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By David Maturo

The pinnacle of professional accomplishment for many in accounting and finance has been, and continues to be, the chief financial officer (CFO). To explore the nature and background of the CFO position, several CFOs from well-known organizations were asked about the steps needed to reach the top.

The CFOs were asked to speak candidly about being and becoming a CFO. The discussions touched on several important subjects, including what functions CFOs perform and what issues concern them the most; what personal attributes and skills help them perform their job; and what steps senior accounting and finance professionals, particularly controllers, can take to become CFOs. The controller, the largest non-CFO demographic among senior-level accounting and finance professionals, is frequently the last stop before reaching the heights of CFO.

The following CFOs were generous with their time and contributed significantly in addressing these questions: J. Kevin Buchi, senior vice president and CFO, Cephalon Inc.; Jacques M. Croisetiere, executive vice president and CFO, Rohm and Haas Co.; Thomas J. Doll, executive vice president and CFO, Subaru America Inc.; David S. Marberger, executive vice president and CFO, Tasty Baking Co.; Jim McKeon, executive vice president and CFO, Genesis HealthCare Corp.; Joel H. Rassman, executive vice president, CFO, treasurer, and director, Toll Brothers Inc.; Howard D. Ross, partner, LLR Partners LLC; Robert A. Schiffner, senior vice president and CFO, Campbell Soup Co.; John R. Schwab, executive vice president and CFO, NCO Group Inc.; Lawrence S. Smith, former executive vice president and co-CFO, Comcast Corp.; and L. Frederick Sutherland, executive vice president and CFO, ARAMARK Corp.

CFO Responsibilities
CFOs have a level of involvement in nearly every function of an organization. They have the responsibility to understand how each function - whether it is operations, marketing, or logistics - works, what value it contributes, and how each can help the organization grow. CFOs are at the hub of the firm, with key information and decisions tending to flow through them. As a result, they must have a solid appreciation of each function, yet are not involved in the details of any function, including accounting.

Because of the central nature of their role, CFOs interact frequently with key people in every area of an organization. A lot of time, therefore, is spent building relationships with them. "Your team members need to understand that you are there to help them achieve their goals, and you have to provide them with the financial context of their efforts in the global organization. The only way to build that level of trust is by spending a lot of time with them," says NCO Group’s Schwab. A cohesive management team can accomplish a great deal together, while dissension and conflicting goals are major wrenches in the machine.

Mission and strategy - The CFO is a partner with the CEO, which means he or she must understand what’s important to the shareholders, what promotes long-term shareholder value, and how to translate these into the company mission and make them a reality. The CFO will heavily influence, and often determine, many of the expectations for the rest of the organization.

According to Tasty Baking’s Marberger, "CFOs don’t simply pass along directives from the CEO. They are more like quarterbacks who plan the plays with the coach, and then execute them together with the team." CFOs work with various departments to analyze their strengths and weaknesses and determine what they need to accomplish their goals. They allocate capital and resources where needed to promote the growth that shareholders are seeking. "There are a lot of options, and limited funding," cautions Genesis HealthCare’s McKeon. "CFOs have to conduct thorough analysis to make intelligent choices. It requires knowing the market, your competition, internal capabilities, relevant technology, and on and on." McKeon adds that "part of being a CFO is knowing what to research and what to look for in your analysis." Marberger agrees, and adds: "You rarely have more than 60 to 70 percent of the information you want to make a decision. You have to accept that some portion of your judgment is based on intuition, and know when it’s time to stop the analysis and make a call." For CFOs, much depends on their confidence in making decisions based on what they know and what they don’t know. Confidence in their team’s abilities and in their relationships with them is critical.

Protection against risk - Managing risk is a big part of a CFO’s responsibility. In many organizations, it is an enterprisewide system of integrated management, with links back to management objectives, in the name of improving operations and enhancing the business. "Like a chess game, you have to think two or three moves in advance," says Subaru America’s Doll. "The outside world is an indicator for your company, and vice versa. Each change results in multiple permutations of how it will impact your company." CFOs are watch dogs, scouting for internal and external problems that could compromise the standing of the company or its accomplishments. They ensure controls are put into place to prevent or mitigate these risks.

Communicating results - CFOs are responsible for the clear financial reporting of a company’s status: internally to the management team, and externally to regulatory agencies. Assuring the integrity of the financials to government bodies has grown as a concern among CFOs in recent years. Nevertheless, their focus is still more targeted toward using the information to understand performance, identify trends, spur dialogue with the management team and shareholders, and make decisions. Rohm and Haas’s Croisetiere offers, "Getting the right measure of profitability is probably the most important aspect of the CFO role today. CFOs must learn to use operating information to effectively assess the performance of the business. In fact, we should probably call them ‘chief performance officers.’" CFOs interpret the numbers for the organization and set benchmarks of performance to which they can hold themselves and the departments accountable.

CFOs communicate results to the board, to debt and equity investors, to the analyst community, and to the public. They have to know their constituents’ issues and be able to address them before asked. "CFOs are able to speak to the financials in plain English, without emotion or drama. They’re also able to create clarity for those outside finance," says Schwab.

More than Controllership
For CFOs, who have moved beyond the tasks of controllership, technical skills are no longer as important as other skills. Their focus goes beyond the statements, and what really distinguishes them are certain intangible skills. Campbell Soup’s Schiffner offers a compelling observation: "Executives, from the CMO and COO to the CFO and CEO, tend to share many of the same characteristics. As executives reach the C-suite, their core attributes become nearly identical, with a healthy dose of excellence in their field of discipline." Some of these core attributes are described below.

Well-rounded - Becoming a CFO means being a generalist. Intelligent choices must be made in the context of a strong and intimate knowledge of the business in which you operate. That means spending a considerable amount of time with operations. Toll Brothers’ Rassman offers, "Good CFOs are not afraid to admit they don’t know something. They’re not embarrassed to look dumb in front of their peers. They ask to be taught, and they learn as many skills as they can. This gives them a broad base on which to make financial decisions." CFOs are aware that they need to challenge themselves to look at the world in different ways, and that ability is difficult, if not impossible, without learning skills beyond accounting and finance.

Financially sophisticated - CFOs are knowledgeable about public finance. "CFOs have to know how the stock market works, how companies are valued, and how changes will be received," says LLR Partners’ Ross. CFOs also need to understand external reporting requirements and provide for a control environment that ensures the accuracy and integrity of the financials. As a result, they pay a lot of attention to technology and the systems that govern their financial data.

On the private-market side, CFOs need experience with debt and equity financing, as well as experience with mergers and acquisitions. These experiences will affect a company’s perceived value, as well as the relative success or failure of its management team to make sustainable improvements to that value.

Communicators - "CFOs have to be good at public speaking," says Cephalon’s Buchi. "They must be able to stand up and communicate in front of their peers, employees, senior management, investors, and the public. In both planned and impromptu settings, they have to be happy and eager to do it." Many times, CFOs are company spokespeople. They need to be able to react well to questions from all types of constituents. Sometimes a complicated and sophisticated response is required, and sometimes a simple or subtle response is more appropriate. ARAMARK’s Sutherland goes further, saying "CFOs need to manage expectations, and to communicate with the management team and shareholders proactively. Instead of avoiding them or waiting for their requests, CFOs need to seek them out, solicit their opinions and reactions, and understand their needs." CFOs are required to communicate before, during, and after any notable event or activity. There should be no surprises or lack of clarity.

Team builders - "You have to have the willingness and desire to hire the smartest people you can, even your future replacement," Rassman says. Good CFOs surround themselves with strong talent that can work together as a team, yet challenge each other to do better. A CFO must be confident in their abilities and comfortable with their limitations. They cannot fear being upstaged or hesitate in recruiting the best and the brightest.

Another layer of teamwork is in having the relationships and fortitude to occasionally hold contrary opinions. Although the CFO is a partner with the CEO, Croisetiere advises, "A CFO must find the right balance of conscience and partnership, of collaborating versus challenging. It is a dual role that is not black-and-white." Contrary opinions and constructive criticism require a good deal of confidence. These actions can help uncover potential problems and proactively consider remedies that can be put in place if needed.

Interpersonal leaders - CFOs are leaders. Schiffner believes "thought leadership" is the heart of it. Simply put, "To be an effective leader, you need to play a primary role in the strategic discussions that set the direction for your company. If you don’t contribute to and shape this dialogue, it is impossible to be a successful CFO or senior executive."

CFOs are also in a people business. There are a lot of paradoxes in how they deal with people: they have to be upfront and direct, yet also diplomatic and respectful; they have to have passion for the business and their role in it, yet make choices objectively; they have to be open and prefer consensus, yet need to make firm decisions and push ahead. CFOs, as part of the management team, need to put the best foot forward in financial communications, yet they must deliver this information honestly and with credibility. People want to know they are hearing the truth, and CFOs must not be uncomfortable giving it.

Doll believes cohesiveness is a big part of a CFO’s leadership. "The team that works together best wins, not the one with the best players. A good team compliments each others’ strengths, and compensates for each others’ weaknesses. Teamwork overcomes raw talent." Also, a key part of leading is demanding performance from your team. CFOs must set high performance standards that are achievable and still force the team to work hard, learn, and work together.

Decision makers - The data for decision-making is not always perfect, so CFOs need to be decisive, often making educated guesses. "The important thing is to have a methodology or a system for making decisions," says Sutherland. "Regardless of the amount of information and analysis you have, you should be able to justify your approach."

Moving Up to CFO
Before a controller can be considered for the role of CFO, he or she first has to nail the controller role by demonstrating performance, mainly through a solid control environment with confidence in transactions and reporting. Given the prevalence of technology in accounting, there is little to no tolerance for error. "The real differentiator of performance is managing people," says Comcast’s Smith. "You need to demonstrate that you can build a team and establish a function that grows strong managers and leaders." Controllers need to execute well, but more importantly they need to teach and mentor well.

Actively manage your career - If you want to be a CFO, you have to position yourself for it. The very nature of the function suggests that one cannot be passive. It requires a personal commitment. Your current work won’t go away, so you’ll need to commit to spending more of your personal time to make it happen. Essentially, you’ll have one-and-a-half jobs for a period. Also, communicate with the people who manage you, namely the CFO and CEO. Ask them to be your mentors and to help you assess your strengths and weaknesses. Share your goals and expectations with them, and enlist their help in getting there. Periodically check in on your progress and reassess. Ask the CFO and CEO to allow you to attend meetings with investors, banks, corporate finance, and the board. Start by simply observing the meetings to get a sense of the types of questions that are asked, the attitude of the audience, and how the questions are handled. Over time, start participating.

"No class will teach you how to be a CFO," says Buchi. "You’ll only learn by doing. Participate in projects and initiatives beyond the scope of your current duties. Most top managers, CFOs included, are busy and overwhelmed. You might get a chance to participate simply by diving in and helping." Participating will teach you skills you might not obtain as a controller, and it will allow the CFO and CEO to see you in a different light. The bigger the challenge, the more opportunity there is to learn and grow your reputation. Seek out projects or areas that are not being served well. Be bold. Make a name for yourself.

With these efforts in place, make sure you are moving up to the next position level, one that increases your degree of challenge and responsibility, every two to four years. If not, you risk losing momentum and stagnating. If opportunity is not available in your current organization, consider options elsewhere. Don’t get caught in the same role, doing the same things, for more than four years. Grow or go. At the same time, don’t leave for a lateral or similar position. If you leave, make sure it’s for a role that moves you to the next step in your path to become a CFO.

Go beyond scope - Outside of controllership, there are certain boxes you need to check in your experience checklist to become a CFO. These experiences include financial analysis, strategic planning, treasury, risk management, mergers and acquisitions, fund raising, and business operations. Ideally, you would have an opportunity along the way to take on a position in each of these areas and learn about them first-hand. Since that may not be possible, you need to work with your mentors and peers to begin participating in projects that will essentially help you to train in, or at a minimum gain a strong appreciation of, those areas. You will have to work harder and do extra to get it.

There is also a broader, business-education component to it. "Controllers are detailed and transaction-oriented," Ross explains. "They cannot lose sight of the end goal of adding value for the shareholders. They have to get out of their comfort zone and adapt new ways of thinking and the way you begin to do that is serving in different areas." The CFOs interviewed unanimously agreed that operations experience was one of the most important experiences to have as a CFO. Making intelligent choices about a business without knowing operations is near impossible.

Build relationships - Work with constituents inside and outside the organization to build and establish an environment of trust and collaboration. Identify key people outside of finance, learn about them and their function in the company, and find out how you can help them. It’s an ongoing and interactive process.
Many decisions about hiring, promoting, or assigning people to projects are decided on the basis of the relationships. Creating ties outside of your sphere of influence allows more people in the organization to get to know you and your abilities, putting you in a position to be considered for more opportunities. Reaching out and speaking to more people also will help you build your people skills, which are critical to becoming a CFO. "Personality and communication become more important than accounting and analysis," says Smith. "You have to have good business and people sense. It’s both natural and developed. Be the best in your natural category that you can."

Final Thoughts
CFOs are not just senior financial professionals. They are business leaders, and as such they need to understand their business intimately, build relationships with the team around them, and work to maximize long-term value. Becoming a CFO is no easy task for a controller. Not only do you need to demonstrate stellar performance in your current role, but you also need to learn and embrace different skill sets and corporate responsibilities. These broad skills are not mutually exclusive, yet, at the same time, they do not seem to complement each other either.

Climbing to the CFO level takes a huge commitment of time and attention, learning some new things and unlearning others. Fortunately, there are people who have blazed the same trail. Use them as mentors. More importantly, start participating in broader business and corporate development initiatives. Start projecting yourself to the next level by diving in and helping the CFO and CEO. There’s risk...and reward. CFOs understand that you can’t have one without the other.

David Maturo is a partner with Attolon Partners LLC, an executive search firm in Philadelphia. He can be reached at dmaturo@attolon.com.

Copyright 1998-2008 PICPA. All rights reserved. Contact journal@picpa.org for reprint permission

By Jeffrey J. Petrell, CPA, JD

Many CPAs either represent nonprofit or charitable organizations, or volunteer their time as board members. These CPAs need to be aware of increasing challenges to tax-exempt organizations on the state and local level, particularly regarding exemption from real estate, Pennsylvania sales and use, and local government gross receipts taxes. Pennsylvania Act 55 of 1997,1 the Institutions of Purely Public Charity Act (IPPC), governs these types of exemptions.2

State and local governments continually challenge nonprofit and tax-exempt organizations to increase their revenues. The challenges may come from the Department of Revenue - which decides whether an entity meets the criteria of a purely public charity - or from local counties, cities, municipalities, and school districts that want to increase the real estate and gross receipts tax base by taxing nonprofits as opposed to raising taxes on for-profit businesses and residents.

The intent of the IPPC Act was to eliminate inconsistent application of eligibility standards for charitable tax exemptions, thus reducing confusion and confrontation among traditionally tax-exempt institutions and political subdivisions and ensuring that charitable and public funds are not unnecessarily diverted to litigate eligibility for tax-exempt status. Based on a review of the cases decided and pending in the Pennsylvania court system, it does not appear that this goal has been satisfied over the past 10 years. Challenges continue, so nonprofits and their boards have to be prepared to defend their exemptions. As a CPA, you can assist in this preparation, but you need to be familiar with the IPPC Act.

Under §5 of the IPPC Act, an institution of purely public charity satisfies the following five criteria:
-- Must advance a charitable purpose
-- Must operate entirely free from profit motive
-- Must donate, or render gratuitously, a substantial portion of its services (community service)
-- Must benefit a substantial and indefinite class of persons who are legitimate subjects of charity
-- Must relieve the government of some of its burden (government service)

Tax-exempt and nonprofit organizations need to realize that they do not automatically qualify as a purely public charity because they are organized under the Pennsylvania nonprofit law. They must meet this five-point test and must continually work at maintaining that exemption. Following is a more detailed breakdown of the five points listed above.

Charitable Purpose
An organization must be structured and operate to achieve one of the following purposes:
-- Relief of poverty
-- Advancement and provision of education
-- Advancement of religion
-- Prevention and treatment of disease or injury
-- Aid for government or municipal purposes
-- Provide for any purpose recognized as important and beneficial to the public, and which advances social, moral, or physical objectives

An organization desiring to meet the charitable-purpose test must ensure that it has a well-documented mission and that organizing documents properly lay out its mission and charitable purposes. In addition, the organization should take every opportunity to communicate its exempt purposes to the public, either through its Form 990 or other means.

No Private Profit Motive
The institution must operate entirely free from private profit motive. This test is satisfied if the nonprofit organization meets all of the following requirements:
-- There is no private inurement to private shareholders or other individuals.
-- The institution applies or reserves all of its revenue in excess of expenses to either further its charitable purpose or to fund other institutions that advance a charitable purpose.
-- The institution does not base the compensation of its directors, officers, or employees primarily on financial performance.
-- Articles of incorporation, or other governing documents, prohibit the use of surplus funds for private inurement to any person in the event of the institutions sale or dissolution.

The Department of Revenue and local taxing authorities are challenging charitable organizations in the area of executive compensation. Charitable organizations should ensure that they are not paying excessive compensation, and should annually ensure that salaries and compensation paid to officers, directors, and employees are considered "reasonable." An independent compensation study may be beneficial for nonprofit organizations. If the resources to obtain an independent study are not available, an organization should perform its own reasonableness study by reviewing data of similar associations from the Forms 990 that are open to public inspection.3 Another important practice is to have an independent board of directors, or subsection of the board, annually approve compensation arrangements.

Community Service
An organization will meet this test if it meets one of seven subtests. Six of the seven subtests are quantitative tests, whereby an organization must demonstrate that it is performing enough community service to be granted exemption. The seventh test is for foundation or fundraising organizations, whereby an organization will meet this test if it raises funds on behalf of other purely public charities and contributes a substantial portion of its funds to those other purely public charities.

Organizations should continually collect and document the required statistical and quantitative data, and determine ways to enhance community service activities. The IPPC Act defines "uncompensated goods and services" as all of the benefits provided by the institution to the community, and they are valued as the difference between the full cost of the goods or services and any fees received for such goods or services. Organizations need to demonstrate that they are providing community services in return for the exemptions that they are receiving.

Organizations may also want to consider entering into a voluntary agreement with a local government to make payments-in-lieu-of-taxes payments (PILOT payments). The legislature put many incentives in the IPPC Act for charities that enter into PILOT agreements. In addition to automatically meeting the relief of government burden test, the organization will receive credit toward the community service test, ranging from 150 percent to 350 percent of the amount paid. This is one way to minimize future exemption challenges by paying an agreed-upon amount to the local governments each year.

Benefitting Legitimate Subjects of Charity
Legitimate subjects of charity are defined as those who are unable to provide themselves with what the institution provides for them. Therefore, an organization should clearly document whom it is benefiting, why the beneficiaries are subjects of charity, and why the donations are substantial and indefinite.

Government Service
An organization will meet the relief of a government burden test if it meets one of six subtests. Three of the six are met if an organization provides a service that the government would be required to provide or fund, or that reduces dependence on government programs. Another subtest is met if the organization receives regular payments for services rendered under a government program that are less than the full costs incurred by the organization. Institutions that advance or promote religion, and that are owned and operated by a corporation or other entity as a religious ministry, will meet the government burden test if it meets the other four purely public charity tests.

As discussed previously, organizations can also meet the government burden test by entering into a voluntary agreement with a local government to make PILOT payments.

Conclusion
The IPPC Act also created a provision that allows small businesses to file a complaint with the Secretary of State if they feel a nonprofit is using its tax-exempt status to engage in unfair competition. There have been challenges on this front, so a charitable organization should take measures to ensure that any business it starts or funds should be related to its exempt purposes as described in its organizing documents.

Challenges to tax-exempt status will continue in the future on several fronts, and nonprofits and charities need to ensure they meet the IPPC Act’s tests to overcome these challenges. In addition, organizations seeking exemption from Pennsylvania sales and use tax need to gather this information and provide it to the Pennsylvania Department of Revenue on Form Rev-72. The exemption needs to be renewed every five years, so charities will need to demonstrate that they meet the tests of a purely public charity.

CPAs that either represent or sit on the boards of nonprofits and charities should demonstrate to their organizations the benefit of documenting the IPPC Act’s tests, and clearly communicating their community value to the state and localities in which they operate.

1 10 P.S. §375
2 Exemptions from Pennsylvania corporate net income tax, capital stock tax, and franchise tax are not governed by the IPPC Act. These exemptions are obtained if corporations are tax-exempt organizations under §501 of the IRC or if they are organized as not-for-profit under the laws of the Commonwealth and would qualify as exempt organizations as defined by §501.
3 Forms 990 filed by tax exempt organizations can be viewed at www.guidestar.org.

Jeffrey J. Petrell, CPA, JD, is a partner in the tax services department of Carbis Walker LLP in Pittsburgh. He can be reached at jpetrell@carbis.com.

Copyright 1998-2008 PICPA. All rights reserved. Contact journal@picpa.org for reprint permission

By Maria F. Boodoo, CPA

When something in a company is amiss financially, CPAs may be part of the team responsible for tracking down the problem. If an illegal act or wrongdoing within a company is suspected, an internal investigation is usually the first step so management can get an idea of what they are dealing with. Whether you are a CPA on the internal audit group, a hired forensic accountant, a part of the audit committee, or a member of management, this column outlines some basic principles of internal investigations that all CPAs should understand.

Team Work
Internal investigations often involve in-house general counsel, regular outside counsel, independent legal counsel, and forensic accountants. The company’s audit committee, depending on the extent of the investigation, will often oversee the investigation. The company’s external auditor also may be involved, approving the selection of the forensic accountants and their work plan as well as conducting a shadow investigation.

A shadow investigation refers to the external audit team’s review or "shadow" of the investigation performed by independent forensic accountants. The external auditor will assess the adequacy of the nature, extent, and timing of the forensic procedures performed. Oftentimes, larger public accounting firms have personnel with specialized forensic skills to conduct this review.

The Investigation
Companies must be cognizant of the fact that the net of an internal investigation must be cast wide enough to determine the extent of the illegal act or wrongdoing. Through this good-faith effort, companies may possibly mitigate harsh penalties meted out by regulatory authorities. Multiple factors will be considered, including, but not limited to, all the issues that may be affected by the suspected wrongdoing, such as accounting and financial disclosure issues. Possible examples include a freeze on all documents subject to the investigation to prevent destruction, a potential list of suspects or conspirators, a schedule of interviews of employees who may have information pertaining to the investigation, and an evaluation of the size of the investigation, including the number of departments or locations.

Once an investigation is under way, the steps may not always be linear. However, there are usually key processes that exist in any investigation. A forensic accountant, member of an audit committee, or an external auditor all need to know what these steps are and what they entail.

Follow a workplan - A workplan that addresses the scope of the issues must be developed. This plan should address the techniques to be used to gather the information, the sources of data to be collected, and the methods used to manage the investigative process, people, and documents. The plan may change over time as new information becomes available.

Define the extent of internal audit’s involvement - Those leading the investigation will decide to what extent the internal audit function will be involved in the investigation. Internal audit’s involvement could potentially impair the independence of the investigation. If internal audit resources are used, the audit committee will detail its relationship with the external forensic accountants, if applicable, and the degree of reliance that will be placed on internal audit’s work.

Communicate with employees - Communication with employees and those outside of the organization must be considered and carefully planned, especially if it involves a public company. Information contained in such communications must not be rushed. Oftentimes there is a rush to tell people the extent of problems before the problems are completely understood and quantified.

Gather relevant documents - Preventing the destruction of useful and relevant documents to the investigation is vital. The investigation should involve the technology department to preserve electronic documentation found on desktop and portable technology, such as handheld devices and laptops. Additionally, as backups and archives are sometimes retained for only 90 days, management should consider extending the document retention policy at the start of the investigation to prevent files from being auto-archived, sent to a backup facility, shredded, or recycled.

Conduct interviews - Those performing the investigation should follow key principles to conducting sound interviews. These include preparing discussion points prior to the interview, having at least two interviewers in the room, choosing the right location and setting to avoid distractions, and monitoring the interviewee’s body language.

Document the investigation and its conclusion - The format and content of the report, and the parties who will view the report, should be established during the investigation’s planning stages. Reports may be oral (to preserve legal privileges) or written. Reports should detail the investigative methodology, the technologies employed, a summary of the documents gathered, a list of persons interviewed and third parties used, results of the analysis of evidence, and a conclusion. Recommended remediation actions may also be included.

An internal investigation is one that involves a collection of basic, but important, procedures. The successful investigation will be one where the right procedures are used and followed in the proper order to create a clear set of data that can be used for the conclusion of the investigation. CPAs, no matter what their role within, or in relation to, a company, need to know what these procedures are in case they are called upon to participate in an internal investigation.

Maria F. Boodoo, CPA, is an auditor with FTI Consulting in King of Prussia, and is a member of the Pennsylvania CPA Journal Editorial Board. She can be reached at mariaboodoo@yahoo.com.

Copyright 1998-2008 PICPA. All rights reserved. Contact journal@picpa.org for reprint permission

By Thomas Rees, CPA

Few accounting rules have caused financial statement preparers and their auditors more headaches than Statement of Financial Accounting Standards No. 133 (SFAS 133), Accounting for Derivatives and Hedging Activities.

The Financial Accounting Standards Board (FASB) has amended SFAS 133 several times since its initial issuance in June 1998, most recently with the issuance of SFAS 155, Accounting for Certain Hybrid Financial Instruments. In addition, FASB, through its Derivatives Implementation Group, issued specific implementation guidance on more than 180 topics. All told, the standard, its amendments, and its implementation guidance provide nearly 1,000 pages of accounting guidelines for the complex instruments known as derivatives. No wonder SFAS 133 has tripped up numerous public registrants, both big and small.

One of the most confusing elements of the accounting standard are the rules relating to embedded derivatives. These requirements are particularly complex, requiring practitioners to consult a seemingly endless stream of Derivatives Implementation Group issuances, Emerging Issues Task Force (EITF) pronouncements, and SEC staff guidance to determine the appropriate accounting. Numerous companies have tripped over the embedded derivative issue. According to the Analyst’s Accounting Observer, 92 companies filed Form 8-K in 2006 to indicate that they would restate their financial statements due to incorrect application of EITF Issue No. 00-19 (EITF 00-19), one of the most important pronouncements in determining the appropriate accounting for embedded derivatives.

This article summarizes the basic accounting requirements for embedded derivatives, provides examples of how certain contractual terms could have unintended accounting consequences, and offers suggestions on how to mitigate the accounting risk these terms raise.

Embedded Derivative
SFAS 133 characterizes an embedded derivative as a provision within a contract, or other instrument, that affects some or all of the cash flows or the value of that contract, similar to a derivative instrument. Essentially, the embedded terms contain all of the attributes of a free-standing derivative - such as an underlying market variable, a notional amount or payment provision, no initial net investment, and can be settled "net" - but the contract, in its entirety, does not meet the SFAS 133 definition of a derivative.

By embedding terms that meet the definition of a derivative into another contract - the "host contract" - that contract’s cash flows may be modified when changes in specified underlying market variables occur. The contract that embodies both the derivative and the host contract is referred to as a "hybrid instrument." Embedded derivatives appear in a variety of contracts, including foreign exchange contracts, lease agreements, insurance contracts, and other arrangements. One of the most common locations for these terms, and an area that has been a primary focus of the SEC, is convertible debt and preferred stock instruments.

For example, assume Trina Company needs working capital and is planning to raise $10 million of funding through capital markets. Based on market conditions and its credit rating, Trina Company plans to issue "straight debt" that pays a 9 percent fixed rate of interest every six months until maturity in 10 years. The debt is considered straight debt because the instrument contains no significant terms that will affect future interest or principal payments. In other words, it has no embedded derivatives.

Assume that Trina Company discusses its planned debt issuance with an investment banker, who suggests altering the straight debt plan to reduce the company’s cost of funds. Accordingly, Trina Company agrees to provide investors with a redemption, or "put," option that enables the holder to redeem the debt after five years. It also adds a provision that enables the holder to convert each $1,000 of principal into 25 shares of Trina Company’s common stock if certain contingencies are met, or any time after seven years. To provide additional protection to the investor, Trina Company includes a provision that, if a change in control of the company occurs, it will pay the holder $300 per $1,000 of principal outstanding, less any previously paid interest, in addition to returning the $1,000 in principal and retiring the debt. This is typically referred to as a "make-whole" provision. Finally, for its own protection, Trina Company adds a call option, giving it the right to retire the debt after seven years. By adding these terms, the required interest rate on the debt is reduced from a 9 percent fixed rate to 6 percent fixed.

Each one of these provisions has the potential to change the future cash flow of the straight debt, depending on changes to underlying market variables - such as market interest rates or Trina Company’s stock price - and therefore may be considered an embedded derivative. In this example, the straight debt is considered the host instrument; the put option, conversion option, make-whole provision, and call option are considered embedded derivatives; and the convertible debt instrument in its entirety is considered a "hybrid instrument." To determine the appropriate accounting for this instrument, both the issuer and the investor must consult a wide range of accounting literature, including SFAS 133, various Statement 133 implementation issues - commonly referred to as Derivatives Implementation Group issuances - and FASB’s EITF guidance.

Standard Complexity
When SFAS 133 was implemented, one of the changes it made was that all derivatives had to be accounted for at fair value on the balance sheet, no exceptions. This approach is consistent with the view that fair value is the only meaningful way to measure a derivative, and with FASB’s stated objective of moving toward full fair-value accounting for all financial instruments. Accounting for derivatives at fair value, however, may result in more volatility in a company’s reported earnings. FASB was concerned that methods would be found to circumvent the SFAS 133 mark-to-market requirement by embedding a derivative in another financial instrument, avoiding the potential volatility in reported earnings that a derivative could cause. Accordingly, FASB included special accounting requirements for embedded derivatives in SFAS 133.

Accounting Requirements
The fundamental concept for embedded derivatives is relatively simple: An embedded term that meets the definition of a derivative, and which is not economically related to the host instrument, is subject to special accounting. Specifically, such embedded derivatives may have to be accounted for separately, as if they were stand-alone derivative instruments. FASB uses the word "bifurcation" to describe the process of separating the embedded derivative from the instrument in which it resides and accounting for them as if they were two distinct financial instruments. Failure to comply with this requirement has been one of the primary sources of SFAS 133 implementation errors, and the cause of numerous restatements.

SFAS 133’s core criteria for determining the appropriate accounting treatment for embedded derivatives is contained in what, on the surface, is a relatively simple three-part test in paragraph 12. Briefly, this test is as follows:
-- Would the embedded term meet the definition of a derivative if it was a stand-alone instrument? If no, the embedded term does not require separate accounting. If yes, go to the next question. When considering this question, the analysis must consider the specific SFAS 133 scope exclusions specified in paragraphs 10 and 11.
-- Is the instrument in which the term is embedded (the hybrid instrument) accounted for at fair value? If yes, the embedded term is already accounted for at fair value, and separate accounting is not required. If no, go to the next question.
-- Are the economic characteristics of the embedded derivative clearly and closely related to the economic characteristics of the host instrument? If the embedded derivative is considered economically closely related to the instrument in which it resides, separate accounting is not required. If the answer to this question is no, the embedded derivative should be accounted for as a separate asset or liability.

The concepts outlined in the three-part test are relatively simple, but the implementation and interpretation of the requirements is complicated. In fact, FASB included implementation guidance on this issue within SFAS 133 and then separately released 40 derivatives implementation issues to help interpret the accounting requirements. In addition, there are numerous EITF pronouncements that must be consulted when performing an embedded derivative analysis. The list of accounting guidance that must be consulted to complete this "simple" analysis is extremely long, and is not for the faint of heart.1

Because this area has been a common cause of accounting errors, I want to highlight two specific elements of the related accounting literature that seem to be the most confusing.

The double-double test - SFAS 133, paragraph 13, indicates that an embedded derivative that only alters the amount of interest paid on a debt instrument would be considered "clearly and closely" related to the host instrument, and thus would not require separate accounting. If there is a possible future interest rate scenario in which settlement of the debt could result in either the investor earning a negative rate of return, or a rate of return that is both more than twice the initial rate of return and twice the then-current market rate of return, it would not be considered clearly and closely related to a debt host instrument. This "double-double" test gets its name from the criterion that requires analyzing whether the embedded derivative term could cause the doubling of both the initial interest rate and the current market rate of interest for a debt instrument of similar credit quality. In other words, if there is any possible scenario in which the investor could earn a future rate of return that is both double the initial rate of the instrument and double the interest rate of a debt instrument of similar credit quality, the embedded derivative would generally need to be accounted for separately from the debt host.

FASB Statement 133’s Implementation Issue No. B16, Embedded Derivatives: Calls and Puts in Debt Instruments, provides applicable guidance and should be consulted when considering the appropriate accounting for these terms.

Paragraph 11(a) scope exception - SFAS 133, paragraph 11(a), indicates that "contracts issued or held by that reporting entity that are both indexed to its own stock and classified in stockholder’s equity in its statement of financial position" are outside the scope of SFAS 133. In other words, such terms meet the equity definition and do not have to be accounted for separately. EITF 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, provides guidance that must be considered when determining whether an embedded derivative meets the definition of equity.

EITF 00-19 requires the issuer to determine whether there is any possibility, even if it is remote, that the embedded derivative could be settled for cash. If the possibility exists, EITF 00-19 requires that the derivative be accounted for as a liability and not as equity. Therefore, it would not be eligible for the paragraph 11(a) scope exception. EITF 00-19 specifies eight criteria that must be met to conclude that the instrument would always be settled in shares and not in cash. The following three criteria often cause embedded derivatives involving share settlements to fail the test:
-- The contract permits the company to settle the embedded derivative in unregistered shares.
-- The issuing company has sufficient, authorized, and un-issued shares available to settle the embedded derivative contract after considering all other obligations to issue such shares.
-- The contract contains an explicit limit on the number of shares to be delivered in a share settlement.
These criteria are applicable when analyzing the conversion feature embedded in debt or preferred stock. If any one of the eight EITF 00-19 criteria is not met with regard to settlement of the conversion feature in shares, then the embedded conversion feature must be accounted for separately.

SEC Focus
The SEC’s Division of Corporation Finance is specifically focusing on embedded derivatives in debt and preferred stock instruments in their review of registrant financial statements. Accordingly, companies that have issued debt or preferred stock that contain embedded derivatives can expect to receive a comment letter from the SEC requesting additional information to support the accounting approach that was followed. A typical comment letter might ask for the details of the analysis of the provisions of EITF 00-19 and SFAS 133 with respect to the accounting for convertible debt.

SEC staff has addressed the accounting requirements for embedded derivatives in speeches at the annual 2005 and 2006 AICPA conferences. In addition, EITF issued D-109 and revised D-98 in March 2007 to provide specific updates from the SEC on how to analyze these transactions. The SEC also addressed accounting requirements in two recent issuances of Current Accounting and Disclosure Issues in the Division of Corporation Finance.

Suggestions to Mitigate Accounting Risk
Since tripping over an embedded derivative is by no means unheard of, and easy to do, below are a few suggestions that may help you identify or avoid accounting errors related to embedded derivatives.

Review existing financial instruments for embedded derivatives. If your organization or client has not formally reviewed each financial instrument/contract to identify embedded derivatives, this should be done immediately. Ideally, one or more individuals should be responsible for reviewing newly acquired financial instruments to determine the appropriate accounting at the inception of the transaction. Documentation of the review should be maintained. This is an important consideration in an external auditor’s evaluation of the company’s internal controls over financial reporting, as required under Section 404 of Sarbanes-Oxley.

Before entering into new transactions, make sure all parties involved are aware of the potential accounting implications. In particular, individuals in the treasury function or others authorized to enter into capital market transactions must understand the accounting requirements of the transaction being considered prior to execution of the trade. SFAS 133 requires companies to evaluate both the financial instrument and the specific terms within it. Accordingly, when raising capital through a debt or preferred stock issuance, all of the terms in the instrument must be considered. Similar analyses should be conducted before purchasing securities issued by other entities. Consult with attorneys to understand the requirements of the instruments being contemplated.

Discuss the accounting implications of transactions and obtain agreement on the proposed accounting from independent accountants before entering the transaction. In general, external auditors have become more reluctant to provide accounting guidance on hypothetical transactions for fear of impairing their independence. If this is the case, consider identifying and retaining third-party consultants who can provide technical advice.

Consider the provisions in SFAS 155 and SFAS 159 that provide entities with the option to elect to account for instruments containing embedded derivatives at fair value rather than separate accounting for the derivative element.

Continue to monitor developments at FASB and SEC for new guidance. This has been an area of significant activity, and FASB has several projects on its agenda relating to derivatives accounting and convertible debt instruments.

1 AICPA and the Convertible Debt, Convertible Preferred Shares, Warrants and Other Equity-Related Financial Instruments Task Force issued a working draft last year of a technical practice aid to help accountants navigate the complex maze of accounting literature in this area. The working draft can be found at http://www.aicpa.org/Professional+Resources/Accounting+and+Auditing/Accounting+Standards/Working+Draft+of+Convertible+Debt+Convertible+Preferred+Shares+Warrants+and+Other+Equi.htm.

Thomas Rees, CPA, is a director in FTI Consulting’s King of Prussia office, where he provides SEC advisory services. He can be reached at thomas.rees@fticonsulting.com.

Copyright 1998-2008 PICPA. All rights reserved. Contact journal@picpa.org for reprint permission

By Dave Woods

Career greatness is the realization of optimal personal and professional productivity; the tapping of one’s natural competencies and passions in conjunction with learned skills and inherent inner drive. A close alignment in these areas leads to a fulfilling career, and a peaceful and productive life. It has been sought by many, yet realized by few. Many of us feel unfulfilled on the job, or feel underutilized by the system that employs us. It does not have to be that way.

The demand for financial leaders is great, which is good for our careers. The personal fulfillment aspect, however, tends to be the trickier part. If we choose to move up, or laterally, to new challenges within our careers, we need to look critically at all the opportunities, remembering to try to align ourselves for career greatness. This is difficult, but possible, and certainly worthwhile.

One of the benefits of aligning our careers with our passions is that we will be working within our natural capability set. Therefore, the work comes naturally to us and provides more satisfaction. Less energy is consumed when working on something that is interesting and within our capability. This results in more time and energy for the non-work passions we value, like family and hobbies. Working toward this career greatness taps into our internal drive to use our skills to their fullest, challenge our minds, and broaden our experiences.

So, how do you explore the concept of career greatness? First, start with an exploratory review of who you are as a person: determine your preferences, capabilities, values, and passions. Know your inherent personality and intellectual capacity. Once you explore yourself and your natural tendencies, look at your interests and create a comprehensive personal profile. Next, create the criteria, based on your preferences, needed to assess career opportunities as they arise. Proactively defining what a great role means to you is the first step toward realizing it. A word of caution: you must be brutally honest when evaluating your abilities and capabilities.

Proactive career management is only the start to career greatness. The broader acts of self-discovery, personal goal setting, and active definition of your personal legacy all help formulate the exceptional career...and the exceptional person. A definition of the role that your occupation will play in your life is critical. Will this role define who you are, and whether you are successful and happy?

Below are the basic steps to achieving career greatness:
-- Be proactive in your career search and personal endeavors, but start with your end goals in mind. Understand the role your occupation will play in your life.
-- Begin with a clear picture of your goals, within both your home and work lives. Goals that are in sync with your values and passions are most effective.
-- Prioritize your life. Create a clear set of values, and maybe a personal mission statement.
-- Think win-win when evaluating career opportunities, but be candid when discussing your qualities and the potential position. Create an environment of full disclosure.
-- Work with a prospective employer on the best way to structure the right role. Be open about how you like to work and how you can best add value.
-- Take the time to reflect and renew yourself, putting work and home life in perspective.
-- Live life from the outside in. Learn to become your own worst critic, and embrace the realities that surround you. Know your limitations, and act accordingly.
-- Coach others to recognize their strengths and preferences. Be a leader in the development of personal and business productivity.

You owe it to yourself and your family to align your career with your passions. Your family wants an effective and peaceful you. Also, businesses are starting to think along the lines of this perspective to find the next level of productivity after the recent wave of technology advancements. Businesses will be looking for more innovative ways to increase productivity from existing resources. As companies focus more on retention over recruitment, extracting the best from the current workforce is the challenge, and achieving your own personal career greatness is to the benefit of both you and your employer.

Dave Woods is an independent productivity consultant with Resoursecure LLC, and a business instructor at DeSales University in Center Valley. He can be reached at dwoods@resoursecure.com.

Copyright 1998-2008 PICPA. All rights reserved. Contact journal@picpa.org for reprint permission

By Rose Marie L. Bukics, CPA

Most people have heard the expression, "Those who can, do; those who can’t, teach." That cliche can’t be further from the truth when it comes to accounting educators. The reality is today’s professors must be able to "do" accounting, and then some. They also have to be entertainers, technology gurus, and creative problem-solvers, as well as accounting profession liaisons with the ability to anticipate future events.

The demand for most of these skills is evident daily in the classroom; the last skill, however, is particularly important since professors must be capable of anticipating in advance how regulatory authorities will change the profession. Only in this way can they best prepare the professionals of tomorrow. Complicating all of the above is the fact that professors serve three masters simultaneously: their academic institutions, the accounting profession, and their students.

Requisite Skills
A professor’s work does not solely consist of the time spent in the classroom. This is something that is not fully understood until one chooses a teaching career. The time spent in preparation dwarfs the time spent in the classroom, even if courses are taught more than once. This aspect of teaching has taken on even more prominence in recent years with the recognition, and incorporation, of different learning styles. Couple this with today’s students, who live in a wired world and want information in "sound bite" length, who commonly think research is synonymous with Google, and who have spent years completing work driven by a cooperative and collaborative learning style.

In the past, understanding financial accounting standards and breaking down their complexity to a level appropriate for 19 and 20 year old students was a challenge. The process was more about the delivery of information in concrete, digestible components that provided students with the building blocks to master the important elements well enough to be able to answer questions that might appear on the CPA Exam.

Today, how that information is delivered and digested by a student is pre-eminent. This changing dynamic has increased the time commitment to reflect and ultimately produce creative ways to deliver material and design assignments. These assignments, however, are not restricted to learning the accounting methods and standards; they must also effectively incorporate the other skills required of accounting professionals: excellent communication skills, ethical considerations, and computer expertise.

One might wonder: why would anyone choose a life of teaching accounting? The answer is simple: the reward. It’s not a reward of the monetary kind; rather it’s a reward of the intrinsic type. And it is what keeps professors toiling endlessly to serve the needs of the profession.

Rewards
When I reflect on the changes in my own teaching over the years, I am truly stunned by both the range and depth of the changes. Yet, there is one constant that remains - the young student sitting in front of me who ultimately joins me as a lifelong member of the accounting profession. How I can affect that young person’s personal and professional life is awe-inspiring, and it is fundamental in the daily working environment of an accounting professor. This opportunity and its subsequent rewards keep accounting professors going.

Many times, years may pass before you realize the impact you have had. Recently, while attending a lunch with a firm recruiting at the college, a member of the recruiting team introduced himself. I was ruminating on his name, and commented that I thought I taught him. His response was, "Yep, you sure did, 20 years ago." He told me that, quite honestly, he didn’t learn much accounting in my class, which was taken his second semester of his senior year. While I was busy processing that stinging comment, he went on to elaborate that he felt he had learned other, more intrinsic things from me that have served him well, both in his professional career and his personal life. He then added that he had been waiting 20 years to tell me that, and to thank me. Needless to say, he made my day.

Rose Marie L. Bukics, CPA, is the Thomas Roy and Lura Forrest Jones Professor of Economics and Business at Lafayette College in Easton, and is a member of the Pennsylvania CPA Journal Editorial Board. She can be reached at bukicsr@lafayette.edu.

Copyright 1998-2008 PICPA. All rights reserved. Contact journal@picpa.org for reprint permission