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By Wilhelm Dingler, JD
Insightful lessons can be learned by reviewing professional liability issues. With this in mind, Mather & Co., a division of Bollinger Inc., provides this column. For more information, contact Mather at philadelphia@bollingerinsurance.com.
Recently, I happened across an article of mine from the 1990s that listed the "Top Ten Trouble Spots for Accountants." What struck me when reviewing the list is that no matter how many times advice of caution is offered, the same troubling items continue to be the top ten problem areas from which liability claims and lawsuits arise:
-- Bookkeeping services and suggesting procedures for bookkeeping to clients. If embezzlement occurs, you are blamed.
-- Significant personal contact with a client and the performance of audit functions. Lack of objectivity can be claimed.
-- No engagement letter. An unclear "he said/she said" situation arises.
-- Lack of clarity regarding the work to be performed (a corollary to the above). Gives rise to client expectations that differ from yours.
-- Tax advice beyond area of expertise. Penalties and disallowance of structures may follow.
-- Involvement with boards or having ownership interests in an entity. Claims can arise of insider dealing and lack of objective accounting practices.
-- No internal procedures for follow-up. Deadlines are important, and "to do’s" can fall through the cracks.
-- Advising more than one party to a transaction without significant disclosures and waivers.
-- Lack of disclaimers in prepared financial statements delineating their purpose and use.
-- Failure to keep current in education and training.
One can easily recognize how the above areas can breed litigation, but there remains a disturbing and persistent disconnect between recognition and action. Take internal procedures for follow-up as an example. It is perhaps the easiest of all the points to correct, yet it is often the most overlooked. The point may seem obvious to many, but, having just undertaken for the fifth time the defense of a professional who missed a Form 706 deadline, one has to assume there is a broader failure of the task-check system. Having it on your calendar is insufficient. You need a backup.
Equally troublesome for many accountants is any combination of personal contact with clients, involvement on client boards or as part owner, and advising multiple parties to a transaction without disclosure. Many contacts are made in the course of a professional career, and sometimes the line between the personal and the professional can be blurred. Be aware of that line, and be especially wary of circumstances that can cloud objectivity. If two members of your usual country club foursome separately seek your advice regarding the tax implications to each of them regarding their upcoming joint venture, you still need conflict waivers and engagement letters. The work can still be performed, but it must be performed in the same professional manner, and with the same safeguards, that you conduct all your business endeavors.
Finally, make sure you clearly explain and detail the services to be performed, as well as those you are not to perform. Make sure you enter into a professional relationship with a blueprint that clearly establishes the expectations on both sides. Failure of expectations is a breeding ground for claims. If expectations are enumerated, a client is hard pressed to complain if you do not do something that was never contemplated in the first place.
The main point of this "Top Ten" and, in fact, all risk management advice, is to be proactive, not reactive. Expect the worst and plan for it. Practicing professionals have a 15 to 25 percent chance of being sued during the course of their career. Simple, yet effective, risk-management techniques can go a long way to placing you in the 75 percent that never gets served a summons or presented with a malpractice claim.
Wilhelm Dingler, JD, is an attorney in the professional liability department of Marshall, Dennehey, Warner, Coleman & Goggin in their Philadelphia office. He can be reached at wxdingler@mdwcg.com.
Copyright 1998-2007 PICPA. All rights reserved. Contact journal@picpa.org for reprint permission
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By Allison M. Henry
The pace of accounting standards convergence is accelerating and is being driven primarily by an investment community that is rapidly embracing International Financial Reporting Standards (IFRS), as promulgated by the International Accounting Standards Board (IASB). At the same time, technological changes, as illustrated by the growing acceptance of XBRL, are challenging the need for the traditional historical financial reporting model. These changes are all converging, which will have a tremendous impact on the accounting and auditing model.
Accounting Standards Convergence
"Financial reporting has become overly complex," says Christopher Cox, SEC chairman. "That means not only are financial statements difficult for investors to understand, but also companies incur excessive costs as a result of complying with voluminous and overly prescriptive accounting and reporting rules."1 SEC is working on a number of initiatives to ease these pressures. One of which is on the international front: expediting the convergence of U.S. Generally Accepted Accounting Principles (GAAP) with IFRS. The transition to a more objectives-oriented set of standards similar to IFRS has been progressing steadily since a concept release in 2000. In that release, the SEC outlined a framework for the convergence process. The goal of the transition, as outlined by the SEC, is to reduce complexity, increase clarity and transparency, and minimize what it referred to as "accounting-motivated structured transactions."2
The convergence process has been ongoing, but some questions are beginning to arise as to whether convergence has come far enough that U.S. markets can accommodate both sets of standards. The FASB-IASB convergence process is unique, compared with the convergence process in other countries where IFRS is increasingly accepted as the global standard for financial reporting. Rather than just reducing differences to achieve convergence, in the United States the FASB-IASB process focuses on achieving the highest-quality standards. Furthermore, convergence does not necessarily mean that the two sets of standards will produce the same exact results. As described by Donald T. Nicolaisen, chief accountant of the SEC, "It is necessary that convergence result in close alignment of the accounting for the same, or essentially the same, transactions; generally comparable results in trends; a continued cooperative will to reduce differences over time; as well as the transparent understanding of any significant differences."3
On March 6, 2007, the SEC convened a roundtable discussion regarding the IFRS "roadmap," which was a term used by Nicolaisen, proposing a process for eliminating the SEC requirement for foreign private issuers to reconcile financial statements prepared under IFRS to GAAP. Participants of the roundtable included issuers, investors, underwriters, and CPAs. The group generally concluded that the IFRS-GAAP reconciliation requirement should be eliminated in the near future. The conversation also yielded insight into the issues surrounding the transition to IFRS:4
-- Reconciliation has become a non-event, and is not heavily relied upon for investment decisions, due to the six-month delay in the preparation of IFRS-GAAP reconciliation.
-- The reconciliation process has furthered the evolution of the convergence process, which has improved the quality of IFRS.
-- GAAP guidance has been useful in interpreting and implementing IFRS.
-- Inconsistencies with GAAP will be minimized over time as investors seek clarifications.
-- As IFRS is consistently applied, the usefulness of IFRS-GAAP reconciliation is decreasing.
-- IFRS application across the globe necessitates consistent global enforcement.
-- Removing reconciliation requirements could be perceived as an endorsement of IFRS.
As a result of the roundtable discussion, the SEC issued a proposed rule on July 2 to eliminate the GAAP reconciliation requirement for foreign private issuers who file financial statements prepared in accordance with IFRS. On Nov. 15, the SEC voted in favor of this proposal. The SEC also issued a concept release in which it will explore whether U.S. issuers should be permitted to prepare financial statements in accordance with IFRS.
While the SEC moves to allow foreign firms listed on American stock exchanges to file financial statements according to international standards, a national survey states that U.S. financial leaders are not convinced this is a good idea. According to a study by Grant Thornton LLP, 56 percent of responding CFOs and senior comptrollers disagree with the SEC position. In addition, 49 percent believed U.S. companies with large overseas operations should not be able to file statements using IFRS. However, a large majority - 91 percent of public companies and 75 percent of private companies - agreed that current U.S. standards are overcomplicated; and 67 percent admitted a preference for principles-based standards.
The implications of these changes should not be minimized. Many issues need to be considered, including the security of the U.S. markets, the roles of various standard-setters, enforcement mechanisms at the international level, the ability and willingness of other nations to strive and achieve the high-quality standards of financial reporting, the funding mechanism for IASB - which is currently voluntary - and the training costs and transition time to a new standard. Additionally, as IFRS is more principles-based and requires a greater degree of professional judgment, variations in accounting treatment may result. This is an uncomfortable proposition for practitioners accustomed to consistency.
At the same time, the underlying cause for much of GAAP’s complexity is the U.S. regulatory and legal environment. Factoring in regulatory compliance and litigation, the United States has the highest-cost reporting process.5 Clearly, legal and regulatory reform is imperative if practitioners are going to be required to use a greater degree of judgment as required by principles-based accounting.
Other Initiatives
A number of initiatives are in progress to reduce the growing complexity:
-- The SEC has created an advisory committee on improvements to financial reporting to study ways to improve financial reporting and reduce complexity.
-- The Private Company Financial Reporting Committee has been launched to serve as an advocate at the FASB for privately held companies.
-- The FASB is working on a codification project that will flatten the GAAP hierarchy to two levels: authoritative guidance and non-authoritative guidance. The goal is to create a complete set of standards that can be accessed topically.
-- On the international level, IASB published an exposure draft that seeks to provide a streamlined set of accounting principles for smaller, non-listed companies based on IFRS.
Changes are developing in the area of how financial and nonfinancial information is conveyed to the investment community as well. Extensible Business Reporting Language (XBRL) and sustainability reporting will impact the convergence equation as we focus less on historical accounting issues and more proactively on strategic reporting. This change in focus will also change the role of auditors.
XBRL is a technology that can globally transform the process for communicating financial information. XBRL provides investors with access to increasingly detailed information that is continuously updated and can be automatically downloaded into basic software products. XBRL is a method for improved communication, greater transparency, and clarity, but it also enables more accurate, expedited analytics, benchmarking, and control analysis. The "data tags" used by the reporting language are universal, therefore information can be seamlessly compared across borders.
The immediate benefit is to the investment community, but internal and external auditors will benefit from improved benchmarking and peer analysis and better access to critical information. This level of transparency will be part of the convergence process, and will need to be considered as the profession evolves.
The SEC is supportive of the transition to XBRL filing, and has agreed to provide expedited reviews of registration statements for public companies who participate in a voluntary interactive data-filing program. In addition, SEC agreed to spend $54 million on a project to overhaul the EDGAR filing system to leverage XBRL. On Sept. 25, 2007, Cox announced the completion of the mapping of the entire GAAP system to a unique XBRL data tag.
Sustainability reporting pulls together information on non-financial factors, such as environmental, social, and governance issues, that may affect future performance, income, and value.6 This information is different than the traditional data provided on solvency. These reports contain forward-looking, nonfinancial information that enables investors to perform meaningful risk analysis and strategic planning. By some accounts, the U.S. is falling behind the international community in providing investors with information relating to the long-term sustainability of a company. Financial institutions are beginning to demand greater access to this information.7 Increasing demand for this data will result in a shift in responsibilities for some in our profession, focusing less on historical data and more on how to communicate information and use unique data to improve management performance.
These new reporting vehicles will change the focus of both internal and external auditors. In a report from the International Audit Networks on global capital markets and the global economy,8 the authors note that standard financial statements have less and less meaning and relevance. The future of auditing "lies in the need to verify the process by which company-specific information is collected, sorted, and reliably reported, and that the information presented is relevant for decision making." These changes represent a shift in perspective from the traditional historical financial statements; and will change the convergence process.
Conclusion
The idea of all these convergence efforts may spark fear in those resistant to change, but opportunities abound for CPAs eager to embrace them. There will be a need for CPAs familiar with both U.S. and international standards to assist in the transition to IFRS. Companies will be looking for experts as they reconfigure their reporting processes, and there will be a need for XBRL and IFRS trainers. At the same time, numerous challenges lie ahead. Costs and time for retraining will not be immaterial. Changes will need to be made to the CPA Exam and standard accounting curriculum. Finally, to a large degree, we may yield control of our professional guidance to an international standard-setter. This undoubtedly will affect the accounting profession in the United States as a whole. It is imperative that CPAs - in industry, practitioners, and professors - keep up with the process and continue to monitor the changes as they unfold.
1 Securities and Exchange Commission speech, http://www.sec.gov/news/speech/2007/spch080207cc.htm.
2 Securities and Exchange Commission Report and Recommendations Pursuant to Section 401 of the Sarbanes-Oxley Act of 2002 On Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers.
3 Securities and Exchange Commission speech, http://www.sec.gov/news/speech/spch040605dtn.htm.
4 Securities and Exchange Commission, http://www.sec.gov/spotlight/ifrsroadmap/ifrsroadmap-transcript.txt.
5 http://www.capmktsreg.org/research.html.
6 http://www.bfmag.com/magazine/archives/article.html?articleID=14750&Print+Y.
7 Ibid.
8 http://www.pwc.com/extweb/pwcpublications.nsf/docid/a3263860a2ac0059802572220057ef35.
Allison M. Henry, CPA, is PICPA’s vice president of professional and technical services. She can be reached at ahenry@picpa.org.
Copyright 1998-2007 PICPA. All rights reserved. Contact journal@picpa.org for reprint permission
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By Robert L. Brown, CPA
In their role as independent auditors, many CPAs work with the audit committees of commercial entities. When it comes to working with the audit committees of nonprofit entities, many of the practices and principles applicable to for-profits also apply, but certain areas require special attention. If you are called upon to help establish a nonprofit’s audit committee, there are many important factors you will need to weigh. Perhaps the most important elements that will ensure the effective operation of audit committees in a nonprofit are getting the right people to serve on the committee, setting the proper agenda, and establishing a sound relationship with the independent auditor.
Get the Right People
The most important aspect of establishing an effective audit committee is getting the right people to serve on it. While public companies are required by law to have "audit committee financial experts" on their audit committees, nonprofits don’t have that demand. While there may be CPAs on the board, there may not be enough to staff a three- or four-person audit committee. The committee should include "independent" board members, those who have no dealings with the organization other than their role as a board member or contributor. The people placed on the committee must be comfortable dealing with financial matters, the workings of balance sheets and statements of activities; be familiar with the work of auditors and their responsibilities; and, perhaps most importantly, be able to act and think independently of management. This last point is worth emphasizing. Nonprofits generally expect board members to be passionate advocates who support the organization in fund raising and in the community. There may be times when performing its function that the audit committee needs to take a hard line, whether that be regarding financial reporting, spending, or ethical matters. In those instances, the committee needs to act without hesitation. To do otherwise will place the organization’s reputation in the community at risk.
Set the Right Agenda
Good planning is critical to making an audit committee effective. Annually, the committee should compile an agenda for the full year that ensures it fulfills its fiduciary responsibilities. Important areas to address in this agenda include the following:
-- Review and approve the scope of the independent auditors’ annual audit plan and related fees.
-- Review management’s risk assessment of the organization.
-- Review any areas unique to the organization, such as executive remuneration and the procedures for handling gifts received with donor restrictions.
-- Review the organization’s plans for compliance with regulations.
-- Review the organization’s plan for identifying and resolving potential conflicts of interests.
-- Review the scope of the internal audit plan, if one exists.
-- Review the results of the annual audit with management and the independent auditors, including a report from the independent auditors regarding matters required to be communicated.
-- Review the organization’s tax returns prior to filing.
The items on the agenda should be accomplished in two or three meetings per year. At a minimum, there should be one meeting before the audit begins, to review the audit plan with the independent auditor; and one after the audit, to review the results. Other agenda items should be able to be covered at one of those meetings, depending on the timing of when they are available.
Establish a Sound Relationship with an Independent Auditor
The independent auditor, in many cases, has two important perspectives that directors do not have. First, he or she works with a finer level of detail than the directors. Second, he or she probably has several nonprofit clients, and perhaps has a practice unit dedicated to serving nonprofits. Audit committees want to establish a sound relationship with the auditor to take advantage of these perspectives. This requires establishing ground rules for communication and other expectations. The audit committee chair should be clear that the committee expects candid and forthright discussions of issues; not just financial reporting issues. Personnel matters, business best practices, or anything the auditor thinks is relevant to the committee should be communicated. The observations from the auditor can be invaluable in terms of confirming or challenging perceptions. To ensure honest dialogue, the committee needs to accept the auditors’ perspectives in confidence.
Robert L. Brown, CPA, is an assurance partner at PricewaterhouseCoopers LLP in Philadelphia. He serves on the boards of the Philadelphia Zoo and Lehigh University, and is chair of Leadership Philadelphia. He can be reached at robert.l.brown@us.pwc.com.
Copyright 1998-2007 PICPA. All rights reserved. Contact journal@picpa.org for reprint permission
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By Bruce J. Rogers, CPA, JD
If your clients are subject to the Alternative Minimum Tax (AMT), there is now a refundable AMT credit that may be available to minimize their tax hit. Individuals who have unused AMT credits that are more than three years old may be entitled to a reduction in their 2007 income tax, and possibly a greater refund.
Exposure to the AMT affects many taxpayers. It is a separately computed federal income tax that eliminates many deductions and credits otherwise available. Individuals are required to pay the higher of either their regular tax or their AMT. The AMT affects more people each year, and is expected to increase from 24 million in 2007 to more than 30 million in 2010.
Those most likely affected by the AMT include taxpayers with children; taxpayers with annual incomes between $100,000 and $500,000; and taxpayers who exercise incentive stock options, incur significant unreimbursed employee business expenses or investment fees, pay high amounts of state and local taxes, pay large amounts of home-equity loan interest, or recognize large capital gains.
AMT attributable to deferral adjustments generates an AMT credit. This credit can be used to reduce regular income tax in a later year; it cannot be used to reduce AMT liability in the year to which it is carried. In other words, if an individual is already paying AMT in a particular year, no AMT credit is allowed. Previously, the AMT credit was nonrefundable.
Congress provided for the refundable AMT credit, effective for tax years beginning after Dec. 20, 2006, in response to the burden resulting from unfavorable treatment of incentive stock options (ISO) under the AMT. Under the new rule, individuals who become subject to the AMT, or whose AMT liability increases, as a result of exercising ISOs, may be entitled to a refundable credit attributable to that AMT liability. The new rule, however, does not alleviate the immediate AMT burden resulting from the ISO exercise, as discussed below.
If a client has long-term unused AMT credit and an AMT credit for the current year, the AMT refundable credit amount can only be claimed if it is higher than the AMT credit otherwise allowed. Note, the long-term unused AMT credit is for that portion of the AMT credit for tax years before the third tax year preceding the tax year. Accordingly, the long-term unused AMT credit for 2007 takes into account unused AMT credits from 2003 and prior years, and the credits are treated as allowed on a first-in, first-out basis. The AMT refundable credit will no longer apply in determining the AMT credit for tax years starting in 2013.
According to the new provision, if this higher credit amount is more than the individual’s regular tax liability, a refund for the excess can be obtained. The amount of the refund is limited to the amount of the extra credit allowed under this rule.
For example, for 2007, Danielle has an AMT refundable credit amount equal to $20,000. Her otherwise allowable AMT credit for 2007 is $13,000. Therefore, for 2007, Danielle would use the AMT credit of $20,000, the higher AMT refundable credit amount. If Danielle’s regular income tax liability for 2007, before applying the credit, is $18,000, Danielle will only need to use $18,000 of her available $20,000 AMT credit to eliminate her 2007 regular income tax liability. She will have $2,000 of the credit remaining. The new rule allows Danielle to secure a $2,000 refund now, instead of having to wait a year.
The AMT refundable credit - before income-level reductions - is computed as follows:
-- For long-term unused AMT credit of less than $5,000, 100 percent of the credit is allowed.
-- For long-term unused AMT credit between $5,000 and $25,000, the maximum allowed is $5,000.
-- For long-term unused AMT credit greater than $25,000, 20 percent of the credit is allowed.
Here is an example of how to apply the long-term unused credit on higher amounts. In 2010, Michael has a $900,000 AMT credit, of which $800,000 is a long-term unused AMT credit. Because Michael’s long-term unused AMT credit is more than $25,000, he may only use 20 percent to compute his AMT refundable credit amount. Therefore, Michael’s AMT refundable credit amount for 2010 is $160,000 (20 percent of his $800,000). This means Michael’s AMT credit for 2010, before any limitation for high-income taxpayers, cannot be less than $160,000.
If adjusted gross income for a tax year exceeds an annually adjusted threshold amount, the AMT refundable credit amount must be reduced by an applicable percentage of that excess. For 2007, the AGI thresholds are: $156,400 for unmarried individuals; $195,500 for heads of household; $117,300 for married individuals filing separately; and $234,600 for married individuals filing jointly and surviving spouses.
Bruce J. Rogers, CPA, JD, is a manager in the tax accounting group of Duane Morris LLP in Philadelphia, and is a member of PICPA’s Personal Financial Planning Committee. He can be reached at brogers@duanemorris.com.
Copyright 1998-2007 PICPA. All rights reserved. Contact journal@picpa.org for reprint permission
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By Edward R. Jenkins Jr., CPA
The National Starch transaction model received some prominent press coverage recently, because this is the structure being used in the pending News Corp. acquisition of Dow Jones & Co. The National Starch structure can be used when a target acquisition has both a minority ownership group of shareholders that exercises control and desires a tax-free treatment of the transaction, and a larger group of shareholders comfortable with a transaction for cash, which is taxable. More common tax-free transactions detailed in Internal Revenue Code (IRC) §368 don’t work in this kind of scenario because an insufficient continuity of interest - arising from the minority, yet controlling shareholder group - precludes the use of more traditional tax-free reorganizations. The minority group may be influenced by estate planning considerations; particularly the potential to avoid income tax on the stock gain and to receive a step-up in basis via IRC §1014 as the low-basis stock transfers through an estate.
National Starch Transaction Structure
The structure of a National Starch transaction works as follows:1 The acquirer company contributes cash to a "Newco" in exchange for all of its common stock. Stockholders in the target company who desire tax-free treatment contribute their stock to the Newco in exchange for preferred stock or a different class of common stock. The Newco then acquires the remaining shares of the target for cash, or uses a merger subsidiary to complete the acquisition.
The legal underpinning of the transaction is an IRC §351 contribution of property for stock in a transferor-controlled corporation. Acquisitive use of IRC §351 is now generally common in circumstances where IRC §368 reorganizations are not desirable or feasible.
Why the Name National Starch?
The term National Starch transaction arises from the 1978 acquisition of National Starch and Chemical Company by Unilever.2 Two elderly shareholders, who together owned 14 percent of National Starch, effectively controlled the company. The two wanted to avoid income taxation on the gain and to use IRC §1014 to receive a step-up in basis for their shares when the shares passed through their respective estates.
The IRS approved the transaction in a private letter ruling, then reversed its position in Revenue Ruling 80-284, then reversed itself again four years later in Revenue Ruling 84-71, indicating that IRC §351 worked in those circumstances. IRC §351 was revised by the IRS Restructuring and Reform Act of 1998 to restrict the use of non-qualified preferred stock. Those restrictions and exceptions are part of the reason why this kind of acquisition agreement must be careful to meet those exceptions to avoid taxable treatment under IRC §351(b).
Use by News Corp.
The Form 8-K filed by News Corp. on Aug. 1, 2007, details the Dow Jones acquisition. Groups A and B of Dow Jones & Co. shareholders can receive either $60 cash per share or Class B units of Newco. Group B, which will receive Class B units of Newco, is limited to no more than 250 shareholders and no more than 10 percent in the aggregate of the outstanding shares of Dow Jones & Co. The number of units received in the exchange by Group B will be determined by dividing $60 by the weighted average closing price of News Corp.’s Class A common shares over the five trading days immediately preceding the close of the transaction. The limitations on the number of shareholders and percentage of units exchanged are intended to make sure the transaction meets the requirements and exceptions under IRC §351.
The transaction is subject to customary closing conditions and shareholder approval as of this writing. Tax counsel is to issue a tax opinion regarding the qualification of the shares contributed as an IRC §351 transaction and that the Class B units issued from Newco are not non-qualified preferred stock within the meaning of IRC §351(g).
Further Uses
The reconciliation of the divergent interests of two groups of shareholders - as in the Unilever-National Starch or the News Corp.-Dow Jones transactions - is a great use of this structure permitted under IRC §351. Other situations may be able to make use of the §351 structure. For example, circumstances may exist where a minority ownership group effectively controls the board of directors. IRC §351 can accomplish tax-free transactions for the minority group when there is insufficient continuity of interest to use the reorganization provisions of IRC §368. Another possible use of the structure could be in management buy-outs of companies. When a corporation is available for sale, and its management would like to buy out the former minority ownership while preserving some of the former minority holders’ tax attributes, a variant of the National Starch structure may work. Additionally, the non-management equity contributors for a management buy-out may want to consider a variant of the National Starch structure for the exit strategy when the time comes for the non-management equity investors to exit.
1 Ginsburg & Levin, Mergers, Acquisitions and Buyouts, Volume 2, Aspen Publishers, January 2007, p. 9-37.
2 BNA Tax and Accounting Center, Portfolio 770 3rd, http://taxandaccounting.bna.com.
Edward R. Jenkins Jr., CPA, is managing member of Jenkins & Co. LLC in Spring Grove. He is also a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at edwardj@wemanagetaxes.com.
Copyright 1998-2007 PICPA. All rights reserved. Contact journal@picpa.org for reprint permission
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By Dmitri D. Shiry, CPA
Section 404 of the Sarbanes-Oxley Act was designed to have a long life. Like anything with an extended life cycle, it seems the regulation is growing and maturing with age.
Auditing Standard No. 5 (AS 5), a new rule from the PCAOB, may change how Section 404 is perceived by corporate America and acted upon by management and auditing firms.
Make no mistake, the spirit of Section 404 is a permanent thing. The law exists to safeguard the investing public by helping to ensure that a public company’s internal controls for financial reporting are up to task. But AS 5, along with other just-released guidance from the SEC, could usher in a new era of flexibility and scalability in how the law is interpreted and carried out.
The premise behind AS 5, coupled with new SEC guidance, is that Section 404 compliance needs to become more of a top-down, risk-based activity. Compliance, therefore, would enable auditors and management to exercise more judgment in focusing on the most critical elements of the audit process, thereby eliminating excessive steps. The hope is a risk-based approach will curb the time and costs in complying with Section 404, a burden that many pundits say is affecting the competitiveness of U.S. markets.
The new standards recognize that past audits of internal controls often took an approach that involved more work performed than necessary, resulting in overkill. The purpose of AS 5 is to focus the audit from the top-down, starting with entity-level controls and stopping when the assertion is met. Those are the big picture elements, but what does a risk-based approach look like at the execution level? The following are some of the key facets.
A focus on fraud - The new rules put a stronger emphasis on the detection of fraud. This may seem curious considering the genesis of the Sarbanes-Oxley Act in 2002. Nevertheless, the former standards didn’t place as strong a spotlight on fraud relative to other types of financial reporting risks. An eye toward fraud will be more ingrained in both the planning and execution of the audit.
Eliminating the evaluation of management’s evaluation - Under the new rules, external auditors no longer have to evaluate and report on management’s process for evaluating internal controls. They only have to issue an opinion in their audit report on the effectiveness of internal controls for financial reporting. This change could reduce a layer of unnecessary work, assuming auditors can effectively audit internal controls without evaluating management’s evaluation process.
Making walkthroughs more of a stroll - Walkthroughs are when an auditor follows the path of an individual transaction, from origination to its reflection in the financial records. The new standard gives auditors more leeway in achieving the same objective without actually having to do the walkthrough, including use of a client’s internal staff or other outside resources who can perform the walkthrough under supervision of the auditor.
Creating more flexibility with multiple locations - When it comes to companies with multiple locations or business units, the new, risk-based approach gives auditors more flexibility in determining which locations need internal controls testing. Auditors are no longer bound by requirements related to coverage ratios. They can eliminate locations or units that don’t represent an appropriate level of risk to the financial statements.
Leveraging existing work - AS 5 eliminates some restrictions on where, and to what extent, auditors can use the work of other sources in assessing internal controls. This includes the work of a company’s internal audit department and other sources within the company. Risk will be the governing factor. For controls carrying low risk, auditors can use findings from other sources as principal evidence for the auditor’s opinion. For controls representing higher risk, including those related to fraud, auditors will be less able to use these findings as a sole source of evidence to substantiate operational effectiveness of the controls.
These are just a few of several changes that will arise from AS 5. They underscore an attempt to make internal control audits more feasible for public companies of all sizes and scale.
How well the new rules fare under actual implementation remains to be seen. We’ll find out as companies start closing the books for 2007, the first year for the new standard. On balance, though, AS 5 may have the right stuff to help Section 404, still a relatively new law, mature to adulthood.
Dmitri D. Shiry, CPA, is a partner with Deloitte Tax LLP in Pittsburgh, and is a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at dshiry@deloitte.com.
Copyright 1998-2007 PICPA. All rights reserved. Contact journal@picpa.org for reprint permission
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By Larry S. Blair, CPA, JD, and Carol G. Murray, CPA, JD
Business owners often choose S corporation status to eliminate the double taxation of profits that would occur with a C corporation election. One of the basic eligibility requirements for S corporation status is that only eligible shareholders can be owners.
S corporations are usually owned by a few individual shareholders, so the question of eligible shareholders is often not difficult. However, with more sophisticated business and tax planning, the likelihood is greater that an ineligible shareholder could become an owner of S corporation shares. Shareholder eligibility is an area where practitioners must take great care, since an ineligible shareholder will terminate the S corporation election.
Internal Revenue Code (IRC) §1361(b)(1)(C) states that nonresident aliens cannot be shareholders of an S corporation, and precludes foreign trusts from being S corporation shareholders. The following types of trusts are permitted to be S corporation shareholders:
-- Trusts treated as owned by a U.S. citizen or individual under the grantor trust rules (IRC §671-679). Care must be taken to make sure nonresident individuals are not involved, and that the single-deemed owner rule is considered.
-- Trusts to which stock was transferred through a will, but only for two years from the date the stock is received by the testamentary trust.
-- Voting trusts created to exercise the voting power of stock transferred to it may be a shareholder. Each beneficiary of the voting trust is treated as one shareholder of the S corporation.
-- Qualified Subchapter S Trust (QSST). QSSTs require that, during the life of the current income beneficiary, there can be only one income beneficiary. The beneficiary’s income interest must terminate on the earliest of either the beneficiary’s death or termination of the trust.
-- Electing Small Business Trusts (ESBT). The ESBT can have multiple beneficiaries, and trust income can be accumulated and sprinkled among multiple beneficiaries. A trust must elect to be treated as an ESBT, which is made by the trustee. The ESBT is treated as two separate trusts for tax liability purposes: the S portion and the non-S portion.
-- Estates.
-- Exempt organizations, as described in §401(a) and §501(c)(3).
Shareholder eligibility matters must be considered when dealing with other business aspects of S corporation ownership, such as stock transfers. For example, if a buy/sell agreement is in place, it must be structured so ineligible shareholders cannot purchase S corporation shares, or the S election is terminated.
Gifting S corporation shares can have significant tax advantages, but you must ensure that the donee is not an ineligible shareholder. The same care must be given during estate planning. Designated beneficiaries must be carefully considered. Buy/sell arrangements also should be tightly drawn to manage S corporation restrictions and prevent transfers to ineligible shareholders.
When a practitioner is involved in more sophisticated business and tax planning with regard to S corporation shares, consideration must be given to the strict rules regarding the eligibility of shareholders. An ineligible shareholder can have disastrous consequences for the S corporation and its shareholders.
Larry S. Blair, CPA, JD, is a partner with the law firm of Metz Lewis LLC in Pittsburgh, and is a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at lblair@metzlewis.com.
Carol G. Murray, CPA, JD, is an associate with Metz Lewis. She can be reached at cmurray@metzlewis.com.
Copyright 1998-2007 PICPA. All rights reserved. Contact journal@picpa.org for reprint permission
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By Ibolya Balog, CPA, and Thomas R. Clay, CPA
One of the duties of the PICPA Committee on Professional Ethics is implementation of the Joint Ethics Enforcement Program (JEEP) between the AICPA and PICPA. This process, established in 1978, permits joint enforcement of the Codes of Conduct of the AICPA and state CPA societies with respect to joint members via a single investigation and, if warranted, a single settlement agreement or joint trial board hearing.
One part of the JEEP agreement specifies that AICPA will perform all investigations of matters coming from U.S. government departments, agencies, regulatory commissions, or other units. Upon concluding an investigation, AICPA will request concurrence from PICPA’s Committee on Professional Ethics with regard to the joint member. Concurrence is sought for both the supposed violation and proposed sanction. Significance of the violation, mitigating factors, and patterns of noncompliance affect the potential conclusions, including a finding of no violation or an enforcement mechanism, such as required corrective action letter or settlement agreement. Required corrective action letters are confidential. They require no signature, and become effective 30 days from issuance, unless rejected. If rejected, the matter may go to the Joint Trial Board for a hearing.
PICPA’s Committee of Professional Ethics received numerous concurrence requests over the past year from AICPA investigations conducted under JEEP. Prior referrals had often originated with the Department of Labor, and pertained to deficiencies in employee benefit audits. More recently, the referrals have come from the Department of Health and Human Services and pertain to major program issues and various reporting matters.
The Report on National Single Audit Sampling Project was issued on June 22, 2007. Based on 208 randomly selected audits out of a population of approximately 38,000 submitted in the April 1, 2003, to March 31, 2004, time frame, 49 percent of the single audits were acceptable. Of the remaining audits, 16 percent had significant deficiencies resulting in limited reliability and 35 percent indicated no reliability. The report concluded that most problems were related to the documentation of understanding of internal controls over compliance requirements, testing of internal controls of at least some compliance requirements, and testing of at least some of the compliance requirements. The most consequential deficiencies, though less frequent, related to misreporting of major programs. One or more major programs were incorrectly identified as having been audited as a major program by 9.4 percent of the large single audit group and 6.3 percent of the smaller single audit group. The National Single Audit Sampling Project authors felt that, "though inadvertent, this is a very consequential error because report users may erroneously rely on opinions that major programs have been audited as major."
The audits reviewed in the National Single Audit Sampling Project were from a period prior to the establishment of AICPA’s Governmental Audit Quality Center, and prior to the issuance of new AICPA and GAO audit standards. Presumably these efforts have improved the results of more recent single audits. The deficiencies, however, resulted in referrals from governmental agencies such as Health and Human Services, to AICPA for ethics investigations.
Practitioners can take steps to preclude themselves from becoming a subject of referral from a federal agency for ethics investigations. Have a current and updated system of quality control, and follow it in practice, paying particular attention to the risk assessment criteria. Attend relevant CPE courses to ensure the competency of personnel assigned to single audit engagements. Respond promptly and completely, and cooperate to the fullest, to any communication received from a regulatory agency reviewing an audit. In the course of responding to an inquiry, if the member determines an error may have occurred, offer to expand the work performed and reissue the report, if necessary. Most importantly, ensure that compliance with professional standards is documented clearly and concisely in the workpapers. Unsatisfactory conclusions from these inquiries can result in sanctions against the clients as well as the auditors.
Ibolya Balog, CPA, is an assistant professor in the Department of Business, Management, and Economics of Cedar Crest College in Allentown, and a member of the Pennsylvania CPA Journal Editorial Board. She can be reached at ibalog@verizon.net.
Thomas R. Clay, CPA, is a partner with Clay & Gascoine LLC in Indiana, Pa. He can be reached at tclay@claygascoine.com.
Copyright 1998-2007 PICPA. All rights reserved. Contact journal@picpa.org for reprint permission
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By Carl W. Back Jr., CPA, and Peter N. Calcara
Last year, Gov. Edward G. Rendell signed into law Act 119, which reforms and streamlines Pennsylvania’s tax administration and appeals process.1 These changes are the most significant reforms in more than a decade, replacing the current corporate tax settlement process with an assessment and reassessment process, and standardizing the administrative appeals filing procedure.2
The so-called "settlement" process for Pennsylvania corporate tax returns was one of the most antiquated and confusing tax administration processes in the country. It caused great distress for both in-state and nonresident practitioners over the years. Soon, things will begin to change for the better.
Act 119 standardizes the use of the term "assessment" throughout the Tax Reform Code.3 This eliminates the terms "settlement" and "resettlement" from the law, bringing corporate tax in line with most other state taxes.
The Department of Revenue (DOR) has announced transition plans for the new process, which takes effect Jan. 1, 2008. Essentially, if DOR issues a settlement with a mailing date of Dec. 31, 2007, or earlier, the old settlement process will apply to that return. If DOR issues a settlement with a mailing date after Jan. 1, 2008, the new process applies, regardless of the tax period of the return or the date on which it was filed.4
Act 119’s Article 27 affects the appeals process related to corporate tax returns.5 It also influences DOR’s assessment powers for those same returns. Under the previous process, the DOR and the auditor general had 18 months to issue a required "settlement" of the return liability. For three years from that mailing date, they had the power to "resettle" the amount. The DOR administratively limited the taxpayers’ ability to request a resettlement through an amended return to a period starting on the expiration of the taxpayer’s right to petition for resettlement via appeal, and ending 18 months after the settlement mailing date.
Under Act 119, the DOR has three years from the return filing date to issue an assessment for underpaid or under-reported liabilities.6 Taxpayers have the option of filing amended returns throughout that same period. The DOR may ask tax-payers to agree to an extension of the assessment period, as in other taxes.
Act 119 did not change the rules for refund petitions. Taxpayers have three years from payment of the tax to petition for a refund. If the overpayment was due to an assessment, the taxpayer has six months to petition for a refund of the assessed tax.7 One word of caution: the three years for the DOR to assess begins when the return is filed. The three years for a taxpayer refund begins on the original date for filing the return, without regard to extensions.
Under the old settlement process, the official notification of an additional liability as determined by DOR was the settlement - or resettlement - notice. For returns under Act 119, those documents will no longer be used. The DOR will use the following notices as per the new law:
-- Notice of Adjustment - Issued when DOR makes a change to a filed return. They may be issued even if there is no tax effect. This notice does not constitute an “assessment” under Act 119.
-- Billing Notice - Used to inform taxpayers of a delinquency. This may occur if entire, self-assessed tax is not paid when return is filed. This gives the taxpayer the opportunity to pay the delinquency before an assessment is issued.
-- Assessment Notice - The official notice of a delinquent amount due. This document triggers the start of any appeal period. If the delinquency is $300 or more, the assessment must include information on the basis for assessment and must be sent by certified mail.8
-- Audit Assessment Notice - An assessment issued specifically as the result of an audit.
-- Estimated Assessment Notice - Assessment issued when, in the DOR’s view, the taxpayer fails to file a complete return. This assessment will be stricken within 90 days of receipt of a complete report. There are no appeal rights on an estimated assessment.
The old "jeopardy" settlement, issued in some cases by DOR for failure to respond to a 30-day letter request for additional information, no longer exists. The equivalent will either be an Assessment Notice - where the dollar amount in question can be determined by DOR - or an Estimated Assessment Notice - where the amount cannot be determined.9
With the law change, the auditor general has the authority, but not the duty, to audit any "determination" of tax by the DOR. The auditor general may then issue its own "determination" of tax, but those determinations must be approved by the DOR.10
Practitioners who have been filing Pennsylvania personal income tax returns will find the above very familiar - with the auditor general filling the role of the treasurer. Actually, that was the intent. Most of the major state taxes now have similar review and appeal procedures in place, so taxpayers and practitioners alike should be spared the "traps for the unwary" that used to abound under the multiple systems that used to be in place.
1 Pa. Act No. 119 (S.B. 993), Oct. 18, 2006
2 72 P.S. §7408.1
3 Act No. 119, §1
4 Id., §33
5 Id., §28
6 Id., §23
7 Id., §6
8 Id., §10
9 Id.
10 Id., §16
Carl W. Back Jr., CPA, is a partner in the state and local tax services group of SMART in Devon, and a member of the PICPA State Taxation and Multi-State Tax Conference committees. He can be reached at cback@smartgrp.com.
Peter N. Calcara is PICPA vice president of government relations. He can be reached at pcalcara@picpa.org.
Copyright 1998-2007 PICPA. All rights reserved. Contact journal@picpa.org for reprint permission
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By Joseph M. Larkin, CPA, PhD
The accounting profession is in an active and robust period. New opportunities and new demands are making the profession a hot employment environment. This is good news for graduating accounting majors, but it creates stiff competition for employers trying to attract the most talented new recruits. Many firms have started to adopt an early identification strategy to target prospective CPA employees while they are still on campus; in some cases, as early as sophomore year. Yes, this is more common among large, national or international firms, but smaller firms can use this approach as well. Here are a few points to consider in any plan to expand your recruiting efforts.
Establish a relationship with accounting faculty - Most professors are well aware of their students’ academic performance and abilities. They can serve as a valuable resource to identify promising future employees. Many students seek career advice from their professors: some express interest in international professional services firms, while others prefer a start in the private sector. If you reach out to faculty, they may keep you in mind while counseling these individuals. A good relationship with the right faculty member can establish a channel where many bright students are brought to your door.
Leverage your staff’s contacts - If you have staff members who graduated within the past few years, encourage them to identify and contact current students at their alma maters. Staff members only a few years older than students can relate to their concerns and expectations.
Get involved with campus events - Many schools have accounting societies, as well as Beta Alpha Psi or other business and professional student societies. They often seek outside speakers for meetings. This is an excellent opportunity to develop relationships with prospective hires. Students will be interested in hearing from the Big Four public accounting firms, but many graduates will start their careers in smaller firms or the private sector, and they want to hear from them as well.
Most schools have accounting-related social events, often in the fall. Contact the accounting department, student organizations, or PICPA for the times and locations of these events.
Firm members of all levels must become involved in recruiting. Students are aware of who attends campus functions. They know the difference between partners and mid-level managers. Sometimes students want to speak with the staff, but most are aware that employment decisions rest with top management. They want contact with them, as well.
Offer internships, externships, and summer employment - A time-tested way to fill full-time positions with talented individuals is to offer students the opportunity to work part-time or to visit the firm. Today, firms commonly hire seniors for summer internships. At the conclusion of the summer, many receive job offers for the following spring, after graduation.
If your firm does not need full-time summer interns, consider an externship. These programs usually cover a few days. The content of these programs is up to the imagination of the firm. It could include job shadowing, or a simple in-house meet-and-greet.
Stress growth opportunities within your organization - Accounting majors are a highly motivated group. They are concerned about starting their careers with opportunities for advancement. Outlining a student’s potential career path at your firm will help them clarify their goals, and illustrate how they can accomplish them. It will let them see themselves in your company, which moves you one step closer to bringing them on.
Large or small, all organizations possess unique circumstances that offer a special opportunity to prospective employees. The recruiting landscape is challenging. To keep up in this dynamic environment, your firm must recruit talent as early and as often as possible.
Joseph M. Larkin, CPA, PhD, is an associate professor of accounting in the Haub School of Business at Saint Joseph’s University, and is director of the accounting internship program. He can be reached at jlarkin@sju.edu.
Copyright 1998-2007 PICPA. All rights reserved. Contact journal@picpa.org for reprint permission
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By David Maturo
As a candidate in accounting and finance, there are many hurdles to clear if you decide to move on to another opportunity, but if you’ve networked well and have a resume that stirs some interest, you are ready for the next challenge: the interview. Like public speaking, interviewing for a job can be intimidating. The skill can be acquired, but it requires time and effort to perform well.
Ostensibly, an interview helps both sides determine if there is a fit between the needs of the company and the qualifications of the candidate. In reality, it is much more than that. Analysis of qualifications is done when a company compares your resume to the job specification, and hiring managers often have several candidates who appear to meet the technical requirements. Employers often find it difficult to determine the optimal technical or functional fit, so chemistry tends to be the differentiator. Thus, the main goal of the interview is to create a meaningful and memorable connection.
Be Prepared
By the time you arrive for an interview, you should already know as much about the opportunity as possible. Learn about the industry, the market, the company, and, of course, the position itself. Find out who the company’s key providers are - such as auditors, legal counsel, and bankers - and see who you can connect with there. This will give you a basic knowledge of recent company history and its current needs. Make inquiries within your personal network to identify any mutual relationships that may help build trust.
Based on your research, prepare and prioritize a list of questions you’d like answered. Consider the relevance of your questions and how they will reflect upon you. Also, try to anticipate the questions they will ask of you. Check with colleagues and other sources to make sure you have a thorough list of potential queries. Be prepared to walk through your background and field questions without having to refer to your resume.
Presentation and dress should be professional and conservative. For men, facial hair should be clean-shaven or neatly trimmed and conservative. Wear little or no jewelry. Unless specifically advised not to, wear your best suit. The point is to be presentable, but more importantly, to have nothing distract from the personal connection you need to make with your potential employer.
The Moment of Truth
Regardless of the person with whom you are meeting - an external recruiter, the hiring manager, or a potential subordinate - give them your best effort in the interview. Be yourself and let your personality shine through, but at the same time, follow the interviewer’s lead with the pace and direction of the discussion. Try to be both relaxed and conversational, as well as professional at all times. Be open, honest, confident, and friendly. Most importantly, remember the goal of establishing a personal connection: make frequent eye contact, point your chest toward the person you’re speaking with, and smile.
A common interviewing mistake is when a candidate starts on a rehearsed sales pitch and tries to force his or her way through it. This can make the free exchange of ideas difficult. Interviewers want to talk about themselves and their challenges. Encourage them by asking questions and actively listening. Understand what is important to them, and speak to it.
When an interviewer asks you about your experience, answer directly and try to elaborate, but be on point and concise. Everything you’ve done may feel important and relevant to you, but if it is not meaningful to the immediate discussion, save it for another time. Incorporate brief examples, where appropriate, to illustrate your responses.
Honesty and directness are important to establishing a relationship. If you don’t know something or are unsure, don’t pretend to know. Interviewers can smell bologna. On the other hand, seize any opportunity to turn a perceived negative into a positive. For example, if you have no experience in the type of valuation analysis in which the interviewer is inquiring, admit it, but immediately ask questions, understand the goal, and offer what analysis you do know that may serve as well. Explain the resources you have at your disposal that would help you get up to speed quickly and deliver.
Follow Up
Be sure to get everyone’s business card at the end of each meeting, and show genuine interest in moving ahead. In-quire about the next steps and when it is acceptable to follow up.
Within 24 hours, send a brief e-mail to each person to thank them for their time. Don’t sell them on who you are again. Simply reference something meaningful from your conversation that demonstrates you’ve heard them. Also, send a short, hand-written thank you note. This is a sophisticated, personal touch in a world of quick, impersonal correspondence. Continue to follow up with your point of contact, on a schedule you agree to, until you get to a conclusion.
Because interviewing is not a technical skill found in most job descriptions, many of us take the ability for granted. We all assume we can present ourselves well enough, and that our experience speaks for itself. The truth is that the skill requires preparation and practice.
We have to know what’s important to us, learn what’s important to our potential employer, and be prepared to work hard at exploring the possibility of a connection.
David Maturo is a partner with Attolon Partners LLC, an executive search firm in Philadelphia. He can be reached at dmaturo@attolon.com.
Copyright 1998-2007 PICPA. All rights reserved. Contact journal@picpa.org for reprint permission
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By Gary C. Bingel, CPA, JD
One of the hottest state tax topics today is the application of FASB Interpretation No. 48 (FIN 48). One reason for this is that the state tax arena historically has been one of high litigation and uncertainty, with relatively little guidance compared with federal tax. An area of uncertainty that is growing in importance relates to what would appear to be a basic FIN 48 question: what state and local taxes are "income taxes" for FIN 48 purposes?
FIN 48 is an interpretation of FASB Statement No. 109 (FAS 109), Accounting for Income Taxes, so the definition of "income tax" found in FAS 109 applies to FIN 48 as well. FAS 109 defines income tax as all "taxes based on income." This definition may be adequate at the federal level, but it has been subject to varying interpretations at the state and local tax levels. There are myriad taxes at the state and local level, some based on gross receipts, gross income, net worth, or combinations thereof. If "income" for FIN 48 purposes means net income, when do state addbacks become so material as to cross the line from a net income base to something else?
An example of this addback issue was the old Michigan Single Business Tax (SBT).1 While SBT calculations started with federal (net) taxable income, taxpayers would add to it all compensation and benefits, as well as depreciation, royalties paid, interest paid, among other items. For many taxpayers, these deductions were the majority of their expenses. As a result, companies with large book and tax losses would still have significant SBT liabilities.
The Pennsylvania Capital Stock and Franchise Tax (CSFT) poses another potential issue. The CSFT uses a five-year average of book income as one component of its tax base and net worth as the other. Is this considered to be a tax based on income? What portion, if any, of a company’s CSFT liability should be included in its FIN 48 analysis?
At the local level, a similar issue exists regarding local business privilege and gross receipts taxes. For instance, Philadelphia imposes a Business Privilege Tax (BPT) with two tax bases: net income and gross receipts. Taxpayers pay both. Should just the net income portion of the BPT be included in FIN 48 calculations?
The Michigan SBT, Pennsylvania CSFT, and Philadelphia BPT are only three examples of many where there is a lack of consistency and guidance. In a small, informal survey,2 various tax professionals were asked whether these taxes, among others, should be deemed "income tax" for FAS 109 and FIN 48. Majorities were achieved on most, but the only tax that had a unanimous decision was the Washington Business and Occupation Tax - 100 percent responded that it was not an income tax. Respondents thus far have been split - about 60 percent to 40 percent - against including the Michigan SBT in their FIN 48 and FAS 109 analysis. While a clear majority - about 85 percent - was against including the CSFT in FAS 109 analysis, there were still 15 percent who thought it was an income tax for these purposes. This author is aware of at least one instance where a major international accounting firm directed a client to include the CSFT in its FIN 48 analysis.
To illustrate the need for clear, consistent guidance, consider this example: one company is located in Philadelphia, the other is in Pennsylvania but outside Philadelphia. Both have similar revenue and net worth, and both have current year losses. If the Philadelphia business includes the CSFT and BPT in its FAS 109 calculations, and the other does not, the two could have materially different tax provisions and financial statements. Also, showing a loss but reflecting income taxes paid results in a negative effective tax rate. Due to these differences, investors may assume the Philadelphia business is not operating as efficiently as the other business, and base their investment decisions accordingly. This obviously does not meet the objective of FIN 48 to improve consistency and transparency of reporting for investors.
There is a clear need for a consistent interpretation of FAS 109 and FIN 48 regarding state taxes. There are several options for an analytical framework of deciding which state taxes are income taxes and which are not. One would be to link the definition of income tax for FIN 48 purposes to a definition used for other tax purposes, such as federal legislation P.L. 86-272.3 There is a fair amount of guidance on interpreting taxes in light of P.L. 86-272, but one problem with this approach is that P.L. 86-272 applies only to net income taxes. Despite this, it seems appropriate that there be some level of consistency between federal legislation, GAAP, and state legislation when it comes to defining income taxes. Unfortunately, until a proper analytical framework is devised, or appropriate guidance is issued, tax practitioners will have to make due with an "I know it when I see it" approach.
1 The "old" SBT was repealed, effective Dec. 31, 2007, and will be replaced by a new Michigan Business Tax (MBT), effective Jan. 1, 2008.
2 The results of this survey are still being compiled. Readers may access it and complete it electronically at www.smartgrp.com.
3 Public Law 86-272 is a federal statute that limits a state’s ability to impose a net income tax on businesses that limit their activities to solicitation of sales of tangible personal property.
Gary C. Bingel, CPA, JD, is managing director of tax services with SMART Business Advisory and Consulting LLC in New York. He can be reached at gbingel@smartgrp.com.
Copyright 1998-2007 PICPA. All rights reserved. Contact journal@picpa.org for reprint permission
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By Dennis G. Raible, CPA
Regulators at the Securities and Exchange Commission (SEC) have been keeping watch the last several years for the backdating of stock options. Nationwide, more than 140 companies are under investigation by the SEC and the Department of Justice (DOJ) for possible exploitation of employee stock option rules.1
The SEC first became aware of stock option machinations from an academic study by Erik Lie. Lie, finance professor at the University of Iowa, uncovered option schemes in 2004. Lie concluded that some executives were retroactively choosing grant dates that generated larger profits. Soon after publication of the study, the U.S. Congress convened hearings on the matter. Backdating schemes may be more pervasive and widespread than imagined, involving dollar amounts well in excess of prior corporate scandals.
The SEC and DOJ civil and criminal investigations are proceeding, and the hunt for violators is intensifying. The IRS has also heightened its efforts to ferret out companies that backdated stock options. In June 2007, the IRS issued a directive to its revenue agents that will influence many corporate income tax examinations.2 The directive applies to examinations of corporations with assets in excess of $10 million, and designates backdated stock options as a "Tier 1" issue. As such, backdated options joins other dubious tax issues among the highest in strategic importance to tax regulators. Revenue agents assigned to the Large and Midsize Business Division are now required to follow the mandate, and inquire about backdated stock options in all corporate examinations.
This article focuses on the general treatment of stock options under federal income tax rules, tax issues involving backdated stock options, and strategies for complying with IRS inquiries during tax examinations.
Stock Options Overview
Stock options are common incentives for executives and other employees to work efficiently and effectively toward increasing the value of company stock. In the case of executives, stock options are often a significant portion of their overall compensation package. Stock options provide the right to purchase company stock on a future date at a preset price. In many instances, the set price is the market value on the day the option is issued. If the value of a company’s stock increases, an option holder can exercise the option to acquire stock at the lower, set price. If the stock options are retroactively dated, or backdated, to a date when the company’s stock price was even lower than it was on the actual grant date, then even more profit will result when the option is exercised.
In general, the accounting rules for stock-based compensation, including stock options, require companies to measure compensation cost based on the fair market value at the grant date. The costs are recognized as expense over the period during which the employee is required to provide service.3
There are two general types of compensation-related stock options listed in the Internal Revenue Code (IRC): qualified options and nonqualified options. Qualified options include incentive stock options and options provided under employee stock purchase plans. Any other options granted in connection with performance of services are nonqualified options.
Tax Issues and Backdated Stock Options
The IRS’s directive on backdated stock options instructs revenue agents to make factual determinations as to whether corporations under examination exhibit any of the three principal tax issue criteria associated with the illegal scheme.
Deductibility of Compensation Expense - In general, IRC §162(m) places an annual limit of $1 million per employee on a publicly traded company’s allowable deduction for compensation paid to the CEO and the four most-highly compensated officers. The regulations also state that "qualified performance-based compensation" is exempt from the $1 million limitation.4 Stock options issued to executives would qualify as performance-based compensation. To qualify for the exception, however, an option must have an exercise price that equals or exceeds the fair market value of the stock on the grant date. If a company played with the SEC rules and backdated executive options, then the exception contained in the regulations would not be met. Therefore, any compensation expense exceeding $1 million that includes misclassified stock options would not be an entirely allowable deduction, and would result in an additional tax assessment.
Qualification as ISO - Because incentive stock option (ISO) rules require an option’s exercise price to not be less than the fair market value of the stock at the time of grant,5 companies that backdate stock options to a lower exercise price, and then treat such options as ISOs for tax return purposes, may find that the options do not qualify as ISOs. The misclassified options could result in unexpected employer withholding, income, or employment tax obligations due on gains realized at the time the options were exercised.
Classification as Discounted Options - If an option was backdated to a lower discounted exercise price, then the "discounted option" may be subject to IRC §409A, which covers nonqualified deferred compensation.6 Taxable income is recognized under IRC §409A as discounted stock options become vested, regardless of whether the options have been exercised. Interestingly, the new law provides that in addition to the regular federal tax on the reclassified transaction, the taxable income will be subject to an additional 20 percent tax. Generally, §409A does not apply to options granted before Jan. 1, 2005, but it does apply to discounted options that were not earned and vested as of Dec. 31, 2004, and to discounted options that were materially modified after Oct. 3, 2004. Under the original transition rules, taxpayers had until Dec. 31, 2007, to amend options to avoid problems under §409A. In September 2007, the IRS announced that taxpayers will have until Dec. 31, 2008, to bring documents into compliance with the final nonqualified deferred compensation regulations. For options granted to certain executives subject to certain disclosure rules of the Securities Exchange Act of 1934, the transition rule was available only through Dec. 31, 2006.
The IRS directive requires agents to make a determination early on in corporate examinations as to whether a backdating of option exercise dates occurred. This ensures that sufficient time remains on the statutory period for assessment on employees’ individual tax returns. Even if a corporation did not participate in a misdating ploy, revenue agents will likely request and inspect copies of the individual tax returns of corporate officers to determine if stock options were treated properly. If necessary, examining agents will place the individual income tax returns under examination if they find that the treatment afforded options on the corporate tax return is inconsistent with reporting on the individual tax returns.
IRS Examination Strategies
The IRS mandates an information document request in all corporate examinations to determine whether backdated stock options are an issue. During a tax examination, respond to all IRS inquiries and furnish all documents sought by the revenue agent. If circumstances make it difficult for a taxpayer to comply with an agent’s requests in a full and timely fashion, most IRS examiners will work with taxpayer representatives to find alternative means to satisfy inquiries.
Companies under IRS examination that did not take part in misdating options could still receive an information document request seeking information to determine whether the company complied with the provisions in IRC §162(m). Corporate tax managers may have to produce executive compensation records, summaries of deferred compensation arrangements, contracts, compensation committee minutes, a description of records, the names of authorizing individuals, and methods used by executives to exercise stock options to satisfy an agent’s inquiry.
If an IRS examiner establishes that a company did misclassify stock options, the IRS will ask the taxpayer to provide various documents, including any SEC filings, internal audit reports, and independent investigative reports. Additionally, the IRS will inquire about the names and positions of executives, exercise prices, the backdate, grant and exercise dates, and the fair market value of underlying stock at key dates.
If a company receives notification that the IRS will be initiating an examination, yet an audit has not commenced, company officials may consider filing a statement with the assigned agent to disclose the existence of backdated stock options. A disclosure made before the corporate examination commences will minimize the likelihood of an accuracy-related penalty being assessed.7 Any resulting stock option tax issues can be rolled up in the agent’s final report.
If a company had backdated stock options in the past, but has not received official notification of an IRS examination, the best course of action to consider is reassessing the company’s tax obligations pertaining to misclassified options and, if necessary, file an amended tax return. The company also may want to consider any withholding and employment tax issues and, if appropriate, amend previously filed returns. Finally, if an appraisal of the corporation’s treatment of misdated options has an effect other than what was originally reported to recipients or employees, the company should notify the individuals and take all necessary actions to treat stock options properly. In some instances, employees may be required to file amended individual income tax returns to reflect the revised corporate classification of stock options.
If a revenue agent proposes an increase in corporate taxable income because backdated options were found, a taxpayer can expect the accuracy-related penalty to be assessed for that portion of an underpayment of tax, attributable to negligence or disregard of rules or regulations, or to any portion attributable to any substantial understatement of tax.8
Several media releases reported that some accounting and law firms reviewed and approved the decisions by compensation committees to backdate stock options.9 If a legal or accounting firm was the preparer of a corporate tax return that incorrectly reported misdated options, and circumstances indicate the preparer’s direct involvement in the decision to backdate the options, then an examining agent may consider a referral to the IRS Director of Practice.10 In such an instance, the return preparer would likely be subject to penalties under IRC §6694.11
By one estimate, more than 2,000 companies may have illegally backdated stock options.12 Most believe that unlawful backdating is now harder for companies to hide from the SEC. Much of the stock option backdating reported in the media appears to have been done prior to the 2002 enactment of the Sarbanes-Oxley Act, which requires grants of stock options to be reported within two days of grant. The two-day reporting requirement may make stock option backdating more difficult, but until the IRS rescinds its directive to Large and Midsize Business Division revenue agents, all corporate returns in the examination pipeline, as well as those scheduled to be examined in the near future, will continue to undergo IRS scrutiny.
1 "Stock Options Backdating," The Wall Street Journal chart of companies under scrutiny, http://online.wsj.com/public/resources/ documents/info-optionsscore06-full.html
2 Industry Director Directive on Backdated Stock Options, Directive #1. Walter L. Harris, director, field specialists, June 15, 2007.
3 Statement of Financial Accounting Standards No. 123(R) is effective for all companies for reporting periods after Dec. 31, 2005, and is a revision of FAS No. 123, Accounting for Stock-Based Compensation.
4 Treas. Reg. §1.162-27(e)(2)(vi)
5 IRC §422(b)(4)
6 The American Jobs Creation Act of 2004 added §409A to the IRC, which provides specific rules governing the tax treatment of nonqualified deferred compensation.
7 IRC §6662(b)(1) & (2) provides for an accuracy-related penalty attributable to the portion of any underpayment of tax attributable to negligence or disregard of rules or regulations, or any substantial understatement of income tax.
8 IRC §6662(b)(1) & (2)
9 "A Founder of Brooks Faces Charges Over Option," Ross Kerber, Boston Globe, July 27, 2007. "Backdating Conviction, A Big First," Eric Dash and Matt Richtel, The New York Times, Aug. 8, 2007.
10 Treasury Department Circular No. 230. If a practitioner is found to have violated any provision of the laws or regulations, they may be censured, suspended, or barred from practice before the IRS, including disbarment and suspension from practice as an attorney, certified public accountant, public accountant, or actuary.
11 IRC §6694(a) provides that income tax preparers shall pay penalties due to an understatement of liability due to unrealistic positions. IRC §6694(b) states that an income tax return preparer shall pay a penalty due to any understatement of liability due to willful or reckless conduct.
12 "Backdating of Executive Stock Option (ESO) Grants," Erik Lie, University of Iowa, www.biz.uiowa.edu/faculty/elie/backdating.htm.
Sidebar 1: Tax Implications of Options
Qualified Options
Corporations. No compensation expense deduction is generally allowable to a corporation with respect to the grant or exercise of qualified options.
Individual Recipients. An employee who receives an incentive stock option (ISO) recognizes income at the time stock is sold, not upon the grant or exercise of the stock option. If certain holding period rules are satisfied, gains on the shares acquired by exercising ISO are taxed as capital gains.*
Nonqualified Options
Corporations. Corporations are entitled to a deduction for compensation expense equal to the amount of ordinary income included in the gross income of the option recipient. A deduction is allowable to a corporation in the same taxable year the employee reports gross income.
Individual Recipients. A nonqualified stock option is taxed to the recipient when it is granted if the option has a readily ascertainable fair market value at that time. If the nonqualified option does not have a readily ascertainable value, then the exercise of the option, and not the grant of the option, is when the individual recognizes ordinary income.
* For purposes of the individual Alternative Minimum Tax, the transfer of stock on the exercise of an incentive stock option is treated as the transfer of stock pursuant to a nonqualified plan.
Sidebar 2: Recent Legislative Attempt to Control Options
This past September, U.S. Senator Carl Levin introduced legislation (S. 2116) that would require a company’s tax deductions for stock option compensation to equal the expense shown on its corporate financial reports filed with the SEC. The legislation would allow corporations to deduct stock option compensation in the same year it is recorded on company books, without waiting for the options to be exercised. The bill would also eliminate favored treatment of corporate executive stock options under IRC §162(m) by making executive stock option compensation deductions part of the existing $1 million limit on deductions that apply to other types of compensation paid to the CEO and the four most highly compensated officers of a publicly held corporation.
Dennis G. Raible, CPA, is a full-time visiting instructor in the accounting department of Saint Joseph’s University, and a member of Raible, Cornaglia, Wenstrom & Raible LLC in Cherry Hill, N.J. He also is recently retired from the IRS’s Large and Midsized Business Division. He can be reached at draible@sju.edu.
Copyright 1998-2007 PICPA. All rights reserved. Contact journal@picpa.org for reprint permission
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By Benjamin Hodes, PhD
Many CPAs are active in their communities. Many of those happen to volunteer their precious time to nonprofit organizations. You may be a CPA in a top position, or you may be a loyal foot soldier for a cause. Either way, evaluating the not-for-profit organization’s leaders - or adopting key leadership traits - could be critical to the success of the organization in which you believe and invest so much time.
The leadership capacity of a nonprofit or exempt organization is extremely important. These organizations often play a critical role in the community, and the organization’s leadership capacity will determine whether or not the fundamental purpose of the organization is effectively articulated and will drive the quality of its strategies. Articulation of purpose and quality of strategy motivate the internal and external supporters of an organization, which is critical to obtaining the financial resources needed to sustain the organization and retain highly qualified staff.
Assessing Leadership
The evaluation of nonprofit leadership can be difficult because it requires a little bit more of a forward-looking perspective, unlike for-profits where historical perspective and past financial results can be used as a benchmark. Whether you serve on a nonprofit board, advise a not-for-profit, or volunteer your time serving a community organization, following some of the points below can provide insight and guidance regarding the leadership capacity of the nonprofit organization.
Evaluation of the board of directors is a good place to start:
-- The board should encourage leadership from the executive director, and this expectation should be explicit in the executive’s job description.
-- The board should encourage leadership training for the executive.
-- Clear goals need to be established for the executive, and they must deal with expected outcomes.
-- The board should insist on a high-performance culture that is outcomes-driven.
-- The board should provide the time and support necessary for the executive to practice leadership.
The next set of points highlight the role of the executive, and his or her leadership capacity:
-- The executive must have a vision for the organization, and articulate it in a persuasive manner.
-- The executive must ensure fidelity to the mission of the organization through measurable or visible ways.
-- The executive should receive leadership training, and should be recognized as a leading voice in the area with which the agency is identified.
-- The executive must be aware of the trends in his or her field, and provide concrete examples to staff that will motivate them to move forward.
-- The executive must encourage trust among the stakeholders in measurable or visible ways.
-- The executive must develop effective and measurable strategies for furthering the mission.
The last set of points that will help you assess leadership capacity concerns the organization’s staff:
-- There should be widespread trust in the executive.
-- The direction of the organization must be clear to all staff.
-- The staff must be challenged and encouraged as they pursue the movement of a mission toward social impact.
-- Creativity must be encouraged and rewarded.
-- There should be a widespread perception that the executive “lives the mission” and models the appropriate behaviors.
Leadership Insights
Four highly regarded leaders in the nonprofit sector were interviewed to obtain their thoughts and views regarding the key issues relating to nonprofit leadership.
Kenneth C. McCrory, CPA, CVA, CFE, mentioned several key issues relating to the leadership of nonprofits and how CPAs might relate to them. McCrory is co-founding partner of McCrory and McDowell LLC in Pittsburgh, which offers a broad array of ser-vices targeted toward both for-profit and nonprofit organizations. From a CPA perspective, considerations of nonprofit leadership are not so much related to audit practice, but rather fall into the category of general business and management.
As such, McCrory emphasizes the need for understanding the board’s role with regard to policy and the executive’s role concerning operations. The chair, for example, has a significant role in the support and protection of the executive, and the prevention of the board straying into management functions. He also emphasizes the mission-driven aspects of a nonprofit and the need to be careful about setting goals that do not reflect the social purpose of the exempt organization. A final point made by McCrory is the need to understand the leadership style of the executive, which will help promote effective communication.
Walter Smith, PhD, is executive director of Family Resources, an agency with the mission to prevent and treat child abuse by strengthening families and neighborhoods. He says the cause-driven nature of nonprofits makes it essential that the leader fundamentally believes in the importance of what he or she is doing. A leader will convince people to follow by demonstrating a sincere passion for the cause and get everyone on the same page because he or she believes the "mission is bigger than we are." Every aspect, including how money is managed, should reflect the mission, and the staff need to be continually aligned with the mission by reinforcing the message of what the organization stands for and why it is in existence. Other points made by Smith include the following:
-- Responsibility equals leadership.
-- Values should inform leadership and leadership should inform values.
-- Outcomes should show up in conversations.
-- The agency should make a difference in the community.
-- Agency leaders must focus beyond internal operations.
Saleem Ghubril, executive director of the Pittsburgh Project, is a well-regarded nonprofit leader in Pittsburgh. The Pittsburgh Project is a community development organization that serves vulnerable residents through an array of youth development programs, homeowner services, and community outreach. Effective nonprofit leaders, according to Ghubril, should do the following:
-- Develop others with an emphasis on the servant-leader model.
-- Envision the highest aspirations.
-- Constantly invoke the vision and the ultimate purpose of the organization.
-- Align the leadership with the organization’s direction.
-- Uphold the dignity of those served by the organization.
-- Live the purpose and values of the organization.
Marilyn Sullivan is executive director of Bethlehem Haven, which aids homeless women by providing them with supportive housing and helping them achieve self-sufficiency. Sullivan believes a strong infrastructure is needed to support leadership. This infrastructure should include explicit expectations, clear goals and objectives, and support. She also believes leaders should focus on strategic thinking, looking at the bigger picture and "around corners" to better position the organization for the future. Other points that Sullivan says are critical include the following:
-- Leaders should continually monitor the organization’s strengths, weaknesses, opportunities, and threats.
-- Leaders need to be aware of life-cycle issues relating to the organization’s programs.
-- Leaders must ensure that appropriate policies and procedures are in place and are adhered to.
Leadership
Leadership, it should be made clear, is not the same as management. Too often, the two are confused. A useful distinction between management and leadership can be found at the online encyclopedia, Wikipedia: "management has to do with power by position; whereas leadership involves power by influence."
The line between the two is not always clear. One thing that is clear, however, is that excellent leaders do not always make excellent managers; nor do excellent managers always make excellent leaders.
There are some who are natural born leaders, but leadership skills can be learned and developed through appropriate training. Please note, there is not just one effective leadership style.
Some leaders are "nice people" and some are not; some are extroverted and some are introverted; some are egocentric and some are self-effacing.
While leaders may have different leadership styles, there are four general attributes that effective leaders do have in common:
-- Leaders have followers. Without followers you cannot lead.
-- Leaders communicate effectively. Leaders are able to be clear regarding the aspirations or vision of the organization, and thus motivate people to work together to achieve that vision and honor the organizational mission.
-- Leaders lead by example. Leaders display the behaviors they expect everyone in the organization to exhibit. This certainly includes ethical behavior, but it also includes a willingness to pitch in and add the extra effort to achieve the desired result.
-- Leaders are strategic. Good leaders develop strategies that make the organization effective and move the organization steadily forward.
Despite the fact that effective leaders display a variety of personalities, styles, and interests, they usually manifest similar behaviors:
-- Leaders focus their attention on what is likely to have the greatest positive effect for the organization.
-- Leaders focus on the organization’s mission and continually seek meaningful outcomes.
-- Leaders foster a culture of high performance, concentrating on the value that individuals are adding to the organization and not personal feelings of likes and dislikes.
-- Leaders can recruit individuals who are smarter or more talented than they are without fear of being overshadowed.
-- Leaders are genuine as individuals, and behave in ways that are consistent with their moral and ethical principles. This is an important element in building trust, without which one cannot be an effective leader.
While nonprofit organizations often have a number of stakeholders - such as funders, recipients of services, and communities at large - among the most important stakeholders are the employees of the organization. This group makes up, to the largest extent, the cadre of followers whom the executive leads.
A good leader will professionally nurture these followers. To do this, the leader should possess sufficient self-awareness to promote effective communication and professional relationships, provide encouragement and support through mentoring, build trust by living the organizational mission, and encourage high performance by implementing a fair and equitable system of evaluation that includes rewards for achievement. A good leader prepares his followers for the future by providing opportunities for growth, allowing for mistakes, and mentoring.
Conclusion
Good leadership is a necessary condition for ensuring the sustainability of a nonprofit organization. The operations of an organization could be flawlessly executed, but the organization could fail because of the wrong strategy or lack of support for the leader. Failure to adequately respond to changes in the environments in which a nonprofit organization fun | |
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