsand/or practice. Retirement minded, sole practi-tioners, and small firms welcome. High retentionand client satisfaction rates. Please call LarryHonigman at (914) 762-0230, or [email protected].

BUSINESS SERVICES

NEED TO INCORPORATE?Complete Incorporation Package Includes:

Preparation–State Filing Fees–Corporate Kit via UPS

Registered Agent Services AvailableNEED TO DISSOLVE or REINSTATE or

AMEND?Qualified Staff to Help Accomplish

Your Corporate or LLC Goals!All 50 States. Simply Call.

INTERSTATE DOCUMENT FILINGS INC.Toll Free [email protected]

CASH MANAGEMENT SERVICESfor small business(646) 823 - 6383

[email protected]

PROFESSIONAL CONDUCTEXPERT

PROFESSIONAL CONDUCT EXPERTFormer Director Professional Discipline, 25 Years Experience, Licensure, Discipline,Restoration, Professional Advertising, Transfer of Practice; AICPA and NYSSCPAProceedings, Professional Business Practice.Also available in Westchester County

ROBERT S. ASHER, ESQ.295 Madison Avenue,New York, NY 10017(212) 697-2950

PEER REVIEW SERVICES

PREPARE FOR PEER [email protected]

718-438-4858Yehuda Bunker, CPA

30 years not for profit accounting.CPE courses in auditing available.

PEER REVIEW SPECIALIZING IN EMPLOYEE BENEFIT PLANS

CIRA, BROKER DEALERS INSPECTIONS & REVIEW SERVICES

JOHN M SACCO, [email protected]

914-253-8757SACCO MANFRE CPA PLLC

Peer Review ServicesHIGH QUALITY / PRACTICAL APPROACHPeer reviews since 1990. Review teams withrecognized experts in the profession.David C. Pitcher, CPA / Gregory A. Miller, CPADAVIE KAPLAN, CPA, P.C.585-454-4161 www.daviekaplan.com

76 AUGUST 2012 / THE CPA JOURNAL

HELP WITH PREPARINGFOR PEER REVIEW.

Financial statement work,audit procedures, workpapers, drafting footnotes. Can fill audit engagement

quality reviewer, manager, or senior roles.Many satisfied clients.

CALL SHIMON D. EINHORN, CPA (917) 318-7498

[email protected]

PEER REVIEWSProviding Peer Reviews since 1990

Available for Consulting. Pre-Issuance Reviews

and MonitoringKurcias, Jaffe & Company LLP

(516) [email protected]

[email protected]

Peer ReviewIf you need help, the first step is

Nowicki and Company, LLP716-681-6367

[email protected]

TAX CONSULTANCY

INNOVATIVE STRATEGIESfor sales and use tax compliance, audits,

refunds, appeals, and bankruptcy.

Extensive multistate experience.

Jeffrey J. Coren, CPA

212-594-6970

SALES TAX, AUDITS, APPEALS, & CONSULTATIONS. Experience: Many years with New York State SalesTax Bureau as auditor and auditor supervisor.

Jack Herskovits. 718-436-7900.

SALES TAX, ISAAC STERNHEIM & CO.Sales tax consultants, audits, appeals, &

consultations. Principals with many years of

experience as Sales Tax Bureau audit

supervisors. (718) 436-7900.


Rates & Word Count:Basic Rate: $4.00 per word; $56 minimum

charge—14 words.

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

*Special Option: Logo in color = $45.00 net

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

Monday of the month preceding the issue date.

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

by the 1st of the month preceding the issue date.

All checks should be mailed to:NYSSCPA

P.O. Box 10489Uniondale, NY 11555-0489

Ad copy should be e-mailedas a Word attachment: [email protected]

(do not send ad copy to P.O. Box).

Please note on the ad copy which issue(s) you would

like the ad to run in and the check number which was sent in payment.

For further information, please call Sales Deskat 215-675-9208, ext. 201,

fax: 215-675-8376, or E-mail:[email protected]

Classified Rates

SALES TAX PROBLEMS?

Are you being audited?

Free Evaluation

Former Head of NYSales Tax Division

• Audits • Appeals • Refund Claims •

* Reasonable fees *

(212) 563-0007 • (800) 750-4702E-mail: [email protected]

LRC Group Inc.Lawrence Cole, CPA

Nick Hartman

Buxbaum Sales TaxConsultants

www.nysalestax.com

(845) 352-2211

(212) 730-0086

A Leading Authority in Sales & Use Tax

For the State of New York

• Sales Tax Audits –

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More than 40 years of successful results!

See our published decisions…

SALES TAX PROBLEMS?

More than 25 years of handling NYS audits

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NYS Sales Tax Auditor on staff. All busi-

nesses, including service stations, pizzerias,

restaurants. Free initial consultation.

Rothbard & Sinchuk LLP

516-454-0800, x204

THE BENEFITS OF EXPERIENCEDo your clients require a Retirement Plan, 403(b) Plan

and/or a Health & Welfare PlanAccountant’s Audit Report for Form 5500?

CONTACT US

Certified Public Accountants & Profitability Consultants

Our Employee Benefits & Executive Compensation Accounting and Tax ServicesGroup provides the experience and expertise your clients deserve

Avery E. Neumark, CPA, JD, LLMRosen Seymour Shapss Martin & Company LLP

757 Third Avenue, New York, NY 10017Tel: 212-303-1806 Fax: 212-755-5600

[email protected] www.rssmcpa.com

A Member of the AICPA Employee Benefit Plan Audit Quality Center


Ad Index & Website Connections

Ad Index & FAXFORMATION Service. Here’s the quickest and easiest way to receive information from the advertisers in this issue of

The CPA Journal. Simply circle the name of the company/product you are interested in and fax this page or a copy to us at:

FAX # 800-605-4392.

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

Not Yet a Member? Well, You’re Missing Out!As a member of the New York State Society of CPAs, you can…Gain exclusive online access to The CPA’s Guide to

Business in New York, a members-only resource.

Utilize the new CCH TaxAware Center and gain FREE access tofederal and state tax news, information and updates, includingcustomizable preferences and searches. As a member, you getunlimited 24/7 access at no cost to you.

Join one of our more than 60 technical committees. Committeeservice is one of the most effective ways for you to perfect yourskills and knowledge, while contributing to your profession. It’ssimple to join. Apply at www.nysscpa.org or contact N. Gomez,Manager of Committees and Administrative Services, [email protected].

Become an active member in one our 15 regional chapters andnetwork with local professionals at CPE and social events.

Contact our members-only Technical Hotline with your questionson taxes, auditing, financial planning and consulting services.

Save up to $125 on your next Foundation for AccountingEducation CPE webinar or live session.

Keep up-to-date with your FREE subscriptions to our publica-tions, The CPA Journal and The Trusted Professional.

Don’t be left out of the loop! Join the Society that focuses onyour professional development. Contact Philip Federowicz at 212-719-8313, or apply online at www.nysscpa.org/join.

NYSSCPAYour Partner in the Profession

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

Camico C2 www.camico.com

Sterling National Bank 01 www.snb.com

Audimation Services, Inc. 25 www.audimation.com

NY DOI 27

Accounting Practice Sales 41 www.accountingpracticesales.com

Transition Advisors LLC 74 www.transitionadvisors.com

Pearl Insurance C3 www.nysscpainsurance.com

PNC Bank C4 www.pnc.com/cfo

Selected Interest Rates 6/30/12 5/31/12Fed Funds Rate 0.10% 0.17%3-Month Libor 0.46% 0.47%Prime Rate 3.25% 3.25%15-Year Mortgage 3.04% 3.07%30-Year Mortgage 3.69% 3.74%1-Year ARM 3.55% 3.55%3-Month Treasury Bill 0.09% 0.06%5-Year Treasury Note 0.71% 0.59%10-Year Treasury Bond 1.64% 1.44%10-Year Inflation Indexed Treas. --0.50% --0.61%

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 6/30/12 YTD Return

S&P 500 1,362 8.30%

Dow Jones Industrials 12,880 5.40%

Nasdaq Composite 2,935 12.70%

NYSE Composite 7,802 4.30%

Dow Jones Total Stock Market 14,209 8.40%

Dow Jones Transports 5,209 3.80%

Dow Jones Utilities 481 3.60%

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 5.71Overall Long-Term Outlook 6.99

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Equity Market Statistics 6/30/12 5/31/12

Dow Jones IndustrialsDividend Yield 2.75% 2.83%Price-to-Earnings Ratio (12-Mth Trailing) 14.02 13.96Price-to-Book Value 2.75 2.65

S&P 500 IndexEarnings Yield 7.20% 7.49%Dividend Yield 2.29% 2.34%Price/Earnings (12-Mth Trailing as Rpt) 13.88 13.36Price/Earnings (Estimated 2011 EPS) 13.13 12.56

Commentary on Significant Economic Data This Month

Retail chains’ year-over-year growth of same-store sales, excluding drugstores, slowed to 2.6% for the month of June. This represented thelower end of expectations that had already been revised downward to the 2.5%–3.3% range. Slow job growth, limited income growth, and weakerconsumer confidence dragged sales growth lower. Weak sales were seen across all segments except the luxury store subcategory, where therewas a 7.6% gain. Drugstores represented the worst-performing subcategory, with a 7.8% year-over-year decline. Same-store sales for the monthof July were expected to grow in the 3%–3.5% range.

Most Prior Key Economic Statistics Recent Month

National

Producer Price Index (monthly chg) 0.10% --1.00%

Consumer Price Index (monthly chg) 0.00% --0.30%

Unemployment Rate 8.20% 8.20%

ISM Manufacturing Index 49.70 53.50

ISM Services Index 52.10 53.70

Change in Non-Farm Payroll Emp. 80,000 69,000

New York State

Consumer Price Index - NY, NJ, CT (monthly) --0.10% 0.10%

Unemployment Rate 8.9% 8.60%

NYS Index of Coincident Indicators (annual) 0.20% 0.40%

As of 6/30/12


Chart of the MonthChain Store Sales

Source: Federal Reserve

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The SEC Staff Report on IFRS

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

For those who have been waiting forthe SEC’s policy decision onwhether—and if so, how and when—

International Financial Reporting Standards(IFRS) will be incorporated into financialreporting for domestic issuers, the July 13,2012, final staff report, “Work Plan for theConsideration of Incorporating InternationalFinancial Reporting Standards into theFinancial Reporting System for U.S. Issuers,”does not provide an answer (http://www.sec.gov/spotlight/globalaccountingstandards/ifrs-work-plan-final-report.pdf). In this case,however, the SEC’s indecision speaks vol-umes: most people seem to agree that, hav-ing a single set of high-quality globalaccounting standards, applied and enforcedconsistently, makes good business sense ona conceptual level, but achieving this goalhas been elusive.

The SEC staff explored variousoptions, ranging from “no action, toincorporating IFRS, to pursuing the des-ignation of the standards of the IASB[International Accounting StandardsBoard] as ‘generally accepted’ for pur-poses of U.S. issuers’ financial state-ments.” According to the report, thevast majority of participants in the U.S.capital markets do not support the adop-tion of IFRS as authoritative; thus, itseems that the last option on the SEC’slist is off the table, at least for now. Thereport cited the following primaryobstacles to incorporating IFRS:■ A desire to maintain some level ofjurisdictional control over accounting stan-dards setting in order to ensure the suitabil-ity of IFRS within the U.S. framework■ The burden of direct conversion to IFRS,including the cost of updating accountingpolicies, systems, controls, and procedures■ The significant effort required tochange references from U.S. GenerallyAccepted Accounting Principles (GAAP)to IFRS throughout the various laws, reg-

ulations, and private contracts that wouldbe affected.

Report RecommendationsGiven these obstacles, the SEC staff

focused their efforts on recommending con-ditions that would likely enhance a poten-tial U.S. transition to IFRS. The staff rec-ommendations included thefollowing:■ Developing IFRS in thoseareas that are underdeveloped,such as the insurance industry■ Providing timely, authori-tative guidance on issues aris-ing from current IFRS■ Using national standardssetters to “assist with individ-ual projects for which theyhave expertise, perform out-reach for individual projects tothe national standard setter’shome country investors, iden-tify areas in which there is a need to nar-row diversity in practice or issue interpre-tive guidance, and assist with post-imple-mentation reviews”■ Enhancing the consistent global appli-cation and enforcement of standards■ Creating mechanisms that specificallyconsider and protect the U.S. capital markets■ Obtaining funding from U.S. sources,whereby the IASB’s reliance on the large pub-lic accounting firms would be eliminated■ Improving investor engagement andeducation regarding the development anduse of accounting standards.

ConvergenceOver the past decade, the IASB and

FASB have made significant progress intheir efforts to minimize the differencesbetween IFRS and U.S. GAAP. But despiteyears of work on the convergence project,some significant discrepancies still exist.Among these are the methodology for rec-

ognizing and measuring asset impairmentlosses; the threshold (i.e., GAAP’s “like-ly” versus IFRS’s “more likely than not”)for recognizing certain nonfinancial liabil-ities (e.g., contingencies); asset(re)valuation; the use of last-in, first-out(LIFO) for inventory costing; the timing ofrecognition for research and development

costs; the differencein accounting foruncertain tax posi-tions; and “asset com-ponentization” (i.e.,separate depreciationfor each componentof an item of proper-ty, plant, and equip-ment).

Going ForwardAlthough making a

decision on whetherto incorporate IFRS

into the U.S. financial reporting systemwas beyond the scope of the staff report,the work plan does establish the ground-work for a possible endorsement-likeapproach toward IFRS in the UnitedStates. With the issuance of the work plan,how far are we from a single set of high-quality global accounting standards?Probably too far for its supporters andtoo close for its opponents.

As always, I welcome your comments. ❑

Mary-Jo Kranacher, MBA, CPA/CFF,CFEEditor-in-ChiefACFE Endowed Professor of FraudExamination, York College, The CityUniversity of New York (CUNY)[email protected]

The opinions expressed here are my ownand do not reflect those of the NYSSCPA,its management, or its staff.

Kicking the Decision Down the Road

2012-08 cpa journal august

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