CPA Journal Feb-14

www.cpaj.com February 2014

+

SEC Focus on Fraud

Analysis of PCAOB Inspections

Achieving Excellence

IN FOCUS INTERVIEWSLeslie F. Seidman

Cynthia M. Fornelli

in Financial Reporting and Auditing

Standards Overload

6 Perspectives

SEC Comment Letter Trends

Publisher’s Column: Succession: A Process, Not a Plan

Correction

Should the Accounting Profession EmbraceMandatory Audit Firm Rotation?

A Reference for Audits of Single FinancialStatements and Specific Elements, Accounts, or

Items of a Financial Statement

16 In Focus

Enhancing Financial ReportingAn Interview with Leslie F. Seidman, Former FASB

Chairman and Director of the Pace University Center forExcellence in Financial Reporting

By Maria L. Murphy

Leslie F. Seidman, FASB chairman from December 2010 to June 2013, is now applying her standards-setting acumen and heraccounting and auditing experience to her new role as executive

director of the Center for Excellence in Financial Reporting at PaceUniversity’s Lubin School of Business. Seidman and CPA JournalEditor-in-Chief Maria L. Murphy discussed the responsibilities ofher new position and her views on the future of standards setting.

Improving Audit QualityAn Interview with Cynthia M. Fornelli,

Executive Director of the Center for Audit QualityBy Maria L. Murphy

For seven years, Cynthia M. Fornelli has served as executive direc-tor of the Center for Audit Quality, whose mission is to to enhance

investor confidence and the public’s trust in global capital markets.Fornelli and CPA Journal Editor-in-Chief Maria L. Murphy

discussed the CAQ’s current projects, as well as the importance oftransparency and the role of audit committees.

C O N T E N T Sf e b r u a r y 2 0 1 4

6PERSPECTIVES

Permission to reprint The CPA Journal articles is granted with few exceptions. Written requests indicating title, author, publication date, and intended use of the reprint should be made prior to each use by writing to the Assistant Editor. The views expressed in articles published in The CPA Journal are those of the authors and not necessarily those of The CPA Journal, unless otherwise indicated. Articles con-tain information believed by the authors to be accurate as of original publication. The reader should not construe the content included in The CPA Journal as accounting, legal, or other professional advice. Ifspecific professional advice or assistance is required, the services of a competent professional should be sought.The CPA Journal (ISSN 0732-8435) is published monthly by The New York State Society of Certified Public Accountants, 14 Wall Street, New York, NY 10005. Subscription Rate: $59.00; Periodicals postage paid at NY, NY and additional mailing offices. POSTMASTER: Send address changes to The CPA Journal, 14 Wall Street, New York, NY 10005, Attn: Subscription Department.

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IN FOCUS16

ESSENTIALS32 Accounting & Auditing

y AuditingQuality Control Criticisms in PCAOB Inspection Reports:

Analyzing the Characteristics of Triennial Firms with and without Deficiencies

By Alan I. Blankley, David S. Kerr,and Casper E. Wiggins

y Standards SettingProposed Conceptual Changes in Financial Reporting:

The Problem of Competing Frameworks and Disclosure Overload

By Robert A. Dyson

48 Taxation y State & Local Taxation

Planning for the New Jersey Inheritance TaxBy Jim Lynch

52 Financey Retirement Planning

Developing Strategic Partnerships with Small Businessesin Retirement Planning: A Review of Recent

Changes and Plan Design OpportunitiesBy Matthew Gaglio and Fely J. Cieza

56 Management

y Practice ManagementStrategic Planning for Small Accounting Practices:

Insights on Services and Satisfaction from the MAP SurveyBy Charles R. Pryor and Jack Elfrink

61 Responsibilities & Leadership

y Regulation of the Profession The Experience Requirement for CPA Licensure:

A Historical and State-by-State ReviewBy Jack Armitage

68 Technology

y Electronic ReportingThe SEC’s Renewed Focus on Accounting Fraud:

Insights and Implications for Auditorsand Public Companies

By Douglas M. Boyle, James F. Boyle,and Brian W. Carpenter

y What to BookmarkWebsite of the Month: North American Securities

Administrators AssociationBy Susan B. Anders

74 Classified Ads

79 Economic & Market Data

80 EditorialApplying Technology to Accounting Fraud

v o l . L X X X I V / n o . 2

32 ESSENTIALS56

PublisherJOANNE S. BARRY

Associate PublisherCOLLEEN LUTOLF

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THE CPA JOURNAL (ISSN 0732-8435, USPS 049-970) is published monthly by The New York StateSociety of Certified Public Accountants, 14 Wall Street, New York, NY 10005. Copyright 2014 by The NewYork State Society of Certified Public Accountants. Subscription rates: NYSSCPA Members (Basic Rate):$30.00. Non-members, United States possessions, Canada, one year $59.00; Students (Undergraduate andGraduate) $30.00; Foreign $71.00; Single copy $10.00. All sub scriptions and remittances may be sent inUnited States funds to The CPA Journal, The New York State Society of Certified Public Accountants, P.O.Box 10489, Uniondale, NY 11555-0489. • Periodicals postage paid at New York, NY and additional mail-ing offices. The matters contained in this publication, unless otherwise stated, are the statements and opin-ions of their authors and are not promulgations by the Soci ety. Publishers Copy Protection Clause:Advertisers and advertising agencies assume liability for all con tent (including text, representation, and illustrations) herefrom made against the publisher. POSTMASTER: Please send address changes to:The CPA Journal, 14 Wall Street, New York, NY 10005, Attn: Sub scription Department. The CPA Journalis a registered trademark of The New York State Society of CPAs.

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FEBRUARY 2014 / THE CPA JOURNAL6

Income TaxesRealizability of deferred tax assets.

The guidance under AccountingStandards Codification (ASC) Topic740, “Income Taxes,” requires a valu-ation allowance on deferred tax assetsif, based upon the weight of availableevidence, it is more likely than not thatsome or all of the deferred tax assetswill not be realized. A company mustconsider both positive and negative evi-dence when determining whether a val-uation allowance is needed. Whenweighting available evidence, compa-nies should consider how objectivelyverifiable it is.

The SEC staff frequently askscompanies to explain how they haveevaluated both the positive and nega-tive evidence when reversing a valua-tion allowance, including— n the magnitude and duration of pastlosses and the expected magnitude andduration of profitability;n the factors leading to losses inprior periods and current profitability;andn the accuracy of income (loss) fore-casts in prior periods, as compared toactual results.

The SEC staff expects companies toprovide disclosures explaining the cir-cumstances that gave rise to thereversal of a valuation allowance.

Projecting future taxable incomerequires estimates and judgmentsabout future events. Companies shouldconsider how much actual results havedeviated from forecasted results in thepast. When significant deviations havehistorically existed, projections of futureincome might be less objectively veri-fiable and might deserve a lowerweighting in the consideration of allavailable evidence. Companies shouldalso ensure that projections used as pos-itive evidence are consistent with pro-jections used to support other accountbalances in the financial statements, suchas in impairment assessments.

Foreign earnings. Companies canovercome the presumption in ASCTopic 740 that all undistributed foreignearnings will be transferred to the par-ent company. No income taxes shouldbe accrued by the parent if sufficientevidence shows that the foreign sub-sidiary or foreign corporate joint ven-ture has invested or will invest theundistributed earnings indefinitely.

The SEC staff frequently challengescompanies’ assertions that foreign earn-ings will be indefinitely reinvested. TheSEC staff has asked companies toexplain how they have overcome thepresumption and to provide evidenceof specific reinvestment plans for for-eign earnings (e.g., past experience,working capital forecasts, long-termliquidity plans, capital improvementprograms, merger and acquisitionplans, investment plans). The inquiries

By Jeremy Simons

t is that time of year when many public companies are in the midst of thefinancial reporting season and nearing the deadline to file audited financialstatements with the SEC. Before putting the finishing touches on theirForms 10-K, companies and their financial advisors might find it helpful tounderstand the latest trends in SEC comment letters in order to enhance theirdocumentation of accounting positions and their disclosure packages. The fol-

lowing sections discuss the areas of most frequent comment by the SEC staff, aswell as a few of the SEC staff’s disclosure tips. Even if a company does notencounter these specific issues, the SEC staff’s comment approach for a partic-ular topic often carries through to other areas.

SEC Comment Letter Trends

I

P E R S P E C T I V E Ss e c p r a c t i c e

(Continues on page 8)

FEBRUARY 2014 / THE CPA JOURNAL 7

p u b l i s h e r ’ s c o l u m n

In this month’s issue of The CPAJournal, authors Charles R. Pryor and

Jack Elfrink provide solid advice forsole proprietors and single firm ownerslooking to grow their firms (“StrategicPlanning for Small Accounting Practices:Insights on Services and Satisfaction fromthe MAP Survey,” p. 56). But what manyCPAs might not—or, according to arecent study, do not—want to consider ishow critical a successful succession planis not only to a firm’s success, but alsoto its very survival.

The Importance of Succession PlanningAccording to the AICPA’s “2012 Private

Companies Practice Section SuccessionSurvey,” fewer than half of multiownerfirms and an alarmingly scant 6% of solepractitioners have a written succession plan.Although managing partners are free to dowhat they want with their firms, those con-cerned about the overall future of the pro-fession should realize that their own firm’sfuture plays a part in that process.Converging demographic, technological,and regulatory forces have created a “per-fect storm” that will have deleteriouseffects on the profession. If that’s notenough to grab firm leaders’ attention, firmsuccession planning is also a personal issue.Without the proper succession plan inplace, a catastrophic illness can have afinancially calamitous effect on the firmpartners’ and employees’ families, as wellas the future of the firm itself.

In the NYSSCPA’s latest economicoutlook survey, a majority of the C-levelCPAs polled said that they or theiremployees were delaying retirement plans,with an overwhelming majority citing theeconomy as the driving factor. This fac-tor, combined with a dearth of young peo-ple entering the profession, will result in

a severe shortage of firm successors. Ifyou are a senior or managing partnerand you do not think you need a succes-sion plan just yet, it might be prudent toask yourself some key questions: If youwere to suddenly leave the firm due tohealth, family, or professional reasons, isthere a plan in place to ensure an order-ly transition for future management? Ifyou are a sole proprietor, does your firm

have a roster of CPAs waiting in thewings to take over the business? Are youremployees aware of what their responsi-bilities would be if you are no longer ableto work? If there are no ownership can-didates in your ranks, would you be inter-ested in merging your practice with anoth-er local firm? Because many firms havenot actively planned to replace theirretiring partners, an explosion of firmmergers in the upcoming decade seemslikely. Firm leaders have to start planningnow for the inevitable sale of their firms,and part of that plan must include identi-fying and preparing future firm leaders.

Encouraging TalentWhy are the trusted professionals that so

many Americans turn to when planningfor their financial futures so hesitant toplan for their own? Many CPAs find devel-oping a successor to be too expensive, donot have a lot of confidence in the pool oftalent they have in the firm, might feelthreatened or pressured to retire beforethey’re ready, or just don’t want to thinkabout giving up control of the firm they ded-icated a significant portion of their lives to.There’s another reason—creating a succes-sion plan forces firm leaders to take a hardand realistic look at their firm’s culture,which might need fixing, and their ownmanagement skills, which might be lacking.

The most critical part of this process isdeveloping a pool of talent within the firm,not just one individual. This is a processthat includes easing into deploying con-trol to other individuals. It fosters account-ability and is also a crucial element ofbuilding leadership. If there is a lack ofleadership talent within the firm, manag-ing partners should look outside the firmfor the right individuals and then bringthem into the fold.

For more resources on succession plan-ning, members should remember that theNYSSCPA has an entire committee divi-sion dedicated to firm practice issues forfirms of every size. Membership on thesecommittees is free for NYSSCPA members,and teleconferencing into monthly meetingsis available. Contact Nereida Gomez,Manager of Committees and AdministrativeServices, at [email protected], for moredetails. q

Joanne S. Barry, CAEPublisher, The CPA JournalExecutive Director & CEO, [email protected]

Succession: A Process, Not a Plan

surrounding permanent reinvestment areoften accompanied by a request to recon-cile a company’s assertion with the dis-cussion of liquidity in management’s dis-cussion and analysis (MD&A).

Reportable SegmentsConsistent with the guidance under ASC

Topic 280, “Segment Reporting,” segmentdisclosures should be based on the “man-agement approach” (i.e., aligned with acompany’s internal management report-ing structure). As a result, the SEC staffoften requests that companies provide adiscussion of their internal structure, anorganization chart, and examples ofresource allocation decisions to support theidentification of operating segments whenresponding to SEC comment letters. Inaddition, the SEC staff often asks to seethe financial information that is providedto a company’s chief operating decisionmaker (CODM), board of directors, andaudit committee. When the CODM regu-larly receives reports that present discreteoperating results for business units, theSEC staff presumes that the CODM usesthese reports to manage and assess per-formance and allocate resources, thusimplicating those business units as operat-ing segments.

The SEC staff routinely expands itsreview of available public informationabout a company, including MD&A, pressreleases, earnings calls, websites, andindustry or analyst presentations. The SECstaff has asked companies to explain anyperceived inconsistencies between themanner in which their business isdescribed in their segment disclosures andelsewhere.

When a company concludes that oper-ating segments can be aggregated into areportable segment, the SEC staff oftenrequests the company to provide a detailedanalysis of how the aggregation criteriawere considered in reaching that conclu-sion. The SEC staff will challenge a com-pany’s conclusion to aggregate operatingsegments when historical or projectedfinancial information suggests that the oper-ating segments do not have similar eco-nomic characteristics, as defined in ASCTopic 280.

A company should consider howchanges in its business might affect its seg-ment reporting. For example, the SEC staffmight want to understand how a signifi-cant acquisition or changes in performanceamong operating segments affected the seg-ment reporting conclusions.

Goodwill ImpairmentThe SEC staff requests that companies

discuss in MD&A the possibility offuture impairment of goodwill for anyreporting unit with an estimated fair valuethat does not substantially exceed its car-rying value (i.e., the reporting unit is at riskof failing a future Step 1 impairment testunder ASC Topic 350, “Intangibles—

Goodwill and Other”). For these “at-risk”reporting units, the SEC staff asks for thefollowing disclosures in MD&A: n The carrying value of the reportingunit n The percentage by which fair value ofthe reporting unit exceeded the carryingvalue for the most recent impairment test n A description of the methods and keyassumptions used to determine fair valueand how the key assumptions were derivedn A discussion of the degree of uncer-tainties associated with key assumptions

n A discussion of any potential events,trends, or changes in circumstances thatcould reasonably be expected to negative-ly affect the key assumptions.

The SEC staff has recently requestedsupplemental information and additionaldisclosures in MD&A that better describethe timing of any impairment charges.

The ASC Topic 350 goodwill guidanceallows companies to perform qualitative,rather than quantitative, impairment assess-ments under certain circumstances. The SECstaff has requested additional informationsurrounding those qualitative judgmentswhen a company concludes that it is morelikely than not that goodwill is not impaired.

Fair Value Measurements The guidance under ASC Topic 820,

“Fair Value Measurement,” requires com-panies to disclose which level within thefair value hierarchy certain fair value mea-surements are categorized. This hierarchyis based upon the inputs used in valuationtechniques, as follows:n Level 1. Quoted prices (unadjusted) inactive markets for identical assets and lia-bilities that the reporting entity can assessat the measurement daten Level 2. Inputs other than quotedprices in active markets for identical assetsand liabilities that are observable, eitherdirectly or indirectly n Level 3. Unobservable inputs.

The SEC staff has questioned compa-nies about their basis for classifying cer-tain assets or liabilities in a particular cat-egory within the hierarchy when the fairvalue measurements are determined inter-nally—for example, the SEC staff remainsskeptical about the classification of cer-tain instruments, such as loans and war-rants, as Level 2 rather than Level 3.

The SEC staff often asks companies toprovide more robust disclosures about thevaluation techniques and inputs they use indetermining fair value. They also ques-tion companies about fair value measure-ments determined using multiple valuationtechniques and the weighting assigned tomultiple valuation indications.

The fair value guidance requires com-panies to disclose the valuation processesrelated to their Level 3 measurements,quantitative information about the signifi-


(Continued from page 6)

The SEC staff often

asks companies to

provide more robust

disclosures about the

valuation techniques

and inputs they use in

determining fair value.

cant unobservable inputs they use in deter-mining these fair value measurements, anda description of the sensitivity of the fairvalue measurements to changes in thesesignificant unobservable inputs. The SECstaff has focused on the following:n When companies disclose a widerange of significant unobservable inputs fora given class of assets or liabilities, dis-closure of weighted-average information orexpanded discussion of the reasons for thiswide range, in order to provide additionalcontext and understanding for investors n When certain classes of assets or lia-bilities are valued using different methods,separate disclosure of the population val-ued under each method n Enhanced disclosures about valuationprocesses, including how a company deter-mines its policies and procedures andhow it analyzes changes in fair value mea-surements from period to period n Expanded descriptions of a fair valuemeasurement’s sensitivity to changes inunobservable inputs in order to addressall of the unobservable inputs for whichquantitative information is provided and toexplain how the inputs significantly affectthe fair value measurement.

Loss Contingencies Despite the fact that the guidance for

loss contingencies has existed for manyyears, the SEC staff continues to findnoncompliance with its disclosurerequirements (ASC 450-20); thus, compa-nies might find it helpful to refresh them-selves on that guidance. In particular, com-panies should remember to disclose 1) theamount or range of reasonably possiblelosses above the amount accrued, 2) thatan amount above any amount accrued isnot material to the financial statements (notjust the balance sheet), or 3) that theamount or range cannot be estimated. TheSEC staff does not object when companiesdisclose the amount or range of reasonablypossible loss on an aggregate basis, whichcan help companies avoid disclosing prej-udicial information.

Recently, the SEC staff has been chal-lenging whether a company’s disclosuresevolve appropriately as loss contingencymatters progress. A company’s narrativeshould include how each matter has devel-

oped over time and how key developmentshave affected the disclosures or amounts rec-ognized in the financial statements. The SECstaff has also focused on a company’s pro-cess for developing an estimated loss orrange of loss, particularly when the com-pany has legal cases that remain open forseveral years. When a loss contingency issettled, the SEC staff will generally revisitprior-period disclosures to see whether theywere adequate and whether the loss recog-nized at the time of settlement was record-ed in the correct period. The SEC staffparticularly challenges the lack of prior-peri-od accruals or the disclosure of a range ofprobable losses when “surprise” settlementsoccur for long-standing legal matters.

Revenue RecognitionGross versus net presentation. For

some companies, determining whetherrevenue should be reported gross or netof certain amounts paid to others can bechallenging. This reporting depends uponwhether the company functions as aprincipal or agent in the revenue transac-tion. The guidance on principal and agentconsiderations under ASC 605-45 doesnot provide any bright lines on whethergross or net presentation is appropriate;rather, it provides indicators suggestinggross or net reporting that often requirecompanies to apply considerable judgmentto their specific facts and circumstances.Companies in service and technologyindustries that do not carry inventory areespecially likely to be questioned by the

SEC staff about gross versus net deter-minations.

The SEC staff frequently requests thatcompanies provide their analyses of each ofthe indicators identified in the guidance tosupport their conclusions. The SEC staff hasdiscussed companies’ consideration of thetwo “strong” indicators of gross reporting:primary obligor and general inventory risk.The SEC staff has indicated that grossreporting is generally appropriate only whenat least one of the two strong indicators ispresent. The SEC staff generally evaluatesthe arrangement and each of the indicatorsfrom the customer’s perspective.

Multiple-element arrangements. Theguidance under ASC 605-25 addresses the

accounting for revenue arrangements withmultiple deliverables—for example, a com-pany may provide multiple products, ser-vices, or combinations thereof to its cus-tomers as part of a single arrangement. Insuch cases, the SEC staff frequentlyrequests that companies do the following:n Provide a complete description of rightsand obligations, separate from the discus-sion of the accounting for those rightsand obligations. n Disclose the judgments made in con-cluding whether a deliverable is or is not aseparate unit of accounting, and, if a deliv-erable is deemed to be perfunctory, disclosethe reasons supporting this conclusion. n Provide an analysis of how the totalarrangement consideration was allocated toeach unit of accounting, explaining how


Recently, the SEC staff has been challenging

whether a company’s disclosures evolve appropriately

as loss contingency matters progress.

the estimated selling price for each wasdetermined and any significant assumptionsused in this determination. n Provide a discussion of the timing andpattern of recognition for each unit ofaccounting.

Long-term contracts. The SEC staffrequests that companies provide addition-al information in the notes to the financialstatements and MD&A when they applythe contract accounting guidance underASC 605-35. Specifically, the SEC staffasks companies to disclose more detailedinformation about changes in estimatesassociated with these arrangements.

MD&AThis continues to be the most frequent

area of SEC staff comment, with disclo-

sures of results of operations being themost frequent area of comment withinMD&A. The SEC staff continues torequest that companies disclose not onlythe significant changes that occurred in theresults of operations, but also why theyoccurred. Companies should quantify anddiscuss the underlying factors that led tosignificant changes in financial statementline items.

In addition, the SEC staff also notes thatdisclosures about critical accounting esti-mates are often too general and shouldnot merely repeat the disclosures alreadyincluded in the significant accounting poli-cies notes to the financial statements.Instead, they should give insight into man-agement’s judgments about accountingpolicies that are subject to the mostuncertainty and complexity.

Companies should consider disclosingthe amounts outstanding and available atthe balance sheet date under each sourceof liquidity. These disclosures also shouldhighlight the company’s cash needs overthe next 12 months, including any signif-icant planned capital expenditures andwhether these expenditures are necessaryor discretionary.

In addition, the SEC staff commonlyasks companies to explain why certainamounts have been excluded from the con-tractual obligations table. They have pub-licly stated that if uncertainties exist aboutthe amounts and timing of certain con-tractual obligations (e.g., variable interestpayments, unrecognized tax benefits,expected payments or contributions to ben-efit plans), a company may include thoseitems within the table and disclose itsassumptions about amounts and timing inan explanatory note to the table.Alternatively, the SEC staff would notobject to a company disclosing uncertainitems only in a footnote to the table. Thefootnotes also should be used to disclosewhich obligations have been included andexcluded from the table.

Non-GAAP Measures The SEC staff requests that companies

modify or remove disclosures when theygive greater prominence to non-GAAPfinancial measures than to GAAP mea-sures. For example, the SEC staff objects

to companies presenting full non-GAAPincome statements. In addition, the SECstaff frequently comments on the require-ment to reconcile a non-GAAP measure tothe most directly comparable GAAPmeasure and disclose the usefulness ofthe non-GAAP measure to investors. Theyoften question companies when their dis-closure indicates that the non-GAAPmeasure is presented as a liquidity mea-sure (e.g., used to assess ability to servicedebt, generate cash flows, or fund acqui-sitions and capital expenditures), but thenon-GAAP measure is reconciled only toa performance measure, such as netincome.

Additional Disclosure TipsIn addition to the disclosure improvement

ideas gleaned from SEC comment letters,companies should consider the followingadvice provided by the SEC staff:n Challenge existing disclosures to makethem clearer and more transparent.n Ensure consistency between matters dis-closed within the financial statements anddiscussed elsewhere in the Form 10-K andwithin other information that is publiclyavailable.n Explain the timing of significant incomeand expense items.n Use precise and defined language. Usingterms that are not defined or understood inU.S. GAAP can confuse readers. n Remove disclosures that relate to mat-ters that are no longer material, includ-ing immaterial disclosures provided inresponse to prior SEC comment letters.The SEC staff believes disclosures thatfocus only on material items are morepowerful.n Eliminate excess information and redun-dancy by looking for ways to streamlinedisclosures.n Provide a clear description of signif-icant accounting policies when severalalternatives are available under U.S.GAAP. q

Jeremy Simons, CPA, is a partner, assur-ance services–professional practice, atErnst & Young LLP, New York, N.Y. Theview expressed here are his own and notnecessarily those of Ernst & Young LLP.


CORRECTION

In “Statutes of Limitationsfor Personal Income Tax

Returns: An Overview of StateRules and Requirements,” byAndrew S. Griffith andKatherine A. Kinkela, pub-lished in the January 2014issue of The CPA Journal, thefinal 10 rows of Exhibit 2,Omission of Income (page47)—from Georgia throughKansas—were inadvertentlyduplicated from Exhibit 3,Amended Returns; althoughthe information is correct inthe context of Exhibit 3, itdoes not belong in Exhibit2.The editors apologize forthe error.

Should the AccountingProfession Embrace

Mandatory Audit FirmRotation?

By Arthur J. Radin

The subject of mandatory audit firmrotation has been periodically dis-

cussed in the United States over the last 80years, starting with the adoption of theSecurities Acts in the early 1930s. Mostrecently, on August 16, 2011, the PCAOBissued Release 2011-006, “Concept Releaseon Auditor and Audit Firm Rotation.”Since then, the PCAOB has closed thehearings and has listed the issue on its 2014agenda, the 10th of 12 such items.Congress rejected the concept when itpassed the Sarbanes-Oxley Act (SOX) of2002, although the law requested that theU.S. Comptroller General study a relatedissue: consolidation in the accountingprofession. In 2013, with the passage ofsection 104 of the Jumpstart Our BusinessStartups (JOBS) Act, Congress specifical-ly prohibited the PCAOB from requiringmandatory auditor rotation of companiescovered by that law. Other countries arealso considering or have adopted variousforms of mandatory auditor rotation.

Members of the accounting professionhave almost unanimously rejected the con-cept of mandatory auditor rotation, but Ibelieve that we would be better served byaccepting it. I find the arguments againstmandatory rotation unconvincing. Given thenever-ending skepticism the profession facesfrom the public, it should lobby for auditfirm rotation. Our focus should be on therules of rotation—that is, which are requiredto make rotation work and which are notneeded? This discussion will focus on thegeneral concept of rotation, rather thanaddressing specific details, such as for howmany years an auditor may serve or whenan auditor can return to an audit.

Addressing the Profession’s ChallengesThe auditing profession is facing many

challenges that could be ameliorated by therequired rotation of auditing firms, such asindependence, lack of competition, and reg-

ulatory overload. Because our clients pay us,the public has always questioned our inde-pendence. This issue is a significant source ofthe “expectations gap.” Engagements that lastfor many years add fuel to this public doubt.The lack of acceptance of auditor indepen-dence is supported by a belief that we are“in bed” with our clients, who have retainedus for many years and have supported ourincomes over that time. In an effort to elim-inate this negative perception, we have

imposed on ourselves, and have had imposedon us by laws and regulators, massive inde-pendence rules; however, these rules fail toaddress the psychological effect on audit part-ners who know that the loss of an important,substantial client would significantly affecttheir compensation and standing in the firm.

The profession is also impeded becausethe vast majority of public company auditsis concentrated in the four largest firms. The“second tier” picks up a moderate number ofpublic company audits, leaving many small-er audit firms with a very small number ofpublic company clients. In addition, the pro-fession is saddled with intra-profession peerreview, PCAOB inspections, and regulatorsthat write more and more detailed rules. Weshould restructure the profession to create a

high level of public trust, which the currentlevels of independence rules and outsideinspections have failed to achieve. To do this,I suggest we turn to mandatory firm rotation.

Concerns Expressed by Commenters Why would firm rotation work? It would

make many of the issues of independenceirrelevant because it would force auditors tobe highly skeptical and mentally independent.Members of the profession, as well as legis-lators and regulators, could then take theappropriate position that the auditor is psy-chologically independent, due to the aware-ness that in a number of years, a new replace-ment auditor will be in a position to exposeany major mistakes or even minor cover-ups.Thus, there would be no reason for an audi-tor to “go along” with a client just to protecta long-term revenue stream.

The PCAOB’s 40-page concept releaseon audit firm rotation received 684 lettersof comment, and the PCAOB held threeroundtables, resulting in 2,007 pages of tran-scripts and 74 submitted papers. (All of thesedocuments are publically available on thePCAOB website.) My sampling of the let-ters and comments found that the respon-dents almost universally opposed mandato-ry rotation, raising the following objections:n Mandatory rotation would raise auditcosts, as each new firm would face a learn-ing curve for which they would have tocharge clients.n Mandatory rotation would result inclients having higher internal costs, as theywould have to “train” a new set of audi-tors after each rotation.n There is little or no objective evidencethat the adage “a new broom sweeps clean”would occur in practice.n Many audit failures occur in the earlyyears after the appointment of a newauditor.n The small number of firms able to handlelarge international audits makes it difficult forsuch companies to find a new auditor.n Public companies might be forced toretain a less experienced auditor in light ofthe small number of large internationalaudit firms.n The number of accounting firms will-ing to perform audits of public companieswould drop as a result of the inability toretain a client indefinitely.


v i e w p o i n t

Members of the

accounting profession

have almost unanimously

rejected the concept of

mandatory auditor

rotation, but I believe

that we would be better

served by accepting it.

Numerous articles have been publishedon auditor rotation. The Deloitte responseto the request for comment evaluatedempirical studies and listed 37 articlesthat opposed mandatory rotation, 8 articlesthat supported mandatory rotation, and 4articles that were neutral on the topic.Nonempirical “opinion” studies have alsobeen performed. None appeared to besufficiently cogent to be quoted in theresponses I studied.

The Case for RotationIt is almost impossible to address

these objections empirically, because thereis no data on mandatory rotation. Theauditors of large and small public com-panies change frequently; I do not believe

that the start-up costs would be as sig-nificant as some of the respondents haveclaimed. Institutions such as New YorkState require periodic bidding on auditsinvolving entities that are larger than mostpublic companies.

Furthermore, there is no empirical dataon the learning-curve costs for a compa-ny being audited by a new firm. Suchcosts might be insignificant, or they mightnot exist at all. Some studies have indi-cated that audit failures are more likelyto occur on a new engagement, ratherthan a long-standing relationship, butthese studies do not appear to have beendecisive. If mandatory rotation were inplace, there would be greater demand forinternational auditing firms. The supplyresponse to this development wouldincrease competition and spread audit-ing knowledge.

Because all of these studies appear notto have produced empirical data that wouldsupport an objective opinion, one is leftwith the following subjective questions:n Is audit error more likely to be createdby a long-time audit firm wanting to keepits client happy, or by a new audit firmlacking experience with the client and anunderstanding of the issues or where theissues might be hidden?n Will there be increased audit costs fora new firm, and can they be mitigated bygreater competition?n Will mandatory rotation create the needfor more firms, resulting in greater com-petition, or will the inability to maintainlong-term clients drive firms out of busi-ness? Will the need for clients to reach out

beyond the Big Four result in greater expo-sure for second-tier and smaller firms,thereby creating more competition?n Would mandatory rotation decreaseindividual auditor expertise, as changewould drive young auditors out of firms,or would the need for more firms createadded opportunities?n Would an auditor try to do a better jobby thinking that a good audit would retainthe client or by worrying that a successorwould find fault?

Under mandatory rotation, the entire areaof independence would have to be reevalu-ated. For mandatory rotation to be viable, thecurrent independence rules would have to berelaxed. SEC Regulation S-X Article 2,covering the qualifications of accountants,contains detailed rules covering auditors andtheir families with respect to various types offinancial arrangements that would render

the firm not independent. Furthermore,there are many services that, if provided,would render a firm not independent. In theUnited States, the share ownership rulesrequire a large number of individuals to eval-uate these details. Large audit firms havecomputer systems to track partner and staffownership of securities. Internationally, theshare ownership rules create issues; more sig-nificantly, they affect the rendering of legaland bookkeeping services, which are appro-priate in other countries. These rules mayblock firms from being able to bid onaudits, reducing the number of potential ser-vice providers.

In its periodic reports and speeches, thePCAOB has emphasized that it has foundexamples of a lack of skepticism, inade-quate audit support, and excessive relianceon management representations in itsinspections. It seems unlikely that eithermandatory rotation—or the lack there-of—would affect these issues.

Finding a SolutionMany of the comments on the concept

release sent to the PCAOB describe sug-gested improvements in auditor indepen-dence, effectively saying that mandatoryaudit firm rotation would not be neces-sary if the independence rules were revisedaccordingly. Suggestions include improv-ing communications with audit commit-tees, having more accountants on auditcommittees, requiring better public com-pany disclosures, and discussing PCAOBinspection findings with the audit com-mittee. One suggestion is that audit com-mittees become more involved in auditorindependence. But is it really useful to havedirectors parsing the profession’s lengthy,esoteric rules on independence? I believethat these responses demonstrate the inabil-ity of the comment-letter writers to direct-ly address the question. The profession hascollectively taken a position against manda-tory rotation without any real basis.Given the points above, I believe weshould rethink this issue. q

Arthur J. Radin, CPA, is the managingpartner of Radin, Glass & Co. LLP, NewYork, N.Y. He is also a member of TheCPA Journal Editorial Board.


If mandatory rotation were in place, there would be

greater demand for international auditing firms.

The supply response to this development would

increase competition and spread auditing knowledge.


a u d i t i n g

A Reference for Auditsof Single Financial

Statements andSpecific Elements,

Accounts, or Items ofa Financial Statement

By Joyce C. Lambert

The recent Clarity Project revised the stan-dard for audits of financial statements

and specific elements, accounts, or items ofa financial statement. This quick referenceguide will review the new standard AU-Csection 805, “Special Considerations:Audits of Financial Statements and SpecificElements, Accounts, or Items of a FinancialStatement.” CPAs should consider the exam-ple provided in the sidebar, IndependentAuditor’s Report, and the flowchart ofaudits of specific elements, accounts, or itemsof a financial statement shown in the Exhibit.

OverviewIn some cases, a business might not need

an audit of all its financial statements, butonly of one financial statement. In othercases, a business might only request anaudit of an element, account, or item in thefinancial statements (i.e., an “account”). Forexample, an auditor might audit all thefinancial statements and the business mightalso request an opinion on an account, orthe auditor might only audit one account.In some situations, the auditor might notgive an opinion on a specific account with-out auditing the financial statements. AU- Csection 805 does not apply to an audit ofgroup financial statements by a componentauditor at the request of a group engage-ment team.

When auditing a single financial state-ment or a specific account, it is necessaryto audit any interrelated accounts, includ-ing any related notes to the financialstatements. When performing an audit ofa financial statement or an account, anauditor must understand the reason theaudit was requested, the appropriatefinancial reporting framework, and who theusers of the report are. When auditing a

single statement, the auditor should deter-mine materiality based upon that financialstatement. If the audit is of a specificaccount, the auditor should determine mate-riality based upon that specific account,rather than the entire set of financial state-ments. If auditing several accounts, theauditor should determine materiality foreach individual account, not the total of theaccounts.

Account based on stockholders’ equi-ty or net income. When auditing a spe-cific account, the auditor should determineif that account is based on stockholders’equity. If it is, the auditor must obtainenough evidence to express an opinion onfinancial position. As a practical matter,this requirement would mandate auditing

the balance sheet. The auditor should alsodetermine if the account is based on netincome. If it is, the auditor should obtainenough evidence to express an opinion onfinancial position and results of opera-tions. As a practical matter, this require-ment would mandate auditing these finan-cial statements, but not the cash flowstatement.

Modified Opinion on the CompleteFinancial Statements

When auditing all of the financial state-ments and giving a modified audit opinion,an auditor should determine how this modi-fication would affect the opinion on the spe-cific account, if any. This effect depends uponwhether the modification is due to an account-ing deficiency or an audit deficiency.

For example, consider a business thatrefused to capitalize a material lease. A qual-ified audit opinion would be issued, due to thematerial accounting deficiency on the overall

financial statements. If the business requestsan audit of property, plant, and equipment, theopinion on these accounts would be affected.Because the modification of the completefinancial statements affects a specificaccount, the auditor is required to give anadverse opinion on that specific account.

On the other hand, if the auditor gave aqualified opinion on the complete financialstatements, due to an inability to obtain suf-ficient appropriate evidence, the auditorwould disclaim an opinion on the specificaccount. If the auditor were unable to con-firm receivables that are material, nor applyalternative procedures, the auditor wouldqualify the opinion on the complete finan-cial statements. In this case, if the businessrequested an opinion on its accounts receiv-

able, the auditor would disclaim an opinionon the schedule of receivables.

If the audit opinion on the completefinancial statements is adverse or a dis-claimer of opinion, a piecemeal opinion ona specific account that would contradict theoverall opinion cannot be given. In somecases, an opinion on a specific accountwould not contradict the overall opinion.In these cases, an auditor can express anunmodified opinion on the specific accountif the following two conditions are met:1) the item is not a major portion of thefinancial statements, and 2) the opinionon the specific account is not publishedtogether with the opinion on the completefinancial statements.

The balance sheet or income statementis a major part of the complete financialstatements; therefore, an auditor cannotgive an opinion on either one if the audi-tor gave an adverse or disclaimer of opin-ion on the complete financial statements.

When auditing a single financial statement or a

specific account, it is necessary to audit any

interrelated accounts, including any related notes

to the financial statements.

Emphasis-of-Matter or Other-MatterParagraphs

When an auditor has audited the entirefinancial statements and included an empha-sis-of-matter or other-matter paragraph in theaudit opinion, the auditor should determinehow this would affect the opinion on thespecific account, if at all. If the paragraph is

relevant to the specific account, the auditorshould include a similar paragraph in the opin-ion on the specific account.

Incomplete Presentation That Is Otherwise GAAP

The guidance for reporting on an incom-plete presentation that is otherwise GAAP

is now included under AU-C section 805.When reporting on an incomplete presenta-tion that is otherwise in accordance withGAAP, such as a partial balance sheet or apartial income statement, the auditor shouldinclude an emphasis paragraph in the report.This paragraph should state the purpose ofthe presentation and should refer to the foot-


EXHIBITAudit of a Specific Item, Element, or Account of a Financial Statement

*If the financial statement opinion has an emphasis-of-matter or other-matter paragraph related to a specific item,then include the paragraph in the opinion on the specific account.

Audited the financial

statements*

Unmodified opinion

Qualified due to specific account’slack of evidence

Qualified due to specific account’smaterial misstatement

Gave adverse ordisclaimer on the

financial statements

Give opinion on the account

Disclaimer on the account

Adverse opinion on the account

Do not give opinion on the account

Give opinion on theaccount only as a

separate report

Item is minor portion of the

financial statements

Item is majorportion of

the financialstatements

Item not based on net income or

stockholders’ equityDid not audit the financialstatements

Item based on stockholders’ equity

Must audit financial position

Must audit financialposition and results

of operations

Give opinion on the account

Give opinion onthe account

Give opinion on theaccount

Item based on net income


note that describes the basis of the presenta-tion. In addition, the emphasis paragraphshould indicate that the presentation is notintended to be a complete presentation of theentity’s assets, liabilities, revenues, or expens-es. Examples include an audit of certain assetsand liabilities to be sold but not the entire bal-ance sheet, or an audit of direct operatingexpenses but not the entire income statement.

Specific Elements, Accounts, or Itemsof a Financial Statement

The following are examples of specificelements, accounts, or items of a financialstatement, as provided in the appendix toAU-C section 805:n Accounts receivablen Allowance for doubtful accountsn Inventoryn Liability for accrued benefits of privatebenefit plansn Intangible assetsn Reported claims in an insurance port-folio and notesn Schedule of externally managed assetsand income of private benefits plans andnotesn Schedule of disbursement in relation toleased property and notesn Schedule of profit participation andnotesn Schedule of employee bonuses andnotes.

A Quick ReferenceThe Exhibit presents a flowchart of the

audit of a specific item, element, or accountof a financial statement. It is divided intotwo sections: when the auditor has audit-ed the complete financial statements andwhen the auditor has not audited thecomplete financial statements. AU-C sec-tion 805 describes the requirements ofauditing a single financial statement, andit changes the previous guidance onauditing a specific element, account, oritem of the financial statement. This shortguide provides a quick reference for anauditor dealing with these audits. q

Joyce C. Lambert, PhD, CPA, CIA, is theArthur Andersen Professor of Accountingat the University of New Orleans, NewOrleans, La.

The following example illustrates the report on an audit of accounts receivable and a completeset of GAAP financial statements; the example is taken from AU-C section 805, Illustration 3:

Independent Auditor’s Report[Appropriate Addressee]

Report on the Schedule We have audited the accompanying schedule of accounts receivable of ABC Company as of

December 31, 20X1, and the related notes (the schedule).

Management’s Responsibility for the Schedule Management is responsible for the preparation and fair presentation of this schedule in accor-

dance with accounting principles generally accepted in the United States of America; this includesthe design, implementation, and maintenance of internal control relevant to the preparation and fairpresentation of the schedule that is free from material misstatement, whether due to fraud or error.

Auditor’s ResponsibilityOur responsibility is to express an opinion on the schedule based on our audits. We conducted

our audits in accordance with auditing standards generally accepted in the United States ofAmerica. Those standards require that we plan and perform the audit to obtain reasonable assur-ance about whether the schedule is free from material misstatement.

An audit involves performing procedures to obtain audit evidence about the amounts and disclo-sures in the schedule. The procedures selected depend on the auditor’s judgment, including theassessment of the risks of material misstatement of the schedule, whether due to fraud or error. Inmaking those risk assessments, the auditor considers internal control relevant to the entity’s prepa-ration and fair presentation of the schedule in order to design audit procedures that are appropriatein the circumstances, but not for the purpose of expressing an opinion on the effectiveness of theentity’s internal control. Accordingly, we express no such opinion. An audit also includes evaluatingthe appropriateness of accounting policies used and the reasonableness of significant accountingestimates made by management, as well as evaluating the overall presentation of the schedule.

We believe that the audit evidence we have obtained is sufficient and appropriate to provide abasis for our audit opinion.

OpinionIn our opinion, the schedule referred to above presents fairly, in all material respects, the

accounts receivable of ABC Company as of December 31, 20X1, in accordance with accountingprinciples generally accepted in the United States of America.

Other MatterWe have audited, in accordance with auditing standards generally accepted in the United States

of America, the financial statements of ABC Company as of and for the year ended December 31,20X1, and our report thereon, dated March 15, 20X2, expressed an unmodified opinion on thosefinancial statements.

Report on Other Legal and Regulatory Requirements [Form and content may vary]

[Auditor’s Signature] [Auditor’s city and state] [Date of the auditor’s report]

INDEPENDENT AUDITOR’S REPORT

EnhancingFinancial Reporting

In Focus

Phot

os b

y Ro

bert

Hor

ne


Former FASB Chairman and Executive Director of the PaceUniversity Center for Excellence in Financial Reporting

By Maria L. Murphy

InterviewAn

Leslie F. Seidmanwith

L eslie F. Seidman served as FASB chairman from December 2010 to June 2013, a culmination of her dis-tinguished career with the organization, first as an industry fellow, later as an assistant director of researchand technical activities, and then as a member of the board. As chairman, she led FASB in providingguidance on global and domestic concerns. ❱❱

18 FEBRUARY 2014 / THE CPA JOURNAL

Seidman is now applying her standards-setting acumen, as well as her accountingand auditing experience with privatecompanies, nonprofit organizations, andpublic companies, to her next role: execu-tive director of the Center for Excellencein Financial Reporting at Pace University’sLubin School of Business. She was alsorecently elected to the board of directorsof Moody’s Corporation.

Seidman met with CPA Journal Editor-in-Chief Maria L. Murphy to discuss herformer role as FASB chairman, her viewson the future goals of FASB and other stan-dards setters, and the details of her newposition. Seidman’s last appearance in TheCPA Journal was an interview publishedin the December 2011 issue.

Looking BackThe CPA Journal: To start off, can you

tell us a little bit about your backgroundand how you first came to FASB?

Leslie F. Seidman: I started my career inpublic accounting and then moved into indus-try, working for JPMorgan in the account-ing policy department. Part of my role wasto monitor what was happening at FASB,and I really got a front-row view. I also par-ticipated in a number of industry groups,where we shared information aboutaccounting issues and developments. WhenI went to a meeting of Financial ExecutivesInternational (FEI) in Chicago with the con-troller of JPMorgan, FASB Board MemberVictor H. Brown made an appeal to indi-viduals who were knowledgeable aboutderivatives, securitizations, and other finan-cial products to come to FASB as a two-yearfellow. On the plane home from Chicago, Isaid, ‘I want to do that,’ and JPMorgan wassupportive of that decision. I was on the staffas a fellow, a project manager, and an assis-tant director, for a total of five years.

Following my work at FASB, I went offon my own and became a financial report-ing consultant providing advisory services. Idid some litigation support work, technicaladvising, and training, and I wrote mybook on financial instruments. Then I got aphone call saying that one of the membersof FASB had stepped down and askingwhether I was interested in being considered.I ended up being appointed to FASB in2003, and I served a total of 10 years onthe board. As you know, I finished up myterm—we have term limits at FASB, a max-imum of 10 years—in June 2013.

What’s interesting about that particularperiod of time is that it was marked by anumber of significant economic and envi-ronmental developments. At the beginning,it was the post-Enron era, and then thefinancial crisis hit. There were a coupleof other environmental developments thatare really important, one being the fulsomeintroduction of the Internet. I think that hada significant effect on the level of interestin what FASB was doing; the ability ofFASB to communicate quickly and broad-ly; and the opportunity for others, includ-ing the media and our stakeholders, to par-ticipate real-time in the process. So therewas a heightened interest—I would sayheightened scrutiny—and heightened par-ticipation in the standards-setting process.

There are pluses and minuses to all of thosedevelopments, but it certainly was an inter-esting time to be at FASB.

CPAJ: Being FASB chairman has tobe a very different experience than otherstaff positions. What was your greatestchallenge in that role?

Seidman: I would say the biggest differ-ence between being a member of the boardand being the chairman of the organizationis the responsibility for being the primary pointperson, in terms of communications and alsostrategy. I don’t really think my challenge interms of technical matters was that differentfrom any other board member. But from astrategic standpoint, the most significant chal-lenge that I faced as the chairman during mytenure was to make sure that the organiza-tion was focusing on the right issues in lightof competing demands and priorities.

To appreciate the significance of thechallenge, you have to understand that theenvironment changes quite quickly. FASBhas a responsibility to the profession andto the public to make sure that it is address-ing the financial reporting issues that aremost important to investors. When I tookover as chairman, the agenda was pretty

locked down in terms of the things that theorganization had been working on, pri-marily relating to convergence with inter-national standards. But this was also dur ingthe financial crisis, which meant a coupleof things: organizations had relatively fewerresources, dealt with relatively more reg-ulation, and faced increased scrutiny. Therewere many people weighing in on whatFASB should be working on—includingCongress. For example, when events likeMF Global happened, they wanted to makesure we were reviewing the accounting forrepurchase agreements; likewise, there wasan increased focus on off–balance sheetaccounting issues.

We had to constantly look at the priori-ties of the organization in light of the feed-

back that we were getting from other play-ers in the system. I tried to make sure wehad regular contact with our stakeholders,including our advisory councils but also theSEC staff and the PCAOB staff—the folkswho are really on the front lines—to makesure we were responsive to the need forany enhancements or additions to theaccounting standards themselves. That meantthat some projects needed to be suspendedor put on the back burner to make room formatters that were considered more press-ing. That’s not an easy thing to do after somany people have invested so much timeand effort on a topic; but I think we madethe right decisions based on the informationwe had at the time.

FASB’s MissionCPAJ: The mission of FASB, as com-

municated by the new chairman, is “toestablish and improve standards of finan-cial accounting and reporting that fosterfinancial reporting by nongovernmentalentities that provides decision-useful infor-mation to investors and other users offinancial reports.” What is your overallperspective on this mission?

We had to constantly look at the priorities of the organization

in light of the feedback that we were gettingfrom other players in the system.


Seidman: You mentioned that the newchairman, Russell G. Golden, articulatedthis mission. But let me reassure you thatwhile the people might change, the mis-sion has not changed for the 40 years thatthe organization has been in existence.Every employee at FASB embraces thesame mission.

The way I’ve always thought about themission is that it is to try to develop stan-dards that present economic activity in aconsistent, unbiased way so that peopleusing financial statements can makeinformed decisions. This is very consistentwith the articulation from Russ, but it isin my own words, with an emphasis on acouple of different points. It’s important tounderstand that FASB is not a regulator,

and FASB is not trying to carry out pub-lic policy. FASB is just trying to tellcompanies how to report their activities ina consistent, faithful manner—it’s as sim-ple as that.

CPAJ: Many in the media are asking,‘Who are these investors?’ Does this referto sophisticated investors? Does it refer tomom-and-pops that buy common stock?

Seidman: FASB means to include in theterm ‘investors’ a broad base of individualswho are making decisions about where todeploy their capital on the basis of reportedfinancial information. That could includeequity investors; that could include lenders—those are clearly investors. It applies to cur-rent investors but also potential investors, andthis is a very important point for those whothink that management really is the primaryuser of financial statements. FASB does notembrace that view. The financials need tostand on their own so that someone outsidethe reporting entity can make an informeddecision about whether to invest. Wealways tack on ‘and other users of financialstatements’—for example, donors in a non-profit context, who are not technicallyinvestors but certainly are making decisions

about where to put their money; suppliers ina commercial setting; regulators; and others.

One point I want to emphasize is thatFASB does expect that all of those partic-ipants have made a reasonable effort tounderstand the financial statements. As toyour point, there are plenty of mom-and-pops out there, myself included, who areknowledgeable and expe-rienced in reading finan-cial statements. But it’s notFASB’s goal to teachbasic economic conceptsthrough the standards.There is an expectationthat the users of financialstatements have a reason-able amount of knowledge

about economics, finance,and accounting so thatthey can make informeddecisions on that basis.You want to keep it assimple as possible, but nottoo simple.

CPAJ: That reallyexplains why it’s so diffi-cult to define the term“investor,” because thereare so many different levels of sophistica-tion. In addition, the nature of what is beingreported on is complicated. How couldFASB meet its mission statement? Howcould financial statement users ever havea reasonable amount of knowledge?

Seidman: You’re making an importantpoint: there are varying levels of sophistica-tion, but even among those with the samelevel of sophistication, they don’t all agreeand they don’t all have the same perspec-tive or priorities. Some might be long-terminvestors, whereas others, like debt investors,are primarily concerned about the ability toget their cash back. What FASB tries to dois solicit input from all of these types of indi-viduals about what they believe to be the

most important and useful information. ThenFASB tries to provide information that willbe useful to most people, and align the deci-sions with the conceptual framework so thatit fits into the broader body of GAAP.

CPAJ: Along the same lines—and thiswas covered extensively at the AICPANational Conference on Current SEC and

PCAOB Developments in December—investors are requiring additional infor-mation. Is it that they really need moreinformation, or just different information?For example, do investors want forward-looking information rather than the basichistorical results model?

Seidman: You would get a differentanswer from every investor or otheruser of financial statements that youspoke with, but I think that there are caseswhere there’s so much information beingdisclosed that it’s just not clear what isthe most important at any given time. Interms of the nature of the improvementsthat I think might be necessary, I thinkwe all have a role to play. The standards

Leslie F. Seidman


setters and the regulators have projectsunderway to evaluate whether changesshould be made to the disclosure require-ments themselves; this way, we can havea fresh look at what might lead to themost useful information. The SEC justissued a staff report about that, and FASB

is in the middle of a disclosure frame-work project.

I also think that companies can takesteps to improve the quality of the infor-mation that they are disclosing. But basedon my discussions with a number ofcompanies over the years, I think theycould use some help. I’ve heard more thanone company say, ‘If someone would justtell us how to do it, we would do it.’ Butthey are very resource-constrained at thispoint in time, and wary of being second-guessed about changes, especially dele-tions. There are a handful of companiesthat have made significant improvementsto the quality of their disclosures; I’d liketo understand how they did it. What werethe guiding principles, and is there some-thing that we all can learn from them?

Last but not least, I want to mention theauditor’s role. When I would participate in

meetings relating to the disclosure frame-work project, FASB members would com-ment that preparers can already exercisesome judgment about what not to disclosebecause of immateriality or lack of rele-vance. Yet there were many cases whereparticipants would say, ‘But my auditors are

making us include that.’There’s kind of a checklistmentality that’s being used,even when an item is imma-terial or irrelevant. I’d like toexplore why that tendencyhas developed and what wecan do, even withoutchanges from the regulatorsor the standards setters, tochange that practice, because

I think it leads to extraneousdisclosures that clutter keymessages.

I think the key to solv-ing this issue is to allowsome flexibility in the

way that information is reported so thatcompanies are disclosing and highlight-ing what’s currently important. But I dothink there are implications to a moreflexible approach. I think there is a fearof second-guessing; when one companyis disclosing something and another com-pany isn’t, there’s going to be a ques-tion raised by the auditor, a peerreviewer, a regulator.

One very practical consideration is thatit takes more time for a company to exer-cise judgment from period to period andto sort out what is most relevant in anygiven period. With accelerated filingdeadlines, this is a practical issue: cancompanies deal with that type of flexi-ble approach in today’s environment?These are things that we need to address,but I think they are solvable and worthpursuing.

Standards Setting and ConvergenceCPAJ: FASB established the Private

Company Council (PCC) in 2012 to focuson the concerns of private company pre-parers, investors, and auditors. In lateDecember 2013, FASB and the PCCissued a framework and a definition ofpublic companies. Do you think thereshould be big GAAP and little GAAP?What do you think will result from thePCC’s interaction with FASB?

Seidman: Let me start by saying that Ithink that the establishment of the PCCwas a strong response to a widespread viewthat the private company voice was notbeing heard in the standards-setting debate.I think it was a good structural change atFASB so that its process for gathering of

information from stakeholders includes reg-ular meetings with people who areknowledgeable about private companyfinancial reporting issues. I’m very sup-portive of that.

In my view, the reason that we got tothis point is the concern that certain stan-dards were too complex and the cost-ben-efit relationship was out of kilter for pri-vate companies. If you look at the concernsthat people have about potential modifica-tions for private companies, I haven’t heardtoo many people express concern about dif-ferences in disclosure, differences in effec-tive dates, or differences in transition meth-ods. What people are mostly concernedabout is whether there should be differ-ences in the basic method for recognizingand measuring assets, liabilities, revenues,and expenses on the financial statements.

Yet there have been elections in GAAPsince its inception. It’s not uncommon forFASB to say, ‘You can do it this way, oryou can do it that way, and disclose whatyou’re doing.’ But when we discuss elec-tions in the context of private companies,people get concerned that we’re establish-

It’s not FASB’s goal to teach basic

There is an expectation that the users

amount of knowledge about

so that they can make


ing a new kind of GAAP. In fact, therealready are some differences within GAAPfor private companies. For example,because of the unique nature of privatecompany stock, there are some differencesin the standard on stock compensationintended to address those unique factors.Having said that, I think we want to bejudicious about elections or differences thatare unfounded, so that we can retain acoherent body of GAAP for the professionand investors. The establishment by thePCC and FASB of a framework to guidewhen differences or modifications will beappropriate is extremely important and ifpeople have concerns that any specific pro-posals would omit important information,they need to speak up.

The key is whether the modification ordifference relates to a unique need of theusers of private company financial state-ments, or whether it’s more appropriatelydescribed as a cost-benefit issue or acomplexity issue. Those are very differentthings, in my opinion, and I think they’reboth valid. But where I would draw thedistinction is that, in cases that are primarilyan issue of the costs and benefits of com-plexity, a simplified solution should alsobe considered for public companies. Inother words, my hope is that, as the roleof the PCC evolves into an advisory groupfor FASB, input about complexity andcost-benefit issues surfaces early in the pro-cess, so that the new standard is influencedpositively for everyone.

CPAJ: International standards andconvergence was a topic that you spenta lot of time on while at FASB. I wantto get your views about that historicaljourney. Also, what are your views onthe current state of convergence?

Seidman: Journey is the right word.FASB’s involvement with internationalaccounting standards and international

financial reporting predates my involve-ment on the board. Back in 1999, FASBissued a vision statement about interna-tional reporting and stated its clear sup-port for improvement and convergence ofglobal accounting standards. Since thattime, FASB collaborated with theInternational Accounting StandardsCommittee, the predecessor of theIASB, and with the national standards set-ters around the world, now known as theInternational Forum of AccountingStandard Setters (IFASS). FASB playeda strong role, along with the FinancialAccounting Foundation (FAF), in helpingto establish the IASB. So you can see thatFASB has a long, strong track record ofsupporting the development of high-qual-

ity global accounting standards. Workingcooperatively in those early days, sever-al significant accomplishments wereachieved, in terms of having standards thatwere closely converged, such as thoseon stock compensation and business com-binations—not identical but closely con-verged—and together, those standards hada significant effect in reducing the mostmaterial differences between U.S.GAAP and IFRS.

As you know, in 2007, the SECremoved the requirement for foreign pri-vate issuers to reconcile to U.S. GAAP,as long as they were following IFRS aswritten by the IASB. That meant thatthere were two GAAPs, if you will, in theU.S. capital markets. Together with theSEC, FASB and the IASB sat down anddeveloped a memorandum of under-standing (MOU) to identify the mostsignificant remaining differences andany topics where the standards were actu-ally pretty close but they believed therewas a need for improvement. That wasthe original MOU, with about 14 majortopics identified, and FASB and the IASB

worked together on those topics for a cou-ple of years.

Over time, the nature of the relation-ship changed from cooperation to moreof a partnership, where the meetings wereconducted jointly in Norwalk or in London,and the goal was to reach the same stan-dards with identical words. That wasextremely time-consuming and difficult.We were able to make some progress usingthat approach, but then came the financialcrisis. The significance of that was, froma standards-setting perspective, thewidespread belief that certain differencesbetween U.S. GAAP and IFRS, and somespecific provisions in both sets of GAAP,were viewed as weaknesses and identifiedas new priorities for both boards to dealwith. There was a need to reconsiderwhether the MOU continued to reflect themost important things to be working on.

But the other thing that happened wasthat the companies themselves were deal-ing with their own business issues relatedto the crisis. They had relatively fewerresources to deal with potential accountingchanges. They generally had more regula-tion to deal with, and there was a perva sivesense of overload in the system related tofinancial reporting and accounting stan-dards development.

And in the middle of that, in 2010, theSEC issued its first couple of staff reportson the status of IFRS. Among its findingswere some concerns about the inconsistentapplication of IFRS, inconsistent auditing,and inconsistent enforcement—whichcaused people to question whether theresulting information would be consistentand worth the cost of change. All of thesefactors led to a different way of thinkingabout what our goal should be. In theabsence of the SEC deciding how theUnited States should pursue any furtherincorporation of IFRS into U.S. GAAP,FASB realized that its primary focus hadto remain improving financial reportingstandards in the U.S. capital markets. Tothe extent that we can reduce or eliminatedifferences between the U.S. standards andIFRS, that is clearly a worthwhile goal topursue—but we should not let perfection(i.e., identical standards) get in the way ofprogress.

And that’s when you started to seeFASB and the IASB occasionally saying,‘We’re going to have to agree to dis-agree. We’re not going to hold up the

economic concepts through the standards.

of financial statements have a reasonable

economics, finance, and accounting

informed decisions on that basis.


whole process until we have exactly thesame words and exactly the same stan-dards.’ Even while I was on the board,there was an evolution in the workingmethods and objectives between the twoboards. There was, initially, a goal ofhaving the standards be substantially con-verged. Then it moved to, ‘No, they needto be identical.’ And now I think it hasmoved back to a best-efforts goal ofbeing substantially converged. I think thatthe relationship between the organizationshas naturally evolved back into more of acooperative, collaborative one, rather thana partnership. FASB and the IASB andother standards setters in major capital mar-

kets around the world can achieve a greatdeal by working cooperatively, leveragingeach other’s work, and sharing informa-tion. Working together that way offers thepotential to continue to narrow the differ-ences such that, at some point, we canreevaluate whether it’s worthwhile toaddress any remaining, more minor dif-ferences. In the meantime, it’s importantto make sure investors know what is con-verged and what is not.

CPAJ: Back to our earlier discussionabout who are the investors and howsophisticated are they—is it attainable tohave those ongoing differences and havepeople understand that?

Seidman: I would say we could probablydo a better job of providing investors witha real-time accounting—pardon the pun—of where the major differences are. My hopewould be that, over time, we can whittledown those differences so that what you

effectively end up with is dialects of the sameaccounting language. To continue the anal-ogy, we can all function speaking English,even though we know that there are certainwords used differently in England versus theUnited States. I do think, though, thatwe’re not there yet. And there’s probablymore we can do to help investors knowwhere the big differences are.

CPAJ: Would you comment on the newSustainability Accounting Standards Board(SASB)? What do you think about newstandards-setting groups like this one thatare proposing that different, additionalinformation be provided to the public?

Seidman: I’m familiar with SASB, and

I’m also familiar with the InternationalIntegrated Reporting Committee (IIRC).What these organizations have in commonis that they’re trying to standardize someof the nonfinancial information thatinvestors and others use to evaluate thelong-term sustainability of a company.

I think that the desire for standardizationof some of this information is natural; ifit’s something that investors or otherusers want, then it’s helpful to have peo-ple present information on the same basis.I’m not really in a position to assesswhether this is the type of information thatevery company would want to report thesame way, but I think that these organiza-tions taking the initiative to advance thedialogue is a very positive thing.

SASB, for example, just issued a stan-dard for healthcare entities. My under-standing is that adoption will be voluntary.At the end of the day, what we want to see

is whether this is the kind of informationthat investors find useful. As to the ques-tion of whether it should become manda-tory, I think that’s something that belongssquarely in the domain of the SEC.

I also think that the process that the IIRCis using on integrated reporting is the rightprocess to follow. It has developed a draftframework, is running a pilot program, andis assessing whether investors find the infor-mation useful. Again, it’s completely vol-untary at this point in time. I think that’sthe way to go. First, demonstrate that thereis an investor need, and then, in various juris-dictions, those who have the authority to pro-mulgate requirements will decide whetherthat’s an important piece of information forinvestors. But I don’t think we’re there yet.

The Role of AuditorsCPAJ: Let’s talk a little bit about the

auditor’s role in improving financialreporting. There has been a lot of talklately about proposed changes to the audi-tor’s report and whether the auditorsshould take more responsibility for decid-ing what is critical to an investor, as wellas to the audit, and should communicatecritical audit matters and other new thingsthat haven’t been in the standard auditreport before—for example, the name ofthe engagement partner and the auditor’stenure. Given your background, what doyou think about some of those proposedchanges to the audit report?

Seidman: My understanding of thePCAOB’s proposal is that it is trying tointroduce measures designed to promotehigh-quality audits; to make sure that audi-tors are independent; and to clarify the roleof the auditor regarding information that’spublished by a company outside of thefinancial statements themselves. Thereseems to be a belief that transparency ordisclosure about these matters by the audi-tor in the auditor’s report will have a pos-itive effect on behavior, and that investorswill understand the information and be ableto put it in the appropriate context. I thinkthat those are good objectives, but I ques-tion whether all of this informationshould be communicated to the public bythe auditor through the auditor’s report.There might be other ways to ensure thatthis dialogue is occurring besides includ-ing it in the auditor’s report.

With regard to critical audit matters, Iwould want to make sure that there weren’t

FASB and the IASB and other standards setters

in major capital markets around the world can

achieve a great deal by working cooperatively,

leveraging each other’s work, and

sharing information.


unintended consequences with thisapproach. For example, what is a criticalaudit matter to one company might not beto another company. That could lead towhat I’ll call defensive disclosure practices,where an auditor discloses a matter as crit-ical because others do, which could obscurethe issues that are most useful to aninvestor in that company. Likewise, thereare some companies that have so manysensitive accruals and significant estimatesin the financial statements that I worrythere might be too much information, suchthat the forest gets lost for the trees. I knowthat the comment period just closed andthe PCAOB is going to get a lot of com-mentary on these matters, so it will be veryinteresting to see where this goes.

Enhancing Financial ReportingCPAJ: The stated goal of the new Pace

University Center for Excellence inFinancial Reporting is “the enhancementof reporting practices for the benefit ofthe investing public.” What doesenhanced financial reporting mean toyou, and what is the center’s role in it?

Seidman: I’d like the center to focuson the continuous improvement in the waypractitioners—and when I say practition-ers, I mean company accountants and audi-tors—approach the process of providinguseful information to investors, because thenature of a public accountant is to servethe investing public. I’d like to provide anopportunity for a dialogue to occur betweenpreparers and auditors about how they areapproaching issues and share that infor-mation so that we can streamline the pro-cess and enhance the resulting informationfor investors. That’s what I mean when Isay enhancement.

CPAJ: Could you give us a little back-ground on the genesis of the center andhow you got involved?

Seidman: Pace has a very strong tradi-tion in accounting education, and it alsohas demonstrated its ability to be innova-tive and responsive to changes in the envi-ronment. When my term was up atFASB, the dean of the Lubin School ofBusiness asked if I would be interested ina role at Pace. Together, we came upwith the concept for the center.

I’m planning to develop a set of activi-ties that will be designed to surface issuesabout financial reporting for discussionamong participants and communicate those

findings or suggestions in a user-friendlymanner. We will provide a forum for prac-titioners to share the issues they areencountering and solutions they have sothat people can learn from each other. Wewill also identify best practices in financialreporting and draw attention to them sothat others can benefit and learn.

I’m hoping that this set of activitieswill be helpful, not only to accountingpractitioners, but also to investors. Wewill not only be focusing on whatinvestors and others find useful, but alsoon how we can get there in a morestreamlined way. In other words, are thereobstacles in the system that are interfer-ing with transparent reporting, such asdisclosure overload and a checklistmentality? I want to find out why anobstacle exists and then see if there’s away we can remove it—for example, bylearning from those who have addressedthe issue and then sharing that informa-tion with other practitioners.

Now, it may well be that someone elsehas to take the ball from there. In otherwords, if an issue seems to require some sortof action by another organization, like FASBor the SEC or PCAOB, then what I wouldhope to do is communicate any suggestionsor recommendations in a very constructiveway so that we are proactively contributingto the resolution of issues.

CPAJ: It sounds very worthwhile. Doother universities do anything like this?

Seidman: Many universities have somesort of center for financial reporting. Whatdistinguishes what I would like to do is thefocus on the practical issues. In other words,I’d really like to understand what types ofissues are interfering with good financialreporting, because I believe that most com-panies and most auditors are trying to do theright thing. Yet, there are times whenthings aren’t as efficient as they could be,or there’s a glitch in the system that hasn’tbeen articulated publicly. That’s where Ithink I can be helpful, to convene the rightpeople and then communicate any ideas thatwe have.

CPAJ: And so the center would,through a website or other means, makeinformation available, similar to what theCenter for Audit Quality and others aredoing?

Seidman: Yes, exactly. CPAJ: That will really be helpful.

While we’re on the topic of education, Iam interested in your perspective onaccounting education. Is it good to be anaccounting graduate these days?

Seidman: Well, I just saw in Timemagazine today a list of the most in-demand jobs, and accountants and audi-tors are number two. And the Bureau ofLabor Statistics is forecasting a 6%increase in job growth for accountants bythe year 2020. So I would have to saythat, yes: it is still a good thing to be anaccountant, and there are plenty of jobsout there. Pace is achieving nearly100% placement for accounting gradu-ates within several months of graduation.It’s still a great career choice.

I have tried a number of different rolesin the profession of accounting, but thereare many other roles that I have not tried.There’s really something for everybodyin the profession, and it’s a good skill setfor any role in business. I think account-ing is a very interesting, challenging, andimportant profession. q

I’d like the center

to focus on the contin-

uous improvement in

the way practitioners—

company accountants

and auditors—

approach the process

of providing useful

information to

investors, because the

nature of a public

accountant is to serve

the investing public.

In Focus

ImprovingAudit Quality


Executive Director of the Center for Audit Quality

By Maria L. Murphy

InterviewAn

Cynthia M. Fornelliwith

I n January, the Center for Audit Quality (CAQ) celebrates its seven-year anniversary; since its inception, it has been ledby Executive Director Cynthia M. Fornelli. The CAQ’s stated mission is to enhance investor confidence and the pub-lic’s trust in global capital markets. Prior to working with the CAQ, Fornelli served as the securities regulation andconflicts management executive at Bank of America; before then, she was the deputy director of the SEC’s Divisionof Investment Management. ❱❱


Fornelli, a member of the Washington,D.C., bar and the American BarAssociation, was recently named for thefifth time to the National Association ofCorporate Directors’ (NACD) “Director -ship 100” list of the most influential peo-ple in corporate governance and for theseventh consecutive time to AccountingToday’s “Top 100.” Fornelli sat down withCPA Journal Editor-in-Chief Maria L.Murphy to discuss creating a dialogueamong stakeholders, the importance oftransparency and the audit committee,and the CAQ’s many ambitious projects.

Promoting Dialogue through OutreachThe CPA Journal: How did the CAQ

get its start?Cindy Fornelli: After the accounting

scandals of the 2000s, such as Enron andWorldcom, I think everybody looked at thevarious roles and responsibilities of theplayers involved, particularly the publiccompany auditing profession. Thethought was that there needed to be a voicethat looked at policy issues impacting pub-lic company auditors, but that that voiceneeded to be informed by and influencedby all of the participants in our capital mar-kets and all of those who benefit from pub-lic company auditing—not just the audi-tors themselves, but also issuers,academics, journalists, regulators, auditcommittees, and investors.

As the CAQ, which is an autonomousorganization affiliated with the AICPA,looks at policy issues or take policy posi-tions, we want to be sure that we’ve doneoutreach and gotten the whole range ofstakeholders’ perspectives and viewpoints.Because I’ve been in the public policyarena through most of my career, I thinkthat the best way to come to thoughtful,informed perspectives is to hear every-body’s voice. We might not alwaysagree, but it’s just important to have thatdialogue. It’s part of our core mission toconvene and collaborate with all of thosestakeholders in public company audits.

CPAJ: How does the organization func-tion in terms of operations and personnel?

Fornelli: We have a staff of 23,including myself, that runs the wholegamut of experience. We have six CPAsin our policy research and professionalpractice groups. We also have a rotatingprofessional practice fellow, who comesfrom one of our member firms—right now,

it’s Susan Brooke from KPMG. We alsorely on our member firms’ resources.

When we set up the CAQ, there were acouple of ways we could have done it: wecould have had all of that expertise in-house,but that would mean we would havedozens—if not hundreds—of employees. Itwould be hard to keep that knowledge fresh.The alternative, which we went with, isthat on the technical or professional prac-tice side of issues, we might form a taskforce, based on firm resources, of individu-als who are experts in that area. They makesure that when we take a policy position,we’re informed from a technical perspective.

We also have strong communicationsand research departments. We support theacademic community, which is one ofour key stakeholders, in doing independent

research that focuses on audit quality andother public company auditing issues.

CPAJ: How does the CAQ’s governingboard operate?

Fornelli: We have a 12-person boardcomposed of the CEOs of the eight largestaccounting firms, the CEO of the AICPA,and three public board members. TheCEOs serve as long as they are in that posi-tion, so we’ve had turnover in the pastseven years. The three public board mem-bers serve staggered terms.

Those public board members are meantto represent those other stakeholders:investors, regulators, academics, and auditcommittees. Right now, our three publicboard members are Harvey J. Goldschmid,former SEC commissioner, who representsboth the investor community as well as theformer regulatory community; Michele J.Hooper, who is a prominent audit com-mittee chair of public companies and ison the NACD board; and Lynn S. Paine,who is a professor at Harvard BusinessSchool and a corporate governance expert.It really is a fantastic group.

CPAJ: What do you enjoy most aboutyour work at the CAQ?

Fornelli: The public company audit isa linchpin of investor confidence in oursystem, and talking to all of the various

constituencies that rely on the work thatpublic company auditors do is very ful-filling and gratifying for me. The menand women that make up the professionare truly remarkable. They demonstrateso much integrity and professionalism. Ihave been very impressed over the lastseven years by the level of commitmentand dedication of public company auditors.

CPAJ: What would you say is yourbiggest challenge?

Fornelli: One is that everybody has apoint of view, so the challenge is figuringout how to have that dialogue and find adispassionate way to share views. But agrowing challenge that I have seen emerg-ing over the last year or two—and that Ithink is going to be even more pronouncedas time goes on—is the disparate, some-

times conflicting, regulatory regimes fac-ing not only public company auditors, butalso public companies. I think investorsin our growing and global economy canget confused just navigating through thatregulation.

Facilitating Research and ImprovingInvestor Confidence

CPAJ: Can you tell us a little bitabout the role of the CAQ in enhancinginvestor confidence and public trust?

Fornelli: We spend a lot of time on out-reach with the investor community. Wehave educational resources that we create—publications aimed at investors and the gen-eral public. We have an in-depth guide topublic company auditing and a guide oninternal controls over financial reporting,for example, which are meant to helpeducate readers who aren’t well versed inwhat a public company auditor does. Wealso have an animated video series,“System of Investor Protection,” availableon YouTube. It has a lovely cast of char-acters and has been immensely popular,with almost 400,000 views in 2013 alone.

We also spend a lot of time with ouracademic constituency. Over the years, welearned that professors were using ourinvestor education materials in the class-

I think investors in our growing and global economy can get confused just navigating

through that regulation.


room, and so we work very closely withthe American Accounting Association(AAA), particularly the auditing section, tomake sure that we’re creating resources thatare helpful and understand how ourresources are being used so that we canrefine and update them.

The CAQ hosts a symposium each sum-mer that brings together leaders from the pro-fession and the academic community. One ofthe key goals of the symposium is to pro-vide a venue where these parties can have arobust dialogue about key issues facing theprofession that can result in the generation ofideas for scholarly research that providesinsights that auditors can use in practice.

We also support independent academicresearch; you can’t have a robust profes-sion unless you have well-trained, well-

educated people coming into the profes-sion, and you can’t have them unless youhave good professors. The CAQ is in itssixth year of providing grant funding forresearch on auditing. It has a research advi-sory board, composed of leading academ-ic scholars and audit partners who reviewand select the projects to be funded.Although the CAQ outlines topics of inter-est to the profession, such as auditing offair value estimates, it does not try to influ-ence the findings or how they are report-ed. We know that it is often difficult foracademics to get access to resources thatthey need to do their research. One yearago, we announced that we were partner-ing with the AAA auditing section on anew initiative: access to audit personnel.This is meant to help researchers, particu-larly PhD students and tenure-track pro-fessors, obtain access to personnel inaccounting firms in order to do behav-ioral or experimental research studies.

CPAJ: How does that actually workin practice?

Fornelli: We work with the AAA audit-ing section and the CAQ governing firms.We’ll put out a call for proposals, as wejust did, and our review committee evalu-ates the proposals. Firms are committedto providing access to the staff level that

the researchers have requested to testtheir hypotheses. For example, they mightask to have 80 senior managers spend 30minutes each to read through a hypotheti-cal audit scenario and answer questionsabout the procedures they would conductbased on the information provided. Thefirms will commit to making thoseresources available. TheCAQ serves as the inter-mediary to preserve theanonymity of the firm andits study participants. Oncethe data are collected, theresearchers conduct theanalysis and write theirpapers. We haven’t seenthe results yet becausethe data collection for the

first wave of projects hasjust been completed, but,for the most part, the aca-demic community is excit-ed, and we are excited tobe supporting this type ofresearch.

CPAJ: You spoke atthe AICPA NationalConference on Current SEC and PCAOBDevelopments in December about investingin talent. What trends do you see in account-ing graduates? Are they finding jobs? Isaccounting still a good field to pursue?

Fornelli: The AICPA issued a report lastJune, “2013 Trends in the Supply ofAccounting Graduates and the Demand forPublic Accounting Recruits,” that revealeda high demand for those coming out of col-lege with accounting degrees. The samestudy showed a nearly 20% increase inaccounting graduates, both at the graduateand undergraduate levels. That’s veryimportant—and very positive—becauseaccounting firms will tell you that theirgreatest asset is their talent, their people.

I know that the firms all spend a greatdeal of time, as does the AICPA, trackingthose numbers and making sure that theprofession is an attractive one, both to enterand stay. Retention is sometimes a chal-

lenge. I don’t want to come off as not sup-porting partner rotation, but it can be dif-ficult for individuals who have to moveevery five years from one client to anoth-er; the practicalities are, at times, a chal-lenge for retaining individuals. Firms arealso very focused on wanting to make theprofession attractive for all individuals,

regardless of their ethnicity and their gen-der. They want it to be a very diverseprofession, and they’re all looking for waysto support that.

CPAJ: At the conference, you alsoshared some positive news: the account-ing profession is strong, investor confi-dence has improved, and restatementstatistics have improved. What do youthink has influenced these trends?

Fornelli: Every year since its inception,the CAQ has conducted the MainstreetInvestor Survey. We believe it’s the only sur-vey of its kind that polls individualinvestors—what we call “the man andwoman on the street”—about their percep-tions of the profession and the health of ourmarketplace, both in the United States andglobally. Even through the financial crisis,the number of those who have confidencein public company audited financial state-ments has remained very high.

Cynthia M. Fornelli


Over the last three years, we’ve asked,‘Who do you think best looks out foryour interests?’ And for three years in arow, the independent auditor scored thehighest. That is just one data point that indi-cates the strength of the profession.

You also mentioned restatements; if youlook at those numbers since the Sarbanes-Oxley Act of 2002 (SOX) reforms wereput into place, you will see that they havedecreased across the board.

CPAJ: So, if things are getting better,is that consistent with all the proposedrulemaking; increased oversight; or theconcerns that sometimes come from thePCAOB and the SEC about auditors notdoing as great a job as they might, aboutinvestors needing more information, orabout fraud on the rise?

Fornelli: In financial reporting or per-formance by an individual auditor, you cannever reach perfection; it’s always a con-tinuous cycle of improvement. There is aquote from legendary football coach VinceLombardi that says perfection is not attain-able, but if you chase perfection, you cancatch excellence. That’s what you see withthe profession and from regulators. There’s

a need for all of us—preparers, audit com-mittees, auditors, regulators, academics—to always strive toward perfection, know-ing that we’re never going to achieve it.

We also have to acknowledge that we hada pretty significant financial crisis over thelast several years. Whenever that happens,the tendency is—and I think it’s the righttendency—to pause and consider everyone’sroles and responsibilities, assess how we canimprove the process, and ask what we should

do to ensure this never hap-pens again. The problem isthat you tend to regulate forwhat happened before andnot for what’s going to hap-pen. I think that’s humannature—none of us has acrystal ball, so we have to try

to learn lessons from whatwe just went through. Weshould take comfort in thefact that, whatever its variouscauses—and I think therewere a lot—the financialcrisis wasn’t about account-ing fraud or financial report-ing fraud.

It’s important that youlook across the entire finan-cial market structure. My

own personal view is that every participantbears some responsibility. I think that’swhy we’re seeing a renewed look at theregulatory process. But also one of thebiggest challenges in this global economyis that every regulator across the globe islooking at these issues and coming up withvarious solutions, which are sometimes atodds with one another.

Transparency and DisclosuresCPAJ: Many say that more trans-

parency is better; people want more infor-mation. How do you think we canimprove transparency in the profession,and who should bear that responsibility?

Fornelli: That’s a thorny issue. We are

in an interesting place in history rightnow because there’s so much informationavailable, but we’re starting to see thatmore isn’t necessarily better. We all talkabout disclosure reform or disclosure sim-plification, and what we really should betalking about is disclosure effectiveness.These very different users—be they ana-lysts, individual investors, large institutionalinvestors—all want different levels of infor-mation and different types of information.

I think we should all own a piece ofthe responsibility, but we need to look atit holistically across the spectrum and say,‘Who is going to do what? Who is respon-sible for what type of disclosure?’ We’vespent a lot of time over the last two yearsworking with the audit committee com-munity, talking about its assessment of

the external auditor, and about how auditcommittees report to investors and fulfilltheir obligations. The audit committee isthe party that’s responsible for oversightand governance of the external auditor andlooking out for the interests of investors.

We hear, more and more, from variousinvestor constituencies, that they want tohave more interaction with the audit com-mittee. The most practical way to do thatis to have the audit committee report onthe processes that it uses to assess the audi-tor and these issues. The CAQ joinedseveral other governance organizations lastfall in issuing “Enhancing the AuditingCommittee Report: A Call to Action,”which includes an analysis of what someaudit committees are currently doing andan encouragement for audit committees tothink about how they should be reportingto investors and fulfilling their obligations[http:// www. audit committee collaboration.org/ Enhancing the Audit Committee Report ACall toAction. pdf]. It’s intended for auditcommittees to look at their disclosures inthe audit committee report, to think aboutwhat their peers are doing, and to consid-er what information they should commu-nicate to investors at that particular point

There are those who would like to get The auditor has a unique role in seeing

There is a hunger to know


in time based on that particular auditcommittee.

“A Call to Action” doesn’t ask audit com-mittees to do more; it asks them to com-municate more about what they are doing—a subtle but important distinction. The reportprovides real-life examples of audit com-mittee disclosures, as well as trends we’reseeing, based upon some research conduct-ed by Deloitte and Ernst & Young.

CPAJ: Do you think that the right peo-ple are on audit committees, that they taketheir roles seriously, and that they knowhow important their roles really are?

Fornelli: Yes. But just as we talked aboutthe continuous cycle of improvement thatauditors are always striving for, audit com-mittees should do the same. I do think thatthe vast majority of audit committee mem-

bers are very dedicated, very committed, andvery effective. What I think could usesome improvement, which is in part whatled to the creation of the audit committeecollaboration, are the disclosures that auditcommittees make about their work. If auditcommittees enhance their disclosures, theremight be more acknowledgement of theimportant work that they do and there wouldbe more transparency about how seriouslythey take their obligations.

CPAJ: Do you think there’s a need fornew or revised regulation about whoshould be on an audit committee or theexperience or background they need?

Fornelli: That was, as you know, a bigdebate in SOX: should there be qualifica-tions for audit committees, and if so, whatshould they be? Ultimately, SOX requiredthat there be a financial expert on the com-mittee. Some have argued that the defini-tion of a financial expert is too broad. Iwould hate to see a definition that is too pro-scriptive because as our markets becomemore complex and more global, I think youwant a diversity of thought. By having arigid definition of who can be an audit com-mittee member—aside from the indepen-dence aspect—I think we could run into

trouble and miss out on the types of indi-viduals that could really bring some inter-esting perspectives to the audit committee.Having said that, disclosure is important,and I think investors have a right to knowthe qualifications of the audit committees ofthe companies in which they’re investing,without prescribing what those qualificationsshould be.

Changes to the Auditor’s ReportCPAJ: There’s been a lot of public

commentary about the proposal to changethe auditor’s report. What is the CAQ’soverall view on proposed changes to theauditor’s report, specifically on criticalaudit matters?

Fornelli: There are two proposals outright now, one with respect to the auditor’s

reporting model and one with respect toidentification of the engagement partnerand others involved in the audit. Withrespect to the auditor’s reporting model,this is—as PCAOB Chairman James R.Doty has stated and as the CAQ hasacknowledged—a transformative propos-al. The audit report hasn’t changed indecades. Both in the PCAOB’s outreachand the CAQ’s outreach, there is a vastacknowledgement that the pass-fail modelwe currently have is instructive and is help-ful; I don’t think anybody wants to get ridof that model.

But there are those who would like toget more of a behind-the-scenes look.The auditor has a unique role in seeingwhat’s going on inside a company. Thereis a hunger to know what the auditorknows. Where that gets difficult is that youreally don’t want the auditor to be the orig-inal source of information. When the CAQdid outreach on the auditor’s reportingmodel—the summary of that outreach ison our website—we heard investors saythat they don’t want the auditors to be theoriginal source of information and theydon’t want competing reports. I think thePCAOB heard that and, in its proposal on

critical audit matters, I think it tried toacknowledge that.

Where the CAQ came out on thePCAOB’s proposal, particularly withrespect to critical audit matters, is that itwas too broad. You would get too muchinformation that would make it hard foran investor to ferret out what was reallyimportant. We came up with an alterna-tive framework that would focus on theinformation that rose to the level of beingso critical in nature that you would shareit with the audit committee. It is the auditcommittee that stands in the shoes ofinvestors and oversees the work of the audi-tors. We thought that would be an appro-priate way to narrow the filters into whatis truly critical. That’s an oversimplifica-tion of our position, but that’s the heart ofit. I think it is a good approach that recog-nizes the roles and responsibilities of thevarious parties. It does potentially giveinvestors more of the information they saythey want, without having dozens, if nothundreds, of critical audit matters. That’sthe CAQ’s position and most of our mem-ber firms’ position. But the audit commit-tee community and the preparer commu-nity do not agree. I think more than 90%of the preparer community and the auditcommittee community opposed thePCAOB’s proposal altogether.

CPAJ: What about the naming of theaudit partner and others associated withthe audit?

Fornelli: On the proposal about engage-ment partner identification, neither thePCAOB nor I have found data that showthat the naming of the engagement part-ner would increase audit quality or account-ability. Another reason you hear for theproposal is transparency. I don’t knowwhat knowing the engagement partner’sname is, without other contextual infor-mation, would get anyone.

Having said that, the CAQ is focusingits efforts right now on, presuming that thePCAOB goes forward with engagementpartner identification, where that identifi-cation would be. Right now, the PCAOBhas proposed it to be in the audit report,but that raises a legal issue of obtainingconsent from the engagement partner, andeven more so with others involved in theaudit. If the disclosure of others involvedin the audit is somewhere outside of theaudit report, you just have to think of thepractical implications.

more of a behindthescenes look. what’s going on inside a company. what the auditor knows.


Mandatory Audit Firm RotationCPAJ: Does the CAQ have an overall

position on mandatory auditor rotation? Fornelli: With respect to mandatory

firm rotation in the United States, the CAQis opposed for several reasons. First and fore-most, there has been no evidence that linkslength of tenure to audit quality. In fact, someacademic research shows it could have anegative impact on audit quality. I don’tknow that that research is dispositive, butthere is no evidence that we found that showsa nexus to audit quality. I believe that thePCAOB itself has acknowledged that.

The other objection that I personallyhave—and that the CAQ and the profes-sion, including the preparer and audit com-mittee communities, have—is that it takesaway the responsibility of those chargedwith governance: the audit committee. It isthe audit committee that should make thedetermination as to which is the bestaudit firm and, frankly, even the engage-ment team for that company. Having aperiod of time where you would have to

change audit firms is just arbitrary, with-out logic.

It takes away from the audit committee’sresponsibilities, so we oppose it for thatreason as well. To that point, we didcome up with an auditor assessment tool.It’s our view that, every year, the auditcommittee should assess the performanceof its auditor and determine whether theauditor should be retained.

CPAJ: Can you comment on the pre-liminary agreement reached on the frame-work for the European Union (EU) auditreform that would require mandatoryaudit firm rotation?

Fornelli: Part of the reason you see theEU moving forward the way it has isbecause, in Europe, the discussion is muchmore about concentration and competition.

Those proposals that would call for auditfirm rotation are meant to address concen-tration and competition. I don’t know thataudit firm rotation will ease the concentra-tion issue, to the extent that there is one, orincrease competition. I personally have notseen information that shows that that wouldbe the case, but it’s a different objective inEurope than in the United States.

The PCAOB Inspection ProcessCPAJ: Does the CAQ get involved at

all in the PCAOB inspection process?Fornelli: Generally we do not; for the

most part, that is a firm-specific issue.Certainly, we have conversations with thePCAOB inspection staff. We have a small-er firm task force and we’ve askedinspection leader Helen A. Munter and herteam to talk to the smaller firms about theinspection process.

We do have a project—a judgmentresource—that would help our memberfirms develop a judgment process, whichtouches on the inspections. Just this past

December, we not only announced, butissued, our first alert to members aboutemerging audit risks, which also toucheson inspections and what the emergingissues are that firms need to be aware of.This is kind of the flipside of a 4010 report.We wanted to get ahead of the curve andalert members to areas that are likely tobe the focus of PCAOB inspection staff.The CAQ is involved in these types ofimportant efforts, but we do not getinvolved in the actual inspection process.

CPAJ: Does the CAQ have a publicview on the PCAOB inspection processoverall?

Fornelli: Let me put it this way: I haveheard Jeanette Franzel, particularly, andother PCAOB board members say theywould like to see the timeliness of the

inspection reports be improved and theinformation that is conveyed in thoseinspection reports be more effective; Icertainly support those efforts.

Another thing that I would encouragethe PCAOB to think about with respect tothe inspection process is—and I say thiswearing my former regulator’s hat—thatit’s important for regulators to not onlyshare the things that are going wrong orthat need improvement, but also the thingsthat work well. I know there is a concernabout regulatory capture, but that’s not real-ly what I’m talking about.

Take fair value, one of the emergingaudit risk areas. I think the PCAOB canand should say—in addition to in a 4010report saying, ‘We’ve seen these five prac-tices that we have real concerns about’—‘Here are alternative ways that might workand we would ask you to consider.’ I don’tthink that’s regulatory capture. I’m not say-ing, ‘Single out one firm’; I’m talkingabout, on balance, stating, ‘Here are somethings to be wary of, and here are somethings to consider.’

I appreciate that there are potential pit-falls, just as there are pitfalls when the CAQprovides best practices, as we don’t set stan-dards. That’s one of the concerns: that thePCAOB endorsing best practices or some-how encouraging certain behavior is stan-dards setting outside the process. I thinkthere are ways to give examples or to askpeople to consider certain things withoutrunning afoul of standards setting.

Developing Audit Quality IndicatorsCPAJ: What’s your take on audit

quality indicators and the PCAOB’s cur-rent project? Specifically, do you thinkit is possible to actually get all of the dif-ferent constituents we talked about toagree on what an audit quality indica-tor is and to come up with a single setof indicators?

Fornelli: The notion of audit qualityindicators is very important. Over the pastseveral decades, many parties have tried todefine audit quality, a framework foraudit quality, or actual metrics or indica-tors of audit quality. Just because it’s harddoes not mean we shouldn’t continue totry. The CAQ certainly supports thePCAOB’s efforts to come up with auditquality indicators.

In fact, the CAQ has a project that itbegan several months before the PCAOB

It’s important for regulators to not only share the things that are going wrong or that

need improvement, but also the things that work well.


announced its project, looking at what auditquality indicators might look like. One ofthe challenges is finding what the right unitof measure is. Are you looking at profes-sion-wide metrics, firm-wide metrics,engagement team metrics, or individualpartner metrics? And then, what is the formand to whom is the form addressed?Working through this, we still don’t havea definitive set of audit quality indicators,nor do I think there will ever be one. Butthat doesn’t mean that you can’t look fora framework or areas. The CAQ wants itto be input and output based.

Where we are, at this point, is that therereally should be a focus on the audit com-mittee. What information does the auditcommittee need to assess its engagementteam? That answers the question, for me,about what is the unit of measure (engage-ment team, in my mind) and to whom thereport would be addressed (the audit com-mittee, in my mind).

I know there are those who want pub-lic reports of audit quality indicators. Butit’s hard to boil it down to something thatis meaningful without context. I think weall need to trust that audit committees areeffectively overseeing the auditors and theirwork. If we don’t trust the audit commit-tee, we should address that concern. It allgoes back to the fundamental, importantrelationship of the audit committee over-seeing the auditor.

Additional CAQ ProjectsCPAJ: What other projects is the

CAQ working on?Fornelli: One thing we haven’t talked

about much at all is our antifraud collab-oration. Over the past several years, wehave worked with those participants inthe supply chain who have the fundamen-tal responsibility to deter and detectfinancial reporting fraud. Those are the pre-parers, and we’re working with FinancialExecutives International (FEI); the internalauditor, which is the Institute of InternalAuditors (IIA); the external auditor,which is the CAQ; and the audit commit-tee, where we’re working with the NACD.We formed a collaboration a few years agoand have developed a whole host of toolsand resources for all of our constituenciesto help those with the responsibility to deterand detect financial reporting fraud. Wehave webinars. We have articles. Wehave case studies.

We should talk a bit about the case stud-ies, which are really exciting. The CAQ,working with these other organizations, hasissued the first of three case studies, whichis a hypothetical fact pattern that shows theimportance of all of those in the supply chainworking together and the red flags thatpeople should have perhaps picked up on.We worked with Harvard Business Schoolto develop the case. We also have a discus-sion guide that goes with it to help withteaching the case. All of this is free of chargeand publicly available at http://www.antifraudcollaboration.org, as well as on each ofthe institutions’ websites. I will note, though,that you have to go through a screen toaccess the discussion guide, because manyprofessors are using it in the classroom,and we don’t want students to get it. Ourwebsite also features a video in which aHarvard Business School case study pro-fessor gives pointers on how to teach thecase. We’ve had almost 200 people trainedto teach the case.

We’ve gotten really good feedback onthe case. The state of Georgia has an annu-al university-level internal audit competitionand it used the CAQ case study. We taughtit at the IIA international conference. TheNACD has taught it, and the NationalAssociation of State Boards of Accountancy(NASBA) taught the case at its annual meet-

ing. Firms are using it to train and educatetheir people.

We’re getting ready to issue the secondone. The first one is Hollate Manufacturingand, as the name implies, a manufacturingcompany is the subject of the case. Thesecond one, which we’re going to be issu-ing in the next couple of months, is CarolinaWilderness Outfitters, a retail operation. Itshows the roles and responsibilities of eachof the participants and walks you throughrelevant questions: What if the CFO hadtalked more to the CEO, or what if theaudit committee had asked questions of theCFO earlier on in the process? Would thepotential fraud have been caught earlier? Thethird one, which is in very early stages, isfocused on a financial institution and willprobably be more technical in nature thanthe first two.

CPAJ: Is there anything else youwould like to share with CPA Journalreaders?

Fornelli: I would really invite your read-ers to visit the CAQ’s website. There’s alot of information on there. There are waysto contact me too. If readers have ideas ofresources or things that the CAQ couldbe doing or should be doing, we wouldvery much like to hear that. These all arethings that we think are important:antifraud, the effectiveness of audit com-mittees, the communication, the disclo-sures, transparency—all the things wetalked about are critically important andare at the heart of what public companyauditors do. Given the important role thatthey play, I think we all need to worktogether to make sure that the process isworking at its best.

CPAJ: What about CPAs in privateindustry? Is there information on theCAQ website for them as well?

Fornelli: The CAQ is, by definition inour charter and our mission statement,focused on public company auditing, butI think those in the private companyrealm will find information that is appli-cable for them on the CAQ website. Ourantifraud materials and the case studies, forinstance, are very applicable. I do knowthat some private companies use ourauditor assessment tool that we createdthrough the collaboration in the privatecompany setting. So there are certainlyareas of interest and resources that CPAsat private companies and private compa-ny auditors would find helpful. q

I think we all need totrust that audit committees are

effectively overseeingthe auditors and theirwork. If we don’t trustthe audit committee,

we should address that concern.

The PCAOB conducts periodic inspections of all registeredpublic accounting firms and issues reports on its findings;inspections are required annually for CPA firms with morethan 100 public clients and at least once every three years

(triennially) for firms with 100 or fewer public clients. CPA firms’quality control (QC) policies and procedures should reflect theelements of QC prescribed by PCAOB standards.

This study examines the QC criticisms in PCAOB inspection reportsand the traits of triennial CPA firms that receive those criticisms. Itanalyzes the nature and frequency of specific QC criticisms releasedin PCAOB inspection reports and provides several examples ofthose criticisms. The percentage of reports citing certain types of QCdeficiencies—particularly those involving independence and moni-toring—has increased with each round of inspection.

Quality Control Criticisms in PCAOBInspection Reports

A C C O U N T I N G & A U D I T I N Ga u d i t i n g


By Alan I. Blankley, David S. Kerr, and Casper E. Wiggins

Analyzing the Characteristics of Triennial Firms with and without Deficiencies

The traits of triennial CPA firms citedfor QC deficiencies by PCAOB inspectionteams are compared with those of other tri-ennial CPA firms. In addition, this studycompares the traits of firms that successful-ly remediated QC deficiencies with thoseof firms that did not do so. There is com-pelling evidence of systematic differences inseveral important traits between firms withQC deficiencies and firms without QCdeficiencies, as well as differences betweenfirms that successfully remediated their QCdeficiencies and firms that did not. This infor-mation can help guide triennial CPA firmsand their advisors as they seek to strength-en their QC systems and prepare for futurePCAOB inspections.

BackgroundSection 101 of the Sarbanes-Oxley Act

of 2002 (SOX) established the PCAOBand specified its mission and duties. SOXsection 104(a) requires the board to con-duct inspections of public accounting firmsthat regularly audit at least one issuer client.One important purpose of these inspectionsis to improve audit quality in order toprotect investors and promote confidencein financial reports.

The inspection process employs a risk-based approach. Inspection teams typicallyreview only selected audits of a CPAfirm’s issuer clients and focus primarily onareas of the financial statements with thegreatest perceived risk of misstatement.Inspection teams also evaluate the firm’s QCpolicies and procedures related to the auditprocess. The inspection team’s review of thefirm’s QC system aims to identify whetherweaknesses related to the firm’s audit pro-cess exist. Such weaknesses might relate toa broad range of matters, including audit per-formance, staff training and continuing pro-fessional education (CPE), independence,client acceptance, and workpaper docu-mentation and retention, among others. If theinspectors find a deficiency in either an auditor the firm’s QC system, they inform thefirm of the deficiency, which the firm mustthen take steps to remediate (PCAOBRelease 2012-003, “Information for AuditCommittees about the PCAOB InspectionProcess,” Aug. 1, 2012).

Part I of PCAOB inspection reports pro-vides information about the inspected CPAfirm, including name and location, numberof offices, number of partners and profes-

sional staff, and number of issuer clients.It also provides information regarding theresults of the board’s review of selectedaudit engagements, including any auditdeficiencies identified during the inspec-tion team’s review of the firm’s workpa-pers. Part I is made publicly available;however, the names of the clients whoseaudit engagements were reviewed remainconfidential and undisclosed.

Part II discusses possible deficienciesin the firm’s QC system identified by theinspection team. As an incentive for firmsto correct the deficiencies promptly, thispart of the report is not made available tothe public unless, in the board’s opinion,the firm fails to satisfactorily remediate thedeficiencies within 12 months. In addition,firms have the opportunity to review andcomment on a draft of the inspection reportbefore it is made public; if the firmchooses to provide a written response, itis included in Part IV of the report. Firmsmay request confidential treatment forany part of their response letter; if the boardgrants such treatment, those sections areredacted from Part IV before the inspec-tion report is made public.

QC Policies and ProceduresCPA firms that conduct audits of one or

more issuers per year must comply withPCAOB QC standards, detailed in QC sec-tion 20, “System of Quality Control for aCPA Firm’s Accounting and AuditingPractice.” A QC system is defined as “aprocess to provide the firm with reason-able assurance that its personnel complywith applicable professional standardsand the firm’s standards of quality” (QCsection 20.03).

QC section 20 provides a framework offive elements that are considered essential tothe design and implementation of an effectiveQC system: 1) independence, integrity, andobjectivity; 2) personnel management (addi-tional requirements provided in QC section40, “The Personnel Management Element ofa Firm’s System of Quality Control—Competencies Required by a Practitioner inCharge of an Attest Engagement”); 3)acceptance and continuance of clients andengagements; 4) engagement (audit) perfor-mance; and 5) monitoring (additional infor-mation provided in QC section 30,“Monitoring a CPA Firm’s Accounting andAuditing Practice”).

Analysis of QC CriticismsWhen a CPA firm fails to remediate QC

deficiencies to the PCAOB’s satisfactionwithin 12 months of the date of the inspec-tion report, the board makes those QC criti-cisms public. This research examined eachnonremediated inspection report and catego-rized the QC criticisms within the frameworkof the five elements presented in QC sec-tion 20.

The data included QC criticisms from 118PCAOB inspection reports for 100 differenttriennial CPA firms that did not sufficientlyremediate their QC defects within the 12-month period allowed by SOX section 104.These 118 reports represent 9% of all trien-nial firms’ inspection reports (1,282) datedprior to 2012.

The majority (87) of these firms hadonly one nonremediated inspection in thedataset, 12 firms had two nonremediat-ed inspections, and two firms had threenonremediated inspections. For purposeof comparison, the authors also examined

33FEBRUARY 2014 / THE CPA JOURNAL


705 inspection reports of triennial firmsthat satisfactorily remediated QC defi-ciencies, and 457 inspection reports oftriennial firms that were not cited for anyQC deficiencies. The inspection reportdates ranged from February 2005 throughDecember 2011.

On average, 2.8 QC deficiencies were citedper inspection report (i.e., 329 deficiencies in118 inspections). Across three rounds ofinspections, the average number of QCdeficiencies per inspection increased from 2.7in the first round to 2.9 and 3.7 in the sec-ond and third rounds, respectively.

Audit performance. As Dana R.Hermanson and Richard W. Houstonshowed in “Evidence from the PCAOB’sSecond Inspections of Small Firms:Driving Improvements in Auditing andQuality Control,” and as confirmed bythe data in this study, the majority of QC

EXHIBIT 1Profile of Quality Control (QC) Criticisms across PCAOB Inspections

First Second Third

QC Criticisms Inspection1 Inspection2 Inspection3 Totals4

Independence, Number (percentage5) of criticisms 22 (10%) 9 (10%) 2 (9%) 33 (10%)integrity,and Number (percentage) of reports 21 (26%) 8 (27%) 2 (33%) 31 (26%)objectivity with criticisms6

Personnel Number (percentage) 4 (2%) 7 (8%) 2 (9%) 13 (4%)management of criticisms

Number (percentage) of reports 4 (5%) 6 (20%) 1 (17%) 11 (9%)with criticisms

Acceptance and Number (percentage) of criticisms 2 (1%) 0 (0%) 0 (0)% 2 (1%)continuance of Number (percentage) of reports 2 (2%) 0 (0%) 0 (0%) 2 (2%)clients with criticisms

Audit performance Number (percentage) of criticisms 183 (83%) 57 (66%) 14 (64%) 254 (77%)


Monitoring Number (percentage) of criticisms 9 (4%) 14 (16%) 4 (18%) 27 (8%)


Total number of criticisms in each round 220 87 22 329

Number of reports with QC criticisms from each round ÷ 82 ÷ 30 ÷ 6 ÷ 118

Average number of criticisms per report from each round 2.7 2.9 3.7 2.8

Notes:1 From 82 first-round inspection reports of nonremediated firms 2 From 30 second-round inspection reports of nonremediated firms3 From 6 third-round inspection reports of nonremediated firms4 From 118 inspection reports of nonremediated firms5 The percentage of criticisms in each round is calculated as the number of criticisms divided by total criticisms in each round of

inspections. Total criticisms in each round are 220, 87, and 22 for the first, second, and third rounds, respectively.6 Because multiple criticisms can appear in each inspection report, the number of reports containing each type of criticism is also

reported. The percentage of reports with criticisms in each round is calculated as the number of reports containing each type ofcriticism divided by the total number of reports (of nonremediated firms) issued in each round of inspections (82, 30, and 6 for thefirst, second, and third rounds, respectively).


criticisms deal with deficiencies in auditperformance (The CPA Journal, February2009, pp. 58–60). Of the 329 QC criticismsdisclosed for 2005–2011, 254 (77%)related to audit performance (see Exhibit 1).The median number of audit performancecriticisms per inspection was 2; theseranged from 0 to 7. (A more detailed anal-ysis of deficiencies in firms’ quality con-trols over audit performance is presentedlater.)

Independence. Several CPA firms werecited for inadequate QC procedures related tothe firm’s independence—10% of all dis-closed QC criticisms mentioned this aspect ofthe firm’s QC system. Such comments onindependence might read as follows:

The Firm’s system of quality controlappears not to provide sufficient assur-ance that the Firm will comply withindependence requirements … theinspection team reported informationindicating that the Firm may not havebeen independent of an issuer auditclient within the meaning of theCommission’s independence require-ments.Two firms were cited for deficient con-

trols related to independence twice—onefirm was cited in its first inspection andagain in its second, whereas another firmwas cited in its first and third inspections.

Monitoring. Of all the QC criticisms,8% involved monitoring. Three firms werecited for inadequate monitoring twice—one firm was cited in its first and thirdinspections, and two firms were cited intheir second and third inspections.

Personnel management. This was thetopic of 4% of the criticisms. No firmwas cited for personnel management issuesin more than one inspection. Specific crit-icisms related to excessive partner work-load, inadequate CPE, and lack of com-petence of the engagement team.

Client acceptance and continuation. Onlytwo inspection reports cited deficiencies forclient acceptance and continuation weak-nesses, which suggests that this is an areaof relative QC strength for many firms.

Analysis. Although the number ofreports with unremediated QC criticismshas declined across inspection visits, thepercentage of reports citing certain defi-ciencies has increased. For example, QCdeficiencies related to monitoring are men-tioned in only 11% of reports from first

inspections, but they are mentioned in 47%of second inspection reports and in 67%of third inspection reports. Similar increas-es are also observed in deficiencies relat-ed to independence and audit performance.It is unclear whether these increases aredue to a greater emphasis on these areasby PCAOB inspection teams or whetherthe firms are not adequately remediatingthese types of QC deficiencies.

QC Deficiencies Related to Audit Performance

As noted previously, the greatest num-ber of QC criticisms relates to audit per-formance. More than 90% of the nonre-mediated inspection reports cited at leastone to three QC problems in this area, withadditional performance criticisms foundin 13 reports (four QC audit problems in7 reports; five problems in 3 reports; sixproblems in 1 report; seven problems in2 reports).

Given the frequency with which defi-ciencies involving controls over audit per-formance are mentioned in inspectionreports, this study examined these typesof deficiencies in greater detail. Inspectionreports mentioned 17 specific types ofQC defects related to audit performance(see Exhibit 2). Four of these accounted for80% of the PCAOB’s criticisms in theaudit performance area. Technical compe-tency, due care, and professional skepti-cism represented the most common issues,followed by concerns with auditor com-munications, appropriate audit tests, andconcurring partner review. Other defi-ciencies cited less frequently related tofraud procedures, financial statement dis-closures, subsequent events reporting, plan-ning and supervision, audit risk and mate-riality assessment, various documentationissues, and others.

Exhibit 2 categorizes the data by the roundof inspection (i.e., first, second, third) in orderto evaluate the extent to which QC defectshave evolved over time. The first round ofinspections resulted in a large number offirms cited for deficiencies related to tech-nical competence, due care, and profession-al skepticism. In the second round, howev-er, this number decreased noticeably. Onlyone firm was cited twice—once in its firstinspection and again in its second inspection.No firms were cited for this deficiency inthe third round. It appears that this deficiency

has been relatively easy for CPA firms toremediate.

An example of a criticism related totechnical competence, due care, and pro-fessional skepticism might read as follows:

The Firm’s system of quality controlappears not to do enough to ensure tech-nical competence and the exercise of duecare or professional skepticism. … Theinspection team reported the Firm failedto obtain sufficiently detailed manage-ment representation letters that relate toall periods covered by the auditor’sreport. … Moreover, the inspection teamreported that the form and content ofaudit reports issued by the Firm failedto comply with PCAOB standards inthat they did not correctly identify thebasis of accounting, make appropriatereference to predecessor auditors, or cor-rectly report on development-stage enter-prises. … Finally, the inspection teamreported that the Firm did not employsufficient procedures to review the audit-ed financial statements and footnotes forerrors and omissions prior to theirissuance.Insufficient auditor communications, par-

ticularly with the audit committee, repre-sented the second most frequently citeddeficiency. Four firms were twice cited for


deficient controls related to auditor com-munications—once in their first inspectionand again in their second. This suggeststhat, for some, these deficiencies have beenrelatively difficult to correct. The follow-ing is an example of a typical criticism inthis area:

The Firm’s system of quality control doesnot provide sufficient assurance that theFirm will make or document all requiredauditor communications with audit com-mittees, including making independenceconfirmations required by IndependenceStandards Board Standard No. 1,

Independence Discussions with AuditCommittees, and formally documentingcommunications with audit committees.Deficient QC over audit tests—also fre-

quently cited in nonremediated inspectionreports—has been increasing over time. Fivefirms were cited for deficient controls relat-

EXHIBIT 2Types of Audit Performance Quality Control (QC) Criticisms

First Inspection Second Inspection Third Inspection Totals

Audit Performance Frequency Percentage of Frequency Percentage of Frequency Percentage of Frequency Percentage of

QC Criticisms (Percentage)1 Unremediated2 (Percentage)3 Unremediated4 (Percentage)5 Unremediated6 (Percentage)7 Unremediated8

Technical competence, 58 (31.7%) 70.7% 4 (7.0%) 13.3% 0 (0.0%) 0.0% 62 (24.4%) 52.5%due care, professional skepticismAuditor 35 (19.1%) 42.7% 10 (17.5%) 33.3% 3 (21.4%) 50.0% 48 (18.9%) 40.7%communicationsAppropriate audit tests 19 (10.4%) 23.2% 22 (38.6%) 73.3% 6 (42.9%) 100.0% 47 (18.5%) 39.8%Concurring partner 42 (23.0%) 51.2% 2 (3.5%) 6.7% 2 (14.3%) 33.3% 46 (18.1%) 39.0%reviewFraud procedures 8 (4.4%) 9.8% 9 (15.8%) 30.0% 2 (14.3%) 33.3% 19 (7.5%) 16.1%Financial statement 3 (1.6%) 3.7% 0 (0.0%) 0.0% 0 (0.0%) 0.0% 3 (1.2%) 2.5%disclosuresSubsequent discovery 1 (0.5%) 1.2% 1 (1.8%) 3.3% 0 (0.0%) 0.0% 2 (0.8%) 1.7%of factsPlanning, performance, 0 (0.0%) 0.0% 1 (1.8%) 3.3% 0 (0.0%) 0.0% 1 (0.4%) 0.8%supervision, and reviewAssessment of audit 0 (0.0%) 0.0% 1 (1.8%) 3.3% 0 (0.0%) 0.0% 1 (0.4%) 0.8%risk or materialityReview of interim 1 (0.5%) 1.2% 0 (0.0%) 0.0% 0 (0.0%) 0.0% 1 (0.4%) 0.8%financial reportsRelated-party 1 (0.5%) 1.2% 0 (0.0%) 0.0% 0 (0.0%) 0.0% 1 (0.4%) 0.8%transactionsAudit reports 1 (0.5%) 1.2% 0 (0.0%) 0.0% 0 (0.0%) 0.0% 1 (0.4%) 0.8%Consultation 0 (0.0%) 0.0% 1 (1.8%) 3.3% 0 (0.0%) 0.0% 1 (0.4%) 0.8%Documentation(insufficient): Engagement 9 (4.9%) 11.0% 3 (5.3%) 10.0% 1 (7.1%) 16.7% 13 (5.1%) 11.0%completion documentDocumentation of 4 (2.2%) 4.9% 2 (3.5%) 6.7% 0 (0.0%) 0.0% 6 (2.4%) 5.1%audit workAssembly of audit 0 (0.0%) 0.0% 1 (1.8%) 3.3% 0 (0.0%) 0.0% 1 (0.4%) 0.8%documentationRetention of records 1 (0.5%) 1.2% 0 (0.0%) 0.0% 0 (0.0%) 0.0% 1 (0.4%) 0.8%Totals 183 (100%) 57 (100%) 14 (100%) 254 (100%)

Notes:1 As a percentage of all audit performance QC criticisms issued during first inspection (183 total)2 As a percentage of all inspection reports with unremediated QC criticisms during first inspection (82 total)3 As a percentage of all audit performance QC criticisms issued during second inspection (57 total)4 As a percentage of all inspection reports with unremediated QC criticisms during second inspection (30 total)5 As a percentage of all audit performance QC criticisms issued during third inspection (14 total)6 As a percentage of all inspection reports with unremediated QC criticisms during third inspection (6 total)7 As a percentage of all audit performance QC criticisms issued during all inspections (254 total)8 As a percentage of all inspection reports with unremediated QC criticisms during all inspections (118 total)


ed to audit tests twice—once in their firstinspection and again in their second. Twoadditional firms were cited in all three inspec-tions. The following is an example of acriticism of appropriate procedures:

The Firm’s system of quality controlappears not to provide sufficient assur-ance that the Firm will conduct all test-ing appropriate to a particular audit. Theinformation reported by the inspectionteam suggests an apparent pattern of fail-ures to perform the appropriate proce-dures related to the testing of revenue… and equity transactions.Another common criticism found in

inspection reports from the first inspec-tion deals with concurring partner review:51% of firms were cited for this deficien-cy. Interestingly, this dropped to 7% in thesecond round, but increased to 33% in thethird. One firm was cited for this deficiencytwice—once in its first inspection and againin its third. The following is an exampleof a concurring partner review criticism:

Questions exist about the effectivenessof the Firm’s existing arrangement forconcurring partner reviews. Having pro-cedures for concurring partner review bya competent reviewer is an importantelement of quality control. Such reviewsshould involve the performance ofappropriate procedures using due careand professional skepticism, with theFirm appropriately addressing thereviewer’s findings and documenting theprocess. The information reported by theinspection team suggests that there is noevidence that the concurring partnerreview procedure used by the Firmresulted in the identification of any ofthe deficiencies noted by the inspectionteam. This may result from a lack ofcompetency, due care or professionalskepticism on the part of the concur-ring partner; and/or the Firm’s failureto properly address the concurring part-ner findings.The fifth most frequently mentioned QC

deficiency related to fraud procedures.Similar to audit tests citations, the percent-age of reports citing fraud procedures hasbeen increasing over time. The following isan example of this type of criticism:

The Firm’s system of quality controlappears not to provide sufficient assur-ance that the Firm will perform all ofthe required procedures in accordance

with the provisions of AU 316,Consideration of Fraud in a FinancialStatement Audit. Specifically, the Firmdid not perform audit procedures to testjournal entries and other adjustments forevidence of possible material misstate-ments due to fraud.Finally, inspection reports identified four

types of deficiencies related to insuffi-cient or inappropriate documentation.These deficiencies involved the engage-ment completion document, documentationof audit work, assembly of audit docu-mentation, and retention of records. Ofthese, deficiencies in the engagement com-pletion document and in the auditor’sdocumentation of audit work were citedmost frequently. The following is an exam-

ple of a criticism involving an engagementcompletion document:

The Firm’s system of quality controlappears not to provide sufficient assur-ance that the Firm will prepare anengagement completion document inaccordance with AS 3, which is neces-sary to demonstrate that the work per-formed by engagement personneladdresses the significant findings andissues of the engagement.The remaining types of QC criticisms

occurred much less frequently, appearingin fewer than 2% of reports in any givenround of inspections. The sidebar,Examples of Other Quality Control (QC)Criticisms Related to Audit Performance,provides examples of these criticisms.


Partner Workload:An audit partner of the Firm has a significant number of issuer clients. The Board has concerns that the significant number of issuer audit clientsassigned to this audit partner may affect the partner’s ability to adequatelysupervise and review audit engagements.

Financial Statement Disclosures:The Firm’s system of quality control appears not to provide sufficient assurance that the Firm will identify any missing or incomplete financialstatement disclosures. Specifically, required disclosures relating to segmentreporting, impairment and business combinations were noted as missing in issuers’ financial statements.

Subsequent Discovery of Facts:The Firm’s system of quality control appears not to provide sufficient assurance that the Firm will perform all required procedures in accordancewith the provisions of AU 561, Subsequent Discovery of Facts Existing at the Date of the Auditor's Report. Specifically, through an issuer’s pressrelease filed 13 days after the date of the issuer's annual report, it firstcame to the Firm’s attention that certain of the financial projections used as the basis for the specialist's fair value calculations were inaccurate orincomplete. The Firm failed to consider whether that information, had itbeen known to the Firm at the date of its audit report, would have affected that report and whether there were persons relying on the financial statements who would attach importance to the information.

Planning, Performance, Supervision, and Review:The Firm’s system of quality control appears not to provide sufficient assurance that the Firm will refrain from issuing audit reports in circum-stances in which doing so is inappropriate because the Firm has notplanned, performed, supervised, or meaningfully reviewed the audit work.… The inspection team identified two cases in which the Firm inappropri-ately issued reports stating that the Firm had performed an audit and thatthe Firm’s audit provided it with a reasonable basis for an opinion eventhough the Firm and its personnel did not plan, did not perform, did notsupervise, and did not meaningfully review the audit work performed inthose engagements. This information provides cause for concern regardingthe Firm’s quality control policies and procedures related to the Firm’s planning, supervision and review of issuer audit engagements.

Audit Risk and Materiality:The Firm’s system of quality control appears not to provide sufficient assurance that the Firm will appropriately assess audit risk at the individualaccount balance, class-of-transaction, or disclosure level … obtain anunderstanding of relevant electronic data processing controls and applica-tions and determine whether such controls have been placed in operation… and consider materiality in planning the audit. … This information provides cause for concern that the Firm will not design and perform audit procedures whose nature, timing, and extent are responsive to theassessed risks of material misstatement at the relevant assertion and financial statement level.

Review of Interim Financial Reports:The Firm’s policies and procedures do not ensure that all required auditprocedures with respect to reviews of quarterly financial information will be performed. During December 2004, the Firm was engaged to audit anissuer’s 2004 financial statements. The issuer’s financial statements included unaudited quarterly financial data for 2004 and the prior year. The Firm did not perform a review of the issuer’s 2004 fourth quarter interim financial information, nor did it perform reviews of the quarterlyfinancial data for the first three quarters of 2004.

Related-Party Transactions:The Firm’s system of quality control appears not to provide sufficient assur-ance that the Firm will perform all required procedures to identify the exis-tence of related parties and related-party transactions in accordance withthe provisions of AU 334, Related Parties. Specifically, the Firm did not per-form audit procedures to evaluate the existence, completeness, and valua-tion of transactions with related parties.

Audit Reports:In the audit reviewed, the issuer’s Form 10-K filed with the Commission includ-ed an audit report in the Firm's name that expressed an unqualified opinion onthe financial statements and did not include an explanatory paragraph regard-ing the issuer’s ability to continue as a going concern. The Firm represented tothe inspection team that it had issued a report including an explanatory para-graph regarding the issuer’s ability to continue as a going concern and that,until the inspection team pointed out to the Firm the absence of any goingconcern paragraph from the audit report included with the Form 10-K, the Firmwas unaware that the audit report filed by the issuer did not include such aparagraph. This information provides cause for concern regarding the Firm’squality control policies and procedures related to detecting and addressing suchinaccuracies, in reports filed with the Commission, concerning the Firm’s asso-ciation with financial statements.

Consultation:The Firm’s system of quality control appears not to provide sufficient assurancethat Firm personnel consult with individuals outside the firm when appropriate,such as when dealing with complex, unusual, or unfamiliar issues. Although theFirm’s policies and procedures require consultation with experts outside the Firmin situations where the Firm has limited experience, no such consultationoccurred with respect to the accounting issue described in Part II.A of this report,despite the Firm’s limited experience in this area.

Engagement Completion Document:The Firm’s system of quality control appears not to provide sufficient assurance that the Firm will prepare an engagement completion documentin accordance with AS 3, which is necessary to demonstrate that the workperformed by engagement personnel addresses the significant findings andissues of the engagement.

Audit Documentation:The Firm’s system of quality control appears not to provide sufficient assurance that the Firm will comply with the audit documentation andretention rules set forth in AS 3. Specifically, numerous audit workpaperswere either not completed by the Firm or not initialed as reviewed by theengagement partner or manager prior to the report release date.

Assembly of Audit Documentation:The Firm’s system of quality control appears not to provide sufficient assurance that the Firm will have a complete and final set of audit docu-mentation assembled for retention as of a date not more than 45 days after the report release date in accordance with AS 3.

Retention and Provision of Records:The Firm’s system of quality control does not provide sufficient assurancethat the Firm will retain appropriate documentation of its audit work and itscompliance with standards relating to quality control. Before and during theinspection field work, the inspection team requested that the Firm provide itwith the audit work papers for an audit of an issuer that the Firm had per-formed. The Firm claimed that it was unable to provide these requesteddocuments, stating that they were in the possession of the issuer, a formerclient. In addition, the firm failed to provide certain continuing education(CPE) records of its owner. The requested workpapers and CPE recordsshould be maintained by the Firm.

EXAMPLES OF OTHER QUALITY CONTROL (QC) CRITICISMSRELATED TO AUDIT PERFORMANCE


EXHIBIT 3Traits of CPA Firms across PCAOB Inspections

Panel A: Firms receiving quality control (QC) criticisms versus firms without

First Inspection Second Inspection Third Inspection

Firms with no Firms with Firms with no Firms with Firms with no Firms with

QC criticisms QC criticisms QC criticisms QC criticisms QC criticisms QC criticisms

Traits (195; 26%) (548; 74%) (208; 49%) (214; 51%) (54; 47%) (61; 53%)

Number of partners 7.0 (12.5)1 4.0 (10.7) 7.0 (11.6) 5.0 (18.5) 9.0 (13.4) 5.0 (13.3)

Number of staff 24.0 (55.5) 14.0 (48.3) 27.0 (52.1) 19.5 (92.1) 41.5 (57.2) 15.0 (55.3)

Number of issuer 3.0 (6.2) 4.0 (11.1) 3.0 (8.3) 6.5 (17.0) 2.0 (6.6) 4.0 (11.5)clients

Partners per issuer 2.0 (3.3) 1.0 (2.4) 2.0 (3.1) 1.0 (2.3) 2.5 (4.1) 1.8 (2.7)clients

Staff per issuer client 7.3 (13.8) 3.2 (9.1) 8.0 (12.5) 3.3 (10.3) 11.8 (16.3) 5.2 (10.8)

Partners and staff 9.6 (17.0) 4.4 (11.5) 9.8 (15.6) 4.3 (12.6) 14.6 (20.4) 7.0 (13.5)per client

Number of offices 1.0 (2.5) 1.0 (2.2) 1.0 (2.2) 1.0 (3.2) 1.0 (2.0) 1.0 (2.6)

Panel B: Firms that remediated QC criticisms versus firms that did not

First Inspection Second Inspection Third Inspection

Firms that Firms that Firms that

Firms that did not Firms that did not Firms that did not

remediated remediate remediated remediate remediated remediate

criticisms criticisms criticisms criticisms criticisms criticisms

Traits (466; 85%) (82; 15%) (184; 86%) (30; 14%) (55; 90%) (6; 10%)

Number of partners 5.0 (12.0)1 2.0 (3.7) 5.0 (21.0) 2.0 (3.5) 5.0 (14.5) 2.0 (2.2)

Number of staff 17.0 (53.2) 4.0 (20.3) 22.5 (105.3) 4.5 (10.9) 20.0 (60.9) 1.5 (3.7)

Number of issuer 4.0 (11.4) 3.5 (9.7) 7.0 (17.5) 5.0 (13.4) 4.0 (11.3) 12.5 (13.3)clients

Partners per issuer 1.1 (2.6) 0.5 (1.2) 1.0 (2.5) 0.4 (1.3) 1.9 (2.9) 0.1 (0.5)clients

Staff per issuer client 3.8 (10.1) 0.7 (3.2) 4.0 (11.2) 0.5 (4.7) 5.5 (11.9) 0.1 (0.4)

Partners and staff 5.0 (12.7) 1.0 (4.4) 5.0 (13.7) 0.9 (6.0) 7.2 (14.8) 0.2 (0.9)per client

Number of offices 1.0 (2.3) 1.0 (1.4) 1.0 (3.4) 1.0 (1.6) 1.0 (2.8) 1.0 (1.0)

Notes:1Median (Mean shown in parentheses)Figures in blue represent statistically significant differences between firms that remediated QC criticisms and firms that did not remediate criticisms received in each round of inspections. Tests of significance are based on the Mann-Whitney test, which assess-es the significance of differences in median values.


Analysis of Traits of Inspected Firms The authors assessed the various traits

of CPA firms cited for QC deficienciesand compared them with other CPA firmsacross the three rounds of PCAOB inspec-tions. (Exhibit 3 presents these traits.) Toexplore the extent to which firms with QCdeficiencies differ from other firms, thedata in Panel A are grouped according towhether the firm was cited for QC defi-ciencies in its inspection report. The dataare also grouped by inspection (initialinspection versus subsequent inspection)to observe how these traits have evolvedover time.

Because no triennial firms have more than100 issuer clients, they are generally com-paratively small CPA firms. Firms withQC deficiencies tend to have fewer part-ners than firms with no QC deficiencies(Panel A). This is consistent with otherresearch (e.g., Helen M. Roybark, “PublicDisclosure of Quality Control Criticisms:Examining PCAOB Inspection Reports toDetermine Differences among Audit Firms,”The CPA Journal, April 2012, pp. 32–39).This difference is statistically significantacross all three rounds of inspections. Themedian number of partners increasedacross each inspection round. For firms withno QC deficiencies, the median number ofpartners increased from 7 in the first roundto 9 in the third round; the median numberof partners in firms with QC deficienciesincreased from 4 to 5.

Firms cited for QC deficiencies are alsosmaller in terms of staff than firms with noQC deficiencies, and this difference hasincreased over time. In the first round ofinspections, the median number of staffmembers in firms with no QC deficiencieswas 24, whereas the corresponding numberin firms cited for QC deficiencies was only14. By the third round, this difference hadgrown to 26 (41 staff members in firms withno deficiencies, but only 15 staff membersin firms with deficiencies).

Although firms with QC deficienciestended to have fewer partners and staff thanfirms without deficiencies, the firms withQC deficiencies had, on average, moreclients registered with the PCAOB. Giventhat firms with lower partner-to-client andstaff-to-client ratios might be less capableof properly managing and staffing theiraudits, these ratios were examined sepa-rately. Across all three rounds of inspec-

tions, the median values of all three ratios(partners to clients, staff to clients, and part-ners plus staff to clients) were significant-ly lower for firms with QC deficienciesthan for firms with no QC deficiencies.

This study also examined whether thetraits of firms that remediated their QCdeficiencies were different from those offirms that did not remediate. Panel B ofExhibit 3 reveals that these differencesare even more striking than those inPanel A—for example, the median num-ber of partners for firms that remediatedwas 5, whereas the median for nonreme-diated firms was only 2. (This differenceis statistically significant and persists acrossall three rounds of inspections.) Similarly,the number of staff was significantly lowerfor nonremediated firms across all threeinspection rounds.

Although the number of clients did notsignificantly differ, the ratios of partners toclients, staff to clients, and partners andstaff to clients were all significantly lowerfor nonremediated firms across all threerounds of inspections. These differencesraise concerns about whether nonremedi-ated firms possess sufficient numbers ofpartners and staff to adequately conduct,supervise, and review their PCAOB auditengagements.

Analysis of FindingsThe predominant QC criticism in every

round of inspections involved some aspectof audit performance. On average, there were2.2 QC criticisms involving audit perfor-mance per report. Specific matters cited mostfrequently were the technical competence ofthe engagement partners and staff, lack ofcommunication between the auditor andthe client’s audit committee, and insufficientor inappropriate audit tests.

Issues involving independence repre-sented the second most common criticism.Following its first round of inspections,the PCAOB expressed an intention toincrease its focus in future inspectionson issues related to independence andfraud procedures (see James J. Farrell andHouman B. Shadab, “The Focus of FuturePCAOB Auditor Inspections,” The CPAJournal, June 2005). This study found thatthe percentage of inspection reports cit-ing deficiencies related to independenceand fraud procedures has increased acrossall three rounds of inspections. In addi-

tion, the percentage of reports citingdeficiencies in monitoring has alsoincreased over time.

This study compared various traits ofCPA firms cited for at least one QC defi-ciency with firms not cited for QC defi-ciencies. The results revealed that firmscited for QC deficiencies generally hadfewer partners and staff than other firms;they also showed lower ratios of partner toclient, staff to client, and partner and staffto client. The magnitude of these differ-ences has grown from the first inspectionround to the third. These findings raise con-cerns that firms cited for QC deficienciesmight be relatively overextended or under-staffed in terms of their ability to proper-ly service their clients.

The authors then focused only on firmscited for QC deficiencies and compared thetraits of firms that satisfactorily addressedtheir deficiencies with those that did not.The differences between the numbers ofpartners and staff members were even larg-er than those observed when comparingfirms with and without QC deficiencies.Specifically, nonremediated firms had evenfewer partners and staff, as well as lowerratios for partner to staff, staff to client, andpartner and staff to client, than firms thatremediated their deficiencies satisfactorily.

This study should serve to remind all audi-tors, regardless of the size of the companiesthey audit, of the importance of establishingand maintaining an effective system of qual-ity control. Effective QC systems help CPAfirms comply with professional standards,rules, and regulations, as well as provide high-quality services. An understanding of theelements of QC systems that are most likelyto be deficient can assist CPAs in monitor-ing the effectiveness of their systems. Finally,this study’s findings can remind CPA firmsof the types of issues that are most frequent-ly cited by PCAOB inspectors when evalu-ating registered firms’ QC systems.Awareness of these issues should help firmsprepare for upcoming inspections. q

Alan I. Blankley, PhD, CPA, and DavidS. Kerr, PhD, are both associate profes-sors, and Casper E. Wiggins, PhD, CPA,is a Big Five Distinguished Professor ofAccounting, all in the Belk College ofBusiness, University of North Carolina atCharlotte.

Agrowing chorus comprising mainly small and medium-sized entities (SME) has asserted that the excessive vol-ume and complexity of current accounting standards—thatis, “standards overload”—has created difficulties for finan-

cial statement preparers, auditors, and users. But such concernsare not new. “Accounting Standards Overload: Relief IsNeeded” was published more than 30 years ago in the Journal

of Accountancy, winning its 1982 Lawler Award (Gerald W. Heppand Thomas W. McRae, May 1982). More recently, the 2001Annual Financial Accounting Standards Advisory Council Surveycited standards overload as a continuing problem. The February28, 2002, edition of the FASB Report, published by the board,reported that a similar problem—disclosure overload—wascausing confusion among financial statement users.

Proposed Conceptual Changes in Financial Reporting

A C C O U N T I N G & A U D I T I N Gs t a n d a r d s s e t t i n g


By Robert A. Dyson

The Problem of Competing Frameworks and Disclosure Overload

The underlying issue is a disagreementbetween varying constituencies over whatshould be included in GAAP; different sub-sets of users demand specialized informationthat meets their particular needs. As a con-sequence, financial statements include infor-mation that satisfies one subset of users butholds no interest for others. This proliferationof information then results in an overload ofboth standards and disclosures.

In response to these concerns, FASB hasproposed the following changes to GAAP:n Convergence with IFRS (issued by theIASB) n Changes in disclosure requirementsn Modified measurement and disclosurerequirements for private companies.

Reporting entities not using GAAP havetraditionally applied other comprehensivebases of accounting (OCBOA), such asan income tax basis or modified cash basis.On June 10, 2013, the AICPA issued yetanother OCBOA, designed specifically forSMEs.

This activity reflects the fragmentationof the concept of a single set of account-ing principles generally accepted by allentities; instead, each project addresses theneeds of a different constituency. In aneffort to correct standards overload, theaccounting profession now faces account-ing basis overload. To highlight the impor-tance of this issue, this discussion willpro vide an overview of the differentaccounting bases being proposed and willconsider the purpose of financial reporting.

Convergence with IFRS IFRS aims to provide a common set of

high-quality accounting principles that aregenerally accepted worldwide. Althoughapplying accrual accounting, IFRS’s lessdetailed rules give financial statementpreparers greater latitude in achievingaccounting objectives than GAAP does.

The SEC has pursued the developmentof a single worldwide framework ofaccounting principles since 1973. In 2007,the SEC permitted companies to use IFRSwhen filing in U.S. capital markets. In July2012, it proposed the latest of a series of workplans on the adoption of IFRS, Work Plan forthe Consideration of IncorporatingInternational Financial Reporting Standardsinto the Financial Reporting System forIssuers, which noted that the vast majorityof U.S. capital market participants support

exploring the adoption of IFRS under cer-tain conditions but do not support completeadoption.

Although the SEC has not made anypolicy decision to require U.S. issuers toapply IFRS, it is encouraging condorse-ment—that is, the convergence of certaininternational and U.S. accounting standardsand the endorsement of specific IFRSs intoGAAP. The convergence process has beena collaborative effort by FASB and theIASB to eliminate the differences betweenGAAP and IFRS by issuing joint account-ing standards; endorsement occurs whenU.S. standards setters either accept or rejectthe incorporation of specific IFRSs intoGAAP. Although condorsement has beendeemed a method for promoting the accep-tance of IFRS, its very nature—changingcurrent IFRS and reserving the right toreject any pronouncements—raises con-cerns as to whether IFRS is really a high-quality basis of accounting after all.

Since the process began in 2002, con-vergence between IFRS and U.S. GAAPhas made some progress, but it remainsincomplete. The two bases are now similarin certain areas, such as business combina-tions, debt, share-based compensation, andearnings per share. Fundamental differencesremain, however, in accounting for assetimpairment; property, plant, and equipment;acquired intangible assets; inventory;research and development; income taxes;bank loan losses and litigation contingen-cies. The expected completion date formajor projects, originally scheduled for June2011, was extended to 2014.

IFRS’s greater flexibility is inherentlyinconsistent with a goal of improving thecomparability of financial statements acrosscountries, industries, and companies.Although a 2011 SEC analysis noted thatcompany financial statements generally com-plied with IFRS standards, it also observeda diversity of practice caused by explicitoptions permitted under IFRS, the absenceof guidance, and noncompliance(http://www.sec.gov/spotlight/globalaccount ingstandards/ifrs-work-plan-paper-111611-gaap.pdf; http://www.sec/gov/spot light/globalaccountingstandards/ifrs-work-plan-paper-111611-practice.pdf). Most coun-tries do not consider IFRS authoritative andapply some type of endorsement procedure.The greater flexibility and endorsementapproach permits different countries to cre-

ate their own versions of IFRS—defeatingthe purpose of a single set of internationalfinancial accounting standards.

Consistent with the endorsement concept,the SEC has identified certain potential per-manent differences between GAAP andIFRS. One such difference, the accountingfor litigation contingencies, could create a sig-nificant issue for auditors. Pursuant to a 1975agreement between the AICPA and theAmerican Bar Association, attorneys provideletters regarding the existence and status oflitigation to the preparers’ auditors. Someattorneys have asserted that the additionalinformation required by IFRS could violatethe attorney/client privilege, which may resultin attorneys refusing to provide importantaudit evidence. In these circumstances, audit-ing standards require auditors to issue a qual-ified audit opinion or a disclaimer of opin ion,which the SEC does not accept for filings bypublic companies.

A second difference pertains to theIASB’s resistance to issuing industry-spe-cific guidance. Instead, the IASB assertsthat its guidance applies to all transactions,regardless of industry, and that industry-specific guidance only complicatesaccounting standards. This position con-flicts with U.S. regulatory practice.

Federal and state regulators govern cer-tain activities of certain industries, suchas investment companies, broker/dealers,financial institutions, oil and gas compa-nies, and rate-regulated utilities. Regulatorsrely on specific industry guidance whenapproving utility rates, assessing the sound-ness of financial institutions, and deter-mining the permissibility of costs for fed-eral procurement contracts. The adoptionof IFRS by public companies could resultin different accounting bases applied byprivate and public companies in regulatedindustries or in the SEC imposing a modelon federal and state regulatory agencies andprivate companies over which it has noauthority. Moreover, federal and state lawsand regulations, which are difficult tochange, would need to be aligned withIFRS prior to implementation.

To date, regulatory authorities have notperformed any comprehensive analysis, butthey have identified certain differencesbetween GAAP and IFRS. For example,GAAP requires that capital shares issuedby certain investment companies, such asmutual funds, be classified as equity (a fun-



damental regulatory measurement), where-as IFRS requires that such shares be clas-sified as liabilities. Funds applying IFRSwould be deemed as having no equity.Investment companies have alreadyadvised the SEC that the current GAAPmore accurately presents their investingactivities and results of operations. Canada,which has adopted IFRS, has expressedsimilar concerns; thus, it permits invest-ment companies not to adopt internation-al standards.

Adoption of IFRS could require revi-sions to contracts, debt instruments, andother agreements that rely upon GAAPmeasurements to determine compliancewith covenants. Private companies enter-ing into these agreements would not havean accounting model other than IFRS andwould be forced to adopt the internation-al standards. A subset of IFRS is avail-able to SMEs that publish financial state-ments but are not held to public account-ability. No one has determined whether therecognition, measurement, and disclosuredifferences permitted by IFRS for SMEsare acceptable to regulatory authorities orcontractual counterparties. The SEC workplan hopes that the Private CompanyCouncil (PCC), discussed later, will addressthe needs of private companies.

The proposed adoption of IFRS accom-modates one set of constituents, internation-al companies and their investors, but notanother, private companies. Multinationalcompanies, which consist of some sub-sidiaries applying GAAP and others apply-ing IFRS, have supported the concept ofone accounting basis for a consolidatedreporting entity. Rather than assuming thatinternational standards will simplify financialreporting, standards setters should considerthe impact that adoption of IFRS couldhave on significant, complex regulatory com-pliance and accounting issues with privatecompanies and government regulators.

FASB’s Disclosure FrameworkOn July 12, 2012, FASB issued an invi-

tation to comment on its disclosureframework, which proposed significantchanges in the nature of disclosuresrequired by GAAP. The proposed frame-work has the stated purpose of improvingthe effectiveness of disclosures by limitingfinancial statement notes to only theinformation that is most important to users.

The disclosure framework was prepared incooperation with certain European advi-sory groups responsible for addressing thetechnical quality of IFRS.

A motivating factor of this project isusers’ concerns about disclosure over-load, which is attributed to the actions ofauditors, legal advisors, and regulators. Infact, most disclosures are required by cur-rent accounting standards and are enforcedby regulators tasked with protecting thepublic interest. Auditors and preparers areunder significant legal pressure to complywith disclosure requirements. Although theobjective of reducing unnecessary disclo-sures is appealing, the mechanisms outlinedin the disclosure framework might createmore confusion than currently exists.

The proposed framework promotes flex-ibility by establishing disclosure objectives,but not content. Its fundamental principlesare that the notes to the financial statementsshould be limited to information that is—n unique to the reporting entity or itsindustry, n not apparent from the financial state-ments or not readily available from publicsources, and n able to make a material difference inassessments of future cash flows.

The framework’s assumption that usershave information on general business risksand general economic conditions, as wellas an awareness of GAAP, common pric-ing models, and SEC reporting require-ments, seems to be more applicable tobro kers and analysts than to less sophisti-cated users.

Permitting greater preparer judgment indetermining the relevancy of disclosures isan attempt to reduce their volume withoutreducing their effectiveness. Althoughthis approach is theoretically sound, it doesnot provide guidance on reliability andmateriality, which are important consider-ations in preparing relevant information.Reliability is defined by Statement ofFinancial Accounting Concepts (SFAC) 2,Qualitative Characteristics of AccountingInformation, as information that is repre-sentationally faithful, verifiable, and neu-tral. The disclosure framework’s objec-tive of providing enough information tomake a difference in a user’s decisions onproviding resources does not address thepotential relationship between the reliabil-ity of information and the continued alle-

gations of misleading financial state ments.Unreliable information is not useful inmaking decisions and, thus, is not relevant.Including information in the financial state-ments that can be reasonably verified (e.g.,audited) with any degree of precisionshould reduce the incidence of alleged mis-leading financial statements. The disclo-sure framework also specifically excludesmateriality from its scope, despite its objec-tive to limit note disclosures to informa-tion that could make a material differencein assessing future cash flows. The inade-quate guidance does not shield preparersand auditors from the legal consequencesof omitting information that seems insignif-icant at the time of financial statementissuance but proves to be significant inthe future.

The proposed framework results in anincomplete presentation of net cash avail-able for future cash obligations. It empha-sizes cash flows derived from the sale ofinvestments, and it omits cash flows fromfuture operations. Many entities generate asignificant portion of their funds from oper-ations and use those funds to settle futureobligations—for example, mortgage prin-cipal and interest due on commercial realestate is typically settled using net proceedsfrom tenant leases. The proposed presen-tation would be complete only in finan-cial statements of certain specialized indus-tries, such as investment companies andemployee benefit plans.

The disclosure framework’s assumptionthat future events can be accurately forecast-ed does not recognize that future cash flowsrelated to equity and credit instruments andoperations are speculative. For example, theframework recommends the disclosure of theterms of financial instruments and other bind-ing arrangements, as well as the likelihoodof counterparty nonperformance. Althoughthey are capable of assessing the possible fail-ure to perform, most preparers do not con-trol the counterparty and cannot identify, withany degree of certainty, specific counterpar-ties that are currently in compliance with con-tract terms but might not be in the future. Inaddition, most contracts have recourse and“escape” clauses, contingent upon specificevents; these create additional uncertainties.Disclosures of uncertainties based on coun-terparty nonperformance and contingentcontractual terms would be extensive anddefeat the purpose of limited disclosures.


On November 12, 2013, FASB direct-ed its staff to prepare an exposure draft thatwould add a chapter on disclosures toSFAC 8, Conceptual Framework forFinancial Reporting. If the exposure draftis consistent with the disclosure framework,it would require preparer and auditor judg-ment to identify user needs; accordingly,guidelines and parameters on identifyingand disclosing such information would beneeded. In addition, this exposure draftshould provide sufficient guidance onreliability and materiality before proposingany guidance derived from the frame-work’s invitation to comment.

The PCCIn December 2009, the Financial

Accounting Foundation (FAF) Board ofTrustees (the parent of FASB), theAICPA, and the National Association ofState Boards of Accountancy (NASBA)established the Blue Ribbon Panel onStandard Setting for Private Companiesto address concerns that certain account-ing standards were not relevant to manyprivate company financial statement users,and that they created unnecessary com-plexity and significant costs for prepar-ers and auditors. Some private companieswere avoiding GAAP requirements byaccepting qualified audit opinions or byadopting OCBOA.

In response, the FAF established thePCC on May 30, 2012. The PCC is respon-sible for identifying any exceptions or mod-ifications to GAAP with respect topri vate company financial statements,developing proposed modifications, andexposing such proposals for public com-ment. FASB must agree with the PCC’sagenda and approve any proposed modi-fications or exceptions. The PCC alsoserves as the primary advisor on the appro-priate treatment of proposed accountingrules for private companies.

On December 23, 2013, FASB and thePCC issued Private Company Decision-Making Framework, A Guide forEvaluating Financial Accounting andReporting for Private Companies. Theguide had the stated objective of identify-ing the circumstances in which alternativerecognition, measurement, disclosure, dis-play, effective date, and transition guidanceshould be permitted for private companyreporting under GAAP. It identified the fol-

lowing factors as differentiating privatefrom public companies:n Types and numbers of financial state-ment users and their access to managementn Investment strategies of primary usersn Ownership and capital structuren Accounting resourcesn Preparers learning about and imple-menting new financial reporting guidance.

Reporting entities are permitted to applyPCC modifications unless specificallyexcluded. Not-for-profit entities andemployee benefit plans may not apply PCCmodifications unless specifically permittedon a standard-by-standard basis. Publicbusiness entities, as defined in AccountingStandards Update (ASU) 2013-12,Definition of a Public Business Entity, arealso prohibited from applying PCCexceptions and modifications. A publicbusiness entity is defined as meeting anyone of the following criteria: n It is required by the SEC to file or fur-nish financial statements.n It is required to file or furnish financialstatements with a regulatory agency.n It is required to file or furnish financial state-ments with a foreign or domestic regulatoryagency for purposes of issuing securities. n It is a conduit bond obligor for conduitdebt securities that are traded in a publicmarket.n Its securities are not subject to contrac-tual restrictions on transfer and it isrequired by law, contract, or regulation toprepare GAAP financial statements to bemade publicly available on a periodic basis.

The final pronouncement clarifies thatentities issuing securities traded on web-sites (as opposed to formal exchanges)—permitted by the Jumpstart Our BusinessStartups (JOBS) Act of 2012—are publicbusiness entities.

The classification of conduit bond oblig-ors as public companies remains a contro-versial issue. Conduit bond obligors areresponsible for settling conduit debt secu-rities, which are debt instruments issued bystate or local governments for the purposeof providing financing to a specified thirdparty. Although the debt instruments areoften in the name of the governmentalissuer, a third party is responsible for theservicing and payment of the debt. A com-mon conduit debt security, for example,is issued by the Dormitory Authority of theState of New York.

A conduit bond obligor is deemed a pub-lic company when its conduit debt securi-ties are traded in a public market. Ascon duit bond obligors are indirectly access-ing the public debt markets, FASB con-cluded that the users of financial statementsof privately held conduit bond obligorsoften have information needs similar toinvestors in public company corporate debtsecurities. Certain FASB members haveacknowledged that some private companyconduit bond obligors face similar resourceconstraints as private companies, and theyhave expressed a willingness to considerdeferred effective dates.

One major issue pertains to private com-panies that choose not to apply, or are noteligible to apply, all or some of the PCCmodifications. FASB and the PCC con-cluded that private companies maychoose not to apply any or all PCC mod-ifications, provided that such decisionsare properly disclosed in the financial state-ments. In addition, private companies noteligible to apply PCC modifications willbe identified, on a standard-by-standard


basis, by factors such as user needs. Forexample, regulated private companieswould be subject to the same industry-spe cific accounting guidance as publiccompanies. This position reflects a pre-sumption that the unique nature of someindustries and their often-specializedaccounting guidance are generally relevantto financial statement users of both publicand private companies.

In January 2014, FASB issuedAccounting Standards Updates (ASU)2014-03 and 2014-02 on “plain vanilla”interest rate swaps and goodwill. Projectson other derivatives, intangible assets,and variable interest entities remain in var-ious stages of consideration.

The FAF and FASB recognize that exten-sive PCC exceptions and modifications couldresult in substantially different accountingstandards for public and private companies;however, this risk can be mitigated if the PCChas a clear mission, coordinates with FASB,and is overseen by the FAF. FASB hasasserted that its guide is not a new concep-tual framework that fundamentally differsfrom the one used by public companies. Inaddition, the FAF specifically prohibits thePCC from adding competing projects to itsagenda that are already under considerationby FASB. In effect, PCC modifications area subset of GAAP.

Financial Reporting Framework (FRF)for SMEs

On June 10, 2013, the AICPA issued theFRF for SMEs with the stated purpose ofproviding a less costly and complicatedframework for SMEs. AICPA personneldeny that the new framework will competewith the PCC. The FRF for SMEs isintended for entities that issue financialstatements but are not required to provideGAAP financial statements. Despite itstitle, the new framework does not defineSMEs and is available to entities of allsizes; however, it should not be applied byentities that intend to go public.

The FRF for SMEs is another OCBOA,like income tax basis and cash basis. Theframework notes that existing OCBOA maybe insufficient or lack adequate standard-ization to meet the needs of entities notrequired to provide GAAP financial state-ments. For example, financial statements pre-pared in conformity with income tax basistheoretically reflect a reporting entity’s

income tax returns; however, the income taxbasis of accounting does not require thedisclosure of certain contingencies, such asmaterial liabilities related to interest rateswaps. The FRF for SMEs requires certaindisclosures of such instruments.

The FRF for SMEs blends GAAP and theaccrual income tax basis of accounting. Itpresents financial statements using an incomestatement focus, rather than the balance sheetfocus favored by GAAP. For example, theFRF for SMEs measures certain investmentsat adjusted cost as a result of actual trans-actions, such as purchase or impairment.Holding gains and losses are not recog-

nized until the date of sale or disposal. Incontrast, GAAP presents the economicwealth of the reporting entity at the end ofthe reporting period, recognizing the changesin value of certain investments as unrealizedgains and losses in each reporting period.

The FRF for SMEs presents four quali-tative characteristics of information that isuseful to financial users: understandability,relevance, reliability, and comparabil i ty.Information is reliable if it is consistentwith the actual underlying transactions, canbe independently verified, and is reason-ably free from error or bias. This indepen-dent verification provides a basis on whichauditors can conclude that amounts areappropriate, as opposed to GAAP, inwhich certain estimates, such as the fair valueof Level 3 investments (based on manage-ment’s assessment of unobservable inputs),are based upon future events and subject tochange.

Some FRF for SMEs guidance is notinformative. For example, the proposal rais-es concerns about, but does not provide cri-teria on, the propriety of recognizing rev-enue from a bill-and-hold arrangement,which typically involves the seller hold-ing the goods within its own premises afterselling them to a specified buyer. Thesearrangements have been associated withfraud by reporting entities falsely claim-ing the sale of inventory still on premises.Entities issuing GAAP financial statementshave traditionally followed the SEC’seasily understood guidance on the recog-nition of bill-and-hold arrangements.

The AICPA has not justified why an addi-tional OCBOA is necessary, given that otherbases of accounting already exist. TheAICPA has repeatedly asserted that pri-vately owned SMEs are looking for a morerelevant, less complicated, and more cost-beneficial framework for their financialreporting needs and that bankers and otherfinancial statement users need more easilyunderstood, more useful financial statementsbased upon a reliable, principles-basedframework. As discussed in the Blue RibbonPanel’s report, many SMEs have alreadyfound a simpler system: applying the incometax or modified cash bases of accounting.In addition, bankers and other users have notembraced the FRF for SMEs at the presenttime. In its related frequently asked ques-tions, the AICPA recommended that pre-parers consult with lenders and other usersbefore presenting financial statements pre-pared using the FRF for SMEs. This advicerecognizes that many loan documents spec-ify the basis of accounting to be applied tofinancial statements. The AICPA did notaddress why it did not meet the above needsby simply proposing enhanced disclosuresfor the income tax or modified cash basesof accounting.

In a June 13, 2013, letter, NASBAadvised private companies not to adopt theFRF for SMEs. NASBA serves as a forumfor state boards of accountancy, which reg-ulate the practice of public accountancyin 55 U.S. jurisdictions. NASBA’s oppo-sition to the FRF for SMEs is based on thedifficulty of regulating and enforcingnonauthoritative guidance, the failure todefine SMEs within the framework, andthe permitted use of GAAP financial state-ment titles without requiring the disclosureof differences from GAAP.

The AICPA has not justi-

fied why an additional

OCBOA is necessary,

given that other bases of

accounting already exist.


The Purpose of Financial ReportingIn an effort to address three decades of

concern about standards overload, the SEC,FASB, and the AICPA have all proposedor implemented significant changes toaccounting standards. But the sheer volumeof proposed changes overwhelms theavowed purpose of reducing standards over-load and undermines the conceptual goalof one set of accounting principles that isgenerally accepted by all. The multiple pro-posals reflect a disagreement over whatshould be included in GAAP. Multiplebases of accounting, many with significantconceptual weaknesses, will confuse usersand create serious training and implemen-tation problems for preparers and auditors.

The disagreement is fueled by FASB’sfavoring one subset of users over all otherstakeholders. SFAC 8 asserts that theobjective of financial reporting is to pro-vide financial information that is useful toexisting and potential investors, lenders,and other creditors in making decisionsabout allocating resources. FASB’s guide,however, classifies investors, lenders, andother creditors as primary users of privatecompany financial statements—and impliesthat vendors, customers, lessors, insurers,regulators, and trustees of employee stockownership plans are secondary users. Theguide’s position is based on the unsup-ported assumption that private companyfinancial statements users have greateraccess to management to obtain addition-al information. In fact, not all users haveaccess to the same information and can-not be assumed to have less need fordetailed disclosures than users of publiccompany financial statements. In addi-tion, financial statement preparers and audi-tors have considerable legal exposure toregulators, sureties, agents, and insuranceproviders and, accordingly, consider themas important as designated primary users.

The financial statements should provide abaseline of measurements and disclosures onwhich users can request specific additionalinformation that they might require. Thisbaseline is important because informationoutside the financial statements is generallynot audited, and it might omit importantinformation or contain misleading informa-tion. As a consequence, the use of financialstatements to validate or corroborate infor-mation obtained from sources other thanfinancial statements can result, on occasion,

in the discovery of information that has beenoverlooked or misunderstood.

The guide and the disclosure frameworkmight create legal problems for auditors.Presumably, the future exposure draftderived from the invitation to comment willinclude FASB’s preliminary decision toprovide users with information on “pastevents and existing conditions that havenot yet met the criteria for recognition in

the entity’s financial statements, but thatare capable of making a difference in deci-sions about providing resources” (Board’sDecision Process, http://www.fasb.org/jsp/FASB/FASBContent_C/ProjectUpdatePage&cid=1176163077030).Financial statement preparers and auditorsdo not have full knowledge of the specif-ic information requirements of all users.The nature of this information is onlyunderstood by the user; furthermore, it issubject to change over time. Any processwhereby auditors have contact with usersto identify specific information needsmight, in some states, create privitybetween those users and the auditors. Suchprivity could result in even greater legalexposure for the auditors if users deem thefinancial statements to be incomplete.

Standards setters need to determinewhether the quality of IFRS is as high asadvertised, given the continuing differencesand extensive changes proposed in the con-dorsement process. The actual quality ofthe standards needs to be addressed,given the potential impact that IFRScould have on regulatory compliance andaccounting issues.

In commenting on various proposals, theNYSSCPA disagreed with the notions thatcertain users are more important than oth-ers and that financial statement disclosuresshould be limited to information that thepreparers and auditors think might be ofinterest to a particular subset of users. As

the designated U.S. accounting standardssetter, FASB should consider whether thisbias has created an environment where dif-ferent users are demanding specificaccounting information that is more respon-sive to their particular needs. To avoidthe proliferation of accounting bases, FASBshould define the objectives and purposesof financial reporting—addressing theneeds of all constituencies by giving

equal weight to the concerns of preparers,auditors, and users. The end result shouldbe clearly understood accounting rules thatfacilitate the preparation and verification offinancial information.

Establishing a BalanceAccounting standards should align with

the needs of users and the ability of pre-parers and auditors to provide that infor-mation with a reasonable degree of pre-cision. The impact of users’ apparentlyinsatiable requests for information on dis-closure, which has arguably resulted instandards overload, must be considered aswell.

Preparers provide information in orderto obtain access to bank loans or to the cap-ital or debt markets. Auditors provide alevel of comfort by verifying that the infor-mation fairly presents the reporting enti ties’financial position, results of operations, andcash flows. Standards setters should be sen-sitive to the constraints on preparers andauditors imposed by the cost of present-ing and auditing the required information,as well as their concerns about litigationexposure if that information proveswrong or incomplete. q

Robert A. Dyson, CPA, is the director ofquality control at MBAF CPAs LLC, NewYork, N.Y. He is a member of The CPAJournal Editorial Board.

Standards setters should be sensitive to the constraints

on preparers and auditors imposed by the cost of

presenting and auditing the required information.


By Jim Lynch

Most estate planners focus onfederal estate tax issues; how-ever, in recent years, the impor-

tance of federal estate planning hasdecreased, due to the $5 million exclusionbeing made permanent and indexed forinflation, as well as portability being madepermanent (see Internal Revenue Code[IRC] sections 2010[c][2][A], [c][2][B],and [c][4]). Conversely, estate planning atthe state level—particularly in thosestates that have decoupled from the feder-al estate tax, such as New York and NewJersey—has become more important.

In addition to an estate tax, New Jerseyalso has an inheritance tax (see New Jer-sey Statutes Annotated [NJSA] section54:5-1). The inheritance tax is paid onbequests made to certain classes of bene-ficiaries. Rates can be as low as 11% andas high as 16% (NJSA section 54:34-2).The inheritance tax can act as a creditagainst the New Jersey estate tax (NJSAsection 54:38-1[b]). As a result, inheritancetax planning is increasing in importancefor those estates where the inheritance taxis equal to or greater than the New Jerseyestate tax.

It is important for the tax advisors ofindividuals with property in New Jersey tofamiliarize themselves with the inheritancetax, as well as situations in which the inher-itance tax will equal or exceed the NewJersey estate tax. This discussion offersplanning techniques for minimizing andmanaging the New Jersey inheritance tax.

Overview of the Inheritance TaxThe New Jersey inheritance tax is

imposed on the transfer of property bybequest to certain classes of beneficiaries.Four classes of beneficiaries exist:n Class A beneficiaries are spouses, civilunion or domestic partners, lineal ances-

tors, and descendants (whether natural oradopted) or stepchildren of the decedent(New Jersey Administrative Code [NJAC]section 18:26-1.1). n Class B beneficiaries were eliminatedby statute, effective July 1, 1963 (see theintroduction to “Transfer Inheritance andEstate Tax,” p. 1 http://www.state.nj.us/treasury/taxation/pdf/other_forms/inheritance/itrins.pdf). n Class C beneficiaries are collateral rel-atives—that is, brothers and sisters—aswell as spouses, civil union partners, sur-viving spouses, or the surviving domesticpartner of the decedent’s son or daughter(NJAC section 18:26-1.1).

n Class D beneficiaries are all other ben-eficiaries not covered by A, B, C, or E(NJAC section 18:26-1.1).n Class E beneficiaries are certain gov-ernmental and not-for-profit organizations,including the State of New Jersey andany of its political subdivisions, and any“educational institution, church, hospital,orphan asylum, public library or Bible andtract society or to, for the use of or intrust for any institution or organizationorganized and operated exclusively for reli-gious, charitable, benevolent, scientific, lit-erary or educational purposes … no partof the net earnings of which inures to thebenefit of any private stockholder or other

Planning for the New Jersey Inheritance Tax

T A X A T I O Ns t a t e & l o c a l t a x a t i o n

individual or corporation” (see NJAC18:26-1.1).

Bequests to institutions outside of theUnited States and to educational institu-tions are not exempt unless the country orinstitution grants a similar exemption tobequests made to New Jersey institutions(NJAC 18:26-1.1). The instructions to theinheritance tax return make it plain that notall not-for-profit organizations (for IRS pur-poses) are considered Class E beneficia-ries—for example, social clubs are not-for-profit organizations, yet they are notcategorized as Class E beneficiaries (seethe introduction to “Transfer Inheritanceand Estate Tax,” p. 1).

Bequests to Class A beneficiaries arenot subject to the inheritance tax (NJAC sec-tion 18:26-2.5). In some cases, except thosein which a spouse is the sole beneficiary,those estates will be subject to the New Jer-sey estate tax (NJSA section 54.39-1[a]).Bequests to Class C beneficiaries are taxfree up to $25,000 per beneficiary. Ratesbegin at 11% for bequests greater than$25,000 and increase to a maximum of 16%on bequests greater than $1.7 million (NJACsection 18:26-2.7). Bequests to Class D ben-eficiaries are tax free if they are less than$500 (see the schedules of “TransferInheritance and Estate Tax,” p. 4). Bequestsgreater than $500 are taxed at 15%, up tothe first $700,000; any excess is taxed at16% (see the schedules of “Transfer Inher-itance and Estate Tax,” p. 4).

A Credit Against the Estate TaxAs previously mentioned, there is a cred-

it against the New Jersey estate tax for anyinheritance tax (see NJAC section 18:26-3.2[a]). The inheritance tax is imposed on thevalue of real or tangible personal propertylocated in New Jersey and, in the case of aresident, all intangible property, wherever itis located. In the case of a nonresident, thetax is imposed only on real or tangible per-sonal property located in New Jersey (seeNJAC sections 18:26-5.2[a] and 5.2[b]).

The New Jersey inheritance tax appliesnot only to testamentary dispositions butalso transfers made in contemplation ofdeath. A transfer by deed, grant, bargain,sale, or gift made more than three yearsbefore the decedent’s death is not consid-ered to be in contemplation of death; how-ever, any such transfer made within threeyears of death is considered to be made

in contemplation of death and is taxedaccordingly, unless the contrary can beproven (see NJSA sections 53:34-1 and18:26-5.7; this issue will be discussed ingreater detail in a later section).

The New Jersey estate tax has a highlyprogressive rate structure, with a top rate of16% (see instructions to New Jersey FormIT-Estate, “Resident Decedent Estate TaxReturn”). The inheritance tax has a muchless progressive rate structure but has thesame top rate (see instructions to New Jer-sey Form IT-R, “Inheritance Tax Return

Resident Decedent”). Therefore, if the entireestate is subject to both the New Jersey inher-itance tax and the New Jersey estate tax,the former will generally be higher; thismakes inheritance tax planning even moreimportant, regardless of the estate’s size.

Planning TipsAlthough the New Jersey inheritance tax

might appear all-encompassing, planningopportunities do exist. First, the proceedsof a life insurance policy on the decedentare not taxable as long as the proceeds


are payable to one or more named benefi-ciaries, other than the estate or the execu-tor or administrator of the decedent’s estate.Alternatively, the proceeds may be madepayable to the trustee of a trust createdunder the decedent’s will (NJSA sections54:34-4 [c] and [f]).

The New Jersey estate tax, on the otherhand, taxes life insurance proceeds in thesame manner as the federal estate tax (seeinstructions to Form IT-Estate, p. 1). There-fore, proceeds payable to an individual ben-eficiary could be subject to the New Jer-sey estate tax; proceeds payable to a trust,however, would not be subject to this tax(NJSA section 54:34-11).

Life insurance. This inheritance tax pro-vision creates a valuable planning tool. Itmay behoove taxpayers to have life insur-ance paid to beneficiaries whose inheri-tances will be subject to the highest taxes.For example, consider an estate with a$1 million life insurance policy and $1 mil-

lion in cash. Two beneficiaries will dividethe estate equally—a brother (a Class Cbeneficiary) and a nephew (a Class D ben-eficiary). If the brother is the named ben-eficiary of the life insurance policy and thenephew receives the $1 million in cash, thetax will be computed as shown in Panel Aof the Exhibit. On the other hand, if thenephew is the beneficiary of the lifeinsurance policy and the brother receivesthe $1 million in cash, the tax is comput-ed as shown in Panel B. This simpleplanning technique, which appears some-what counterintuitive, will save about$46,000 in taxes. A simple analysis of thedifference will show that, even with less-er sums, the savings can be significant(Panel C).

Gifts made in contemplation of death.A second planning opportunity involvesthe rule that gifts made within three yearsof death are, without evidence to the con-trary, presumed to have been made in con-

templation of death and are added back tothe estate (NJSA section 54:34-11). Theburden is on the taxpayer to show that agift was not made in contemplation ofdeath. This is a question of fact, and oneof the most important factors is the donor’smotivation in making the gift (see Swainv. Neeld, 28 NJ 60, 65 [1958]).

This is similar to the federal rule thatexisted until 1976, which also requiredthe adding back of gifts made in contem-plation of death if made within threeyears of death. Like the New Jersey rule,the federal rule had a rebuttable presump-tion that all gifts made within three yearsof death should be added back (seeLawrence Brody, Richard L. English, andLucinda A. Althauser, “Section 2035Transfers,” Tax Management Portfolios,vol. 818, citing IRC section 2035, as ineffect in 1954).

In 1976, Congress changed the law andsimply required all gifts made in three


EXHIBITPlanning for the Inheritance Tax: Calculations

Panel A:

Life Insurance $1,000,000 Tax $ 0Cash $1,000,000 Tax $700,000 at 15% $105,000

$300,000 at 16% $ 48,000Total $153,000

Panel B:

Life Insurance $1,000,000 Tax $ 0Cash $1,000,000 Tax $ 25,000 exempt $ 0

Tax $975,000 at 11% $107,250Total $107,250

Panel C:

The difference is computed as follows:$25,000 at 15% $ 3,750 The first $25,000 is exempt for C beneficiaries.$675,000 at 4% $27,000 The difference between the D rate of 15% and the C rate of 11% on $75,000.$300,000 at 5% $15,000 The difference between the D rate of 16% and the C rate of 11% on the final $300,000.$1,000,000 $45,750 Total

If $200,000 was the amount of life insurance involved, the savings would be $10,750:$25,000 at 15% $ 3,750$175,000 at 4% $ 7,000$200,000 $10,750 Total

years of death to be added back. This wasdone to eliminate the considerable litigationthat had arisen as a result of the rebuttablepresumption that all gifts made within threeyears of death were made in contemplationof death (see Brody et al., citing the HouseWays and Means Committee report on theTax Reform Act of 1976).

In Swain v. Neeld, the New JerseySupreme Court discussed the criteria fordetermining whether a gift was made incontemplation of death:

Relevant factors to be considered …include, but are not limited to: the ageand general condition of health of thedonor at the time of making the gift; thetime interval between the inter vivostransfer and death; the existence of adesire to evade inheritance taxes;whether or not the inter vivos transferwas part of a testamentary scheme orplan; past history of substantial gifts bythe donor; whether or not the gift wasmade to the natural objects of thedonor’s bounty; whether or not thereexisted an emergency situation whichmay have prompted the donation (e.g.,donee’s illness requiring large expendi-tures) (http://nj.findacase.com/research/wfrmDocViewer.aspx/xq/fac.19581020_0040100.nj.htm/qx).According to the court’s decision in

Swain v. Neeld, the state does not need toshow that contemplation of death was theonly motive; it merely needs to show thatcontemplation of death was an impelling,or important, motive in the decision to givethe gifts (p. 69).

Planners can suggest that clients set up aregular gifting program to individuals whoare not beneficiaries under the donor’s will.If such a program is in place for a sufficientlength of time, there is a strong likelihoodthat it will not cause gifts made within threeyears of death to be included in the taxableestate for inheritance tax purposes. This isbecause one of factors to be considered is“past history of substantial gifts” (Swain v.Neeld, p. 70). Such a history would pointtoward a determination that the gifts madewithin three years of death were not madein contemplation of death; rather, they werepart of a long-established gift program thatbenefitted other individuals. The fact that giftswere being made to individuals who werenot beneficiaries under the will would tendto show that contemplation of death was

not an impelling motive—the donor couldhave changed the will after becoming con-cerned about death if the donor wanted thedonees to receive an inheritance.

Furthermore, the gifting history wouldalso show that the donor was decidingwhether to make a gift to a particulardonee, not just when the donor was going

to make a gift. The importance of thisfactor is illustrated by Makris et al. v.Director, Division of Taxation (4 N.J.Tax 139 [1982]). In this case, the decedent,Argiris Fantis, made substantial gifts dur-ing the years 1967–1969 to his nephews,nieces, and his niece’s husband; these rel-atives were very close to the decedent.

In 1970 and 1972, the decedent madefurther gifts to his nephews and his niece’shusband. The decedent’s will, executed in1969, left his estate to his two nephewsand his two nieces, with 30% going to var-ious charities. The decent passed away in1972, after several years of ill health. Thestate sought to add back the 1970 and 1972gifts to the decedent’s estate.

The court decided in favor of the state,finding that the dispositions made by thedecedent—the 1967–1969 gifts, the 1970and 1972 gifts, and the testamentary dis-positions—were part of a plan. The courtfound that the decedent’s chief concern waswhen, rather than whether, his relativeswere to enjoy his property. Thus, the court

concluded that these dispositions weremade in contemplation of death.

It should be further noted that these giftswere a substantial part of the decedent’sestate. The 1967–1969 gifts representedmore than 50% of his estate, and the1970 and 1972 gifts together representedapproximately 36% of his estate. In addi-tion, the court asserted that if the donorchooses whether to make a gift to a par-ticular donee, rather than when to make thegift, the gift will not be considered to bein contemplation of death.

IRAs, pensions, and annuities. A thirdplanning technique involves individualretirement accounts (IRA), pensions, andannuities. Annuities are generally subjectto the New Jersey inheritance tax (NJACsection 18:26-5.19; see NJSA section18:26-6.14 for a discussion of federalpensions and NJSA section 18:26-6.15for a discussion of New Jersey state andlocal pensions). Similarly, IRAs and pen-sions, with the exception of certain feder-al and New Jersey state and local pensions,are generally subject to tax (NJAC sec-tion 18:26-5.17). But New Jersey lawalso provides that the beneficiaries of thoseannuities, pensions, and IRAs receive abasis in them equal to the amount subjectto the inheritance tax. This means that,for New Jersey gross income tax purpos-es, the beneficiary will only have incomewhen the amount received is in excess ofthe basis in the contract (see N.J. BulletinGIT-1, “Pensions and Annuities,” pp. 8–9).Therefore, each distribution will be madeup of two parts—a recovery of basis andincome. Only the latter portion is subjectto New Jersey gross income tax. This willcontinue until the last distribution, afterwhich the account will have a zero bal-ance. At that point, all remaining basis willbe recovered (N.J. Bulletin GIT-1).

Reducing the BurdenAs demonstrated in this discussion, the

New Jersey inheritance tax can representa significant burden for taxpayers, distinctfrom federal estate taxes. With careful plan-ning, however, the burden can be amelio-rated for heirs. q

Jim Lynch, Esq., CPA, is a senior man-ager at Sobel & Co. LLC, Livingston,N.J.


If a regular gifting program is in place for asufficient length of time,

there is a strong likelihoodthat it will not cause giftsmade within three years

of death to be included inthe taxable estate for

inheritance tax purposes.


By Matthew Gaglio and Fely J. Cieza

Ageneration ago, CPAs and otherfinancial advisors played an inte-gral role in helping small business

owners create retirement plans for them-selves and their employees. Accountants,in particular, were instrumental in devel-oping the strategy behind the plan andtailoring the design to meet each owner’sunique goals and objectives. Once the smallbusiness implemented the plan, a CPAremained actively involved in pension man-agement in order to ensure that the tax ben-efits associated with offering a companyretirement plan were fully realized.

The Tax Reform Act of 1986 changedthis. It eliminated much of the incentivefor small businesses to provide pensionplans. Over time, companies replaced tra-ditional pension plans with one-size-fits-all assets under management plans, suchas 401(k) plans and individual retirementaccounts (IRA); these were managed bylarge brokerage companies that focusedon rate of return. In essence, company-sponsored retirement plans became com-moditized and focused more on theproduct than on thoughtful strategy anddesign. As a result, financial advisorslargely removed themselves from the pro-cess altogether.

Recently, emphasis has started to shiftback toward strategic, customized plandesign. Because certain provisions in the taxcode under the Economic Growth and TaxRelief Reconciliation Act (EGTRRA) of2001, the Pension Protection Act (PPA) of2006, and the American Tax Payer ReliefAct (ATRA) of 2012 have been made per-manent, pension plans are reemerging in theform of qualified plans, including defined-benefit and defined-contribution plans. Whendesigned well, such plans might enable smallbusiness owners to shelter more money thanhas been possible in the last 30 years.

Recent legislation opens the door forCPAs to play a more strategic role inretirement planning for small businesses,which could further strengthen their rela-tionships and potentially bring in morebusiness if the CPA offers value-addedservices. Because many CPAs do not haveexpertise in pension and retirement plan-ning, they may need to establish work-ing partnerships with specialists in thefield to capitalize on the opportunitiesafforded by the changes and new plandesigns. They should also review therecent legislative changes and the various

types of plans discussed in the followingsections.

Key Highlights of the PPAOnce seen as highly inflexible, quali-

fied plans can easily be tailored today, dueto key changes brought about by the PPA.It made permanent several EGTRRA pro-visions set to expire in 2010; these includ-ed higher contribution and benefit limi-tations for qualified plans, as shown in theExhibit, as well as increased IRA and401(k) deferral limits and higher com-pensation limits.

Developing Strategic Partnerships with Small Businesses in Retirement Planning

F I N A N C Er e t i r e m e n t p l a n n i n g

A Review of Recent Changes and Plan Design Opportunities

The maximum 401(k) deferral for 2014is $17,500 ($23,000 for those who are 50years and older). The deduction limit fordefined-contribution plans is 25% of eli-gible compensation, which is equal to thetotal compensation paid to all employeeseligible to participate, with an individualcompensation limit of $260,000 for 2014.Pensionable compensation includes W-2income, as well as net Schedule C com-pensation and partnership net K-1 incomeafter the appropriate deductions. (Note thatK-1 income from an S corporation is notpensionable.)

The PPA and ATRA also made perma-nent a variety of Roth 401(k) provisions andallowed for catch-up contributions. In addi-tion, Internal Revenue Code (IRC) section404(a)(7) enables employers sponsoring adefined-benefit plan covered by thePension Benefit Guaranty Corporation(PBGC) to also sponsor a defined-contribu-tion plan without having to combine the twoplans for deduction-limitation purposes.

Qualified Plan Design OpportunitiesThere are several plan designs that can

benefit small businesses, but the three mostsignificant are cross-tested plans, 401(k)safe harbor plans, and defined-benefit anddefined-contribution plans.

Cross-tested plans. Typically, profit-shar-ing plans are structured so that eligibleemployees receive a contribution based ona certain percentage of their salary. Thepercentage is the same for each employee,regardless of compensation. For example,if the contribution is set at 3%, a plan par-ticipant earning $50,000 is eligible for a$1,500 contribution, whereas a participantearning $75,000 will receive a contributionof $2,250. In some cases, an integrated orpermitted disparity allocation formula is usedso that employees earning more than theSocial Security taxable wage base ($117,000for 2014) may receive an additional contri-bution of up to 5.7%. The maximum con-tribution to a profit-sharing plan for 2014 is$52,000. (If the plan is a 401(k) and the par-ticipant is 50 years or older, another $5,500is permitted.) But a traditional profit-shar-ing allocation based on compensation wouldresult in contributions of as much as 25% ofcompensation for other employees as well.

With a cross-tested formula, smallbusinesses can allocate distinct contribu-tion rates for different groups of eligible

employees. This plan’s design givesemployers the flexibility to provide sig-nificantly larger contributions for highlycompensated employees, making it anattractive option for rewarding and retain-ing key staff. This new structure is possi-ble as a result of IRC section 401(a)(4),

which allows employers to divide plan par-ticipants into classes and make disparatecontributions to the plan for each class. Anumerical formula based on an analysisof projected benefits at retirement age isgiven in order to illustrate whether the ben-efits provided to highly compensated andnon–highly compensated employees arecomparable; if they are, the allocation isconsidered nondiscriminatory and is per-mitted. The result is that the contributionsfor employees can be significantly lowerthan would be the case in a traditionallyallocated profit-sharing plan—often at thelevel of between 3% and 5% of compen-sation, depending upon employee demo-graphics.

401(k) safe harbor plans. As of2001, a new 401(k) safe harbor planbecame available that offers automaticpassage of the average deferral percent-age (ADP) test and may satisfy the top-heavy minimum contribution require-ment. The ADP test generally limits theamount that highly compensated employ-ees can defer to 1.5 times the averagedeferral as a percentage of compensa-tion of the non–highly compensatedemployees. The top-heavy minimum con-tribution generally requires an employerto contribute at least 3% of compensationfor all employees eligible to make anelective deferral. If a 401(k) safe harborcontribution is made, highly compensat-ed employees can defer the maximum401(k) deferral ($17,500 for 2014, plusan additional $5,500 for those 50 yearsand older). If the 3% safe harbor contri-bution is made, the top-heavy require-ments mandating minimum contributionsfor employees who are not owners orofficers are deemed satisfied.

Two types of 401(k) safe harbor con-tributions exist. In the first, each eligibleparticipant receives an employer contri-bution equal to 3% of compensation(which will usually satisfy the top-heavyminimum requirements for the plan). Inthe second, eligible participants whomake a salary deferral election receivea dollar-for-dollar matching contributionon the first 3% of their deferral and anadditional $0.50 per $1.00 for the next2%. Regardless of which option isused, contributions are 100% vestedimmediately; however, highly compen-sated employees have the ability to makethe maximum deferral, even if no


EXHIBIT Maximum Benefit Limitation for Defined Benefit Plans, 2014

Retirement Age Annual Life Annuity Single Sum*

62 $210,000 $2,600,000

65 $210,000 $2,400,000

*Actuarially computed on the basis of 5.5% interest and the 2013 Internal RevenueCode (IRC) 417(e)(3) applicable mortality table. In addition, 10 years of plan partici-pation is needed to accrue the maximum benefit.

Recent legislation opens

the door for CPAs to play

a more strategic role in

retirement planning for

small businesses.

non–highly compensated employeesmake a deferral.

Defined-benefit or defined-contributionplans with a carve-out design. A carve-out design essentially allows plans toexclude certain employees who might have

otherwise met the normal eligibilityrequirements from participating in the plan.IRC section 410(b) allows an employer todivide employees into separate groups, aslong as each group includes a certain per-centage of non–highly compensatedemployees. As a result, it might be possi-ble to exclude a significant number ofnon–highly compensated employees,depending upon the percentage of highlycompensated employees included in theplan. By carving out a smaller group ofemployees and establishing a defined-ben-efit plan only for this group, employershave more flexibility in allocating theplan’s benefits.

Along with the coverage requirementsof IRC section 410(b), IRC section401(a)(25) requires that most defined-benefit plans benefit a minimum numberof eligible employees (both highly com-

pensated and non–highly compensated);this requirement must be consideredwhen the plan is designed. Defined-bene-fit plans require a greater commitment andmandated funding that must be recognizedwhen such a plan is established; however,

because defined-benefit plans generallypermit higher contributions and higheraccumulations than most other types ofplans (especially for older employees), theycan provide a higher degree of retirementincome security than profit-sharing or401(k) plans.

Qualified Plan Design: A Team EffortPerhaps the biggest misconception to arise

during the last two decades is that compa-ny retirement plans are solely for employ-ees. When properly structured, retirementplans can—and should—also benefit thebusiness itself through various tax advan-tages for the owners, partners, and other keyemployees. Qualified plans provide a solidstrategy for realizing this goal.

The real problem today is that manysmall businesses have plan designs in placethat contribute more toward employee

retirement plans than legally required or donot fully leverage the financial and taxadvantages. This is, in large part, becauseretirement planning has traditionallyfocused on asset allocation, 401(k) plat-forms, and funds and products—not ontruly designing a plan to fit the needs ofthe organization and its employees. TheEGTRRA regulations made permanentby the PPA and ATRA have changedthis, making qualified plans highly des-ignable again for their ability to maximizebenefits for both employers and theiremployees. Few small business owners,however, realize how much they could besaving, because their financial advisorsmight not be familiar with the changes,especially if they have not been in the fieldfor very long.

It is important for financial planners torefresh themselves on these changes inorder to best aid small business owners andemployees. They should fully understandthe nuances of the new tax provisions andshould be able to perform a feasibilitystudy for small businesses. The goal is touncover whether the business is contribut-ing more than required or paying moretaxes than needed, as well as whether thereare any additional tax shelter opportuni-ties for the business. In the authors’ expe-rience, it’s not uncommon to find that awell-designed qualified plan could sub-stantially reduce taxes.

This is why financial advisors, particu-larly CPAs, must get back into the busi-ness of being strategic partners with smallbusinesses when it comes to plan design.(See the sidebar, Building a RetirementPlanning Team, for other important partiesthat can be included in the retirement plan-ning process.) In this way, CPAs can cre-ate new opportunities for their practice, aswell as for the small businesses theywork with. The opportunity to meet witha small business owner and participate inthe design of a retirement program can leadto other business opportunities for a CPA,especially if the CPA provides some formof investment tracking service or estateplanning assistance. q

Matthew Gaglio and Fely J. Cieza areregistered representatives and financialadvisors of Park Avenue Securities LLC,Rye Brook, N.Y.


Several parties can become involved in the retirement planning process: n An attorney responsible for setting up a pension trust n An accountant working with an insurance professional to design the plan,determining contributions, cash flow, and overall budgetn An actuary puting the design to the test using an actuarial algorithmic formulabased on benefits earned at retirement and the aggregated percentage of compensation n Finally, a broker investing money as defined by the specific plan design.

BUILDING A RETIREMENT PLANNING TEAM

When properly structured, retirement plans can—and

should—benefit the business itself through various tax

advantages for owners, partners, and key employees.

As a group, accounting practices are still recovering fromthe Great Recession of 2007–2009. Individually, some prac-tices are growing more quickly than others—specifically,the growth rate of small, sole-proprietor practices has paled

in comparison to their larger competitors. Small accountingpractices reported growth in net client fees of only 1.5% for 2011,whereas average growth was 5.6%. This means that, on average,

small practices grew at roughly one-quarter the rate of larger firms.The difference highlights the importance for small firms of bench-marking the operations of larger firms.

This article draws distinctions between the operations of small,sole-proprietor accounting practices generating less than $200,000in client fees and those of larger practices, with an emphasis on thosegenerating $200,000–$500,000 in client fees. Single-owner firms

Strategic Planning for Small Accounting Practices

M A N A G E M E N Tp r a c t i c e m a n a g e m e n t


By Charles R. Pryor and Jack Elfrink

Insights on Services and Satisfaction from the MAP Survey

also dominate this group of larger firms,though they are larger and have survivedlonger on average than the group referredto as sole proprietors.

Comparisons are based upon the data col-lected in the 2012 National Management ofan Accounting Practice (MAP) Survey, abiennial survey sponsored by the AICPA Pri-vate Companies Practice Section, in associ-ation with the Texas Society of CPAs.Data from the survey are broken out by firmsize, making it very useful for illuminatingcritically important strategic planning issuesfor growing firms. There exist noteworthydifferences between small sole proprietorsand larger firms in their sources of feesand—more importantly, from a strategicplanning perspective—the relative impor-tance of different services changes as firmsgrow. In addition, significant differences inthe operational spending patterns that relateto client and employee satisfaction merit con-sideration by smaller firms when planningfor growth.

Differences in FeesThe most effective strategic expenditures

for any accounting practice not only sup-port the greatest sources of fees but alsothe engines of growth. Consequently, a soleproprietor must anticipate changes in therelative importance of the many sources offees important to a growing practice.Exhibit 1 lists 18 sources of fees identi-fied in the 2012 MAP Survey.

As an accounting practice grows, netfees from all sources also grow. Despitethe increasing variety of services offeredby today’s accounting practices, however,one subset constitutes the core servicesoffered by firms of all sizes. Approximately92% of net fees come from just six fun-damental services, regardless of firm size.Exhibit 2 shows the percentage of netfees attributable to these six types of ser-vices for each firm size (where size is mea-sured by net client fees).

Although all six core services are impor-tant sources of fees in practices of any size,they are not of equal importance. Forexample, the single largest source of fees forfirms of all sizes is tax services—account-ing for nearly 60% of net fees in small firms.These six core services also differ in theirgrowth potential. Consequently, their rela-tive contributions to the mix of total feeschange as a firm grows.

Among the six core sources of fees,only individual tax and assurance servicesare truly dynamic in their importance togrowing firms. The importance of theremaining four core services does notchange much with growth, as illustratedby Exhibit 3. This does not, however,mean that these services, or even noncoreservices, should be ignored or even deem-phasized. For example, consulting servicesaccount for only 8% of sole proprietorfees and even less for larger firms; nev-ertheless, the massive layoffs during therecent recession and continuing highunemployment represent an opportunityfor growth. The many out-of-workfinancial professionals, including CFOsand controllers, may help improve andexpand the consulting arm of an account-ing practice. Decisions about the viabili-ty of such an expansion strategy for anyparticular practice should be based on theowners’ goals and the demographics anddemands of the firm’s market.

Among the six core services, the relativeimportance of audit/attest/assurance servicesincreases the most rapidly as firms grow,eventually contributing as much as tax ser-vices for the largest firms. In addition,while the various forms of assurance engage-ment become increasingly important forgrowing firms, the importance of individu-al tax work, relative to other services, dropsprecipitously, as shown in Exhibit 4. Infact, over 95% of the decrease in theimportance of individual tax work to the mix

of fees can be explained by the growth inassurance services, principally auditing.

Exhibit 4 should not be interpreted tomean that individual tax services do not growwith firm size; on the contrary, the impor-tance of fees from individual tax services toa growing practice cannot be overestimat-ed. But Exhibit 4 does show that fees fromindividual tax services decline as a percent-age of total fees with firm size. Because theseservices are the largest source of fees forsmall firms, it is important to note thatthese fees grow at a somewhat slower ratethan the firm as a whole. Nonindividual taxservices are the second largest source of feesfor the sole proprietor (after individual tax).But this type of service grows at a faster ratethan individual tax work and more closelymatches the growth rate of the firm.

Fees from audit/attest/assurance servicesare significantly less than those from eithercategory of tax service, but as accountingpractices grow, the importance of assuranceservices grows faster than any other core ser-vice. (See Exhibit 5 for a comparison of thegrowth in importance of these core servicesby firm size.) The important thing to notefor sole proprietors is that assurance servicesgrow in importance at a faster rate than anyother core service, but by virtue of their size,tax services are still responsible for moregrowth in total fees than any other service.

Billing/Accounts ReceivableSole proprietors also differ from larg-

er firms in how fees are billed and col-


EXHIBIT 1Sources of Fees for an Accounting Practice

Audit (nonpublic clients) Mergers and Acquisitions

Audit (publicly held clients) Niche Specialties

Attest/Assurance (other) Payroll

Business Valuations Personal Financial Planning

Compilations and Reviews Risk Services/Internal Audit

Consulting Tax (individual)

Forensic Accounting/Litigation Support Tax (nonindividual)

Investment Advisory Services Write-Up

IT Consulting Other

Source: 2012 MAP Survey


lected. The primary billing method usedby sole proprietors, like all firms, is hourlybilling, comprising roughly 75% of allfees. But there are a couple of notable dif-ferences in how the remaining 25% offees are billed. The three most importantnonhourly billing methods for all firms,in decreasing order of importance, arefixed-fee billing, value billing, and per-tax-form fees. Sole proprietors employtwo of these nonhourly billing methods atdifferent rates than larger firms. Largerfirms are more than 25% more likely touse fixed-fee billing, and although per-tax-form fees are only used by 22% ofsole proprietors, firms with over $500,000in net fees use this billing method signif-icantly less.

From a strategic planning perspective, itis worth noting that while fewer than onequarter of even the smallest practices arebilling clients using per-tax-form fees, near-ly 60% of fees come from tax services. Itis critically important to know the marketand competition. One interpretation of theMAP survey data is that most accountingpractices do not see themselves directlycompeting with the huge, tax-preparationfranchises where per-tax-form fees mightbe more commonplace.

Another notable billing-related differenceacross firm sizes is in the management ofaccounts receivable. The average accountsreceivable balance for practices of all sizesis about 17% of annual net fees, with baddebts around 1%. Sole proprietors aredoing a better job with timely collections;they reported that 58% of their receiv-ables were current at year-end, comparedwith an average of only 45% for all other

firm sizes. Over 40% of sole proprietors’accounts receivable are more than 30days old, yet larger firms are almost 80%more likely to charge interest on delinquentreceivables.

In addition, at year-end, sole propri-etors possessed, on average, half of theunbilled work-in-process of larger firms,expressed as a percentage of annual netfees. Assuming that this doubling ofunbilled work-in-process for larger firms isdue to increases in demand for particularservices (i.e., assurance services) a solepractitioner must plan for the impliedincrease in working capital needed to sus-tain growth in these areas.

Differences in SpendingRather than siphon off increasing prof-

its as the firm grows, successful practicesplow those profits back into the firm at anincreasing rate. Total expenses average47% of net fees for sole proprietors,while the operations of their nearest com-petitors, in terms of size, consume morethan 55% of fees, and that number increas-es for even larger firms. Sole proprietorsmust not only plan on tying up more oftheir net worth in the growth of the prac-tice, they must also think strategically aboutthe spending patterns most likely to fostergrowth. The 2012 MAP survey points toat least two areas of significant differencein strategic spending between sole propri-etors and larger firms that should be con-sidered for benchmarking: the client’sexperience and the employee’s experience.

The client’s experience. Location seemsto be very important to growth, becausegrowing firms increasingly invest in more

expensive office space. Although the num-ber of square feet of office space per staffmember actually declines as firms grow,the total cost of space per person increas-es. Sole proprietors spend an average of$12 per square foot for office space whiletheir closest competitors, in terms of size,spend 15% more, and that increases foreven larger firms. Some of this increasedspending is undoubtedly driven by attemptsto expand markets, for example, movingfrom suburban to urban offices. Neverthe-less, some of the premium spent foroffice space is almost certainly attributableto the branding effect of more upscale loca-tions; of course, these two motivations arenot mutually exclusive.

Sole proprietors also differ in their useof technology in ways that might impacta client’s experience. The 2012 MAPSurvey asked respondents about their useof 12 different forms of technology com-monly used by accounting practices: web-sites, client portals, blogs, social media,multiple computer screens, the paperlessoffice, accepting credit cards, remote net-work access, cloud-based software, Skypeor similar services, digital delivery of taxreturns, and mobile technologies. Sole pro-prietors were 75% more likely than largerfirms to use none of them. A few of thenotable differences have the potential todiminish client satisfaction—credit cardpayments, websites, and client portals.

Larger firms are nearly 60% more likelythan sole proprietors to accept credit cardpayments. Failure to accept this form of elec-tronic payment may create a competitive dis-advantage for sole proprietors. Sole propri-etors do not operate with any more accounts

EXHIBIT 2Percentages of Net Client Fees from Six Core Services, by Firm Size

$200,000– $500,000– $750,000– $1.5 million– $5 million–Fee Source <$200,000 $500,000 $750,000 $1.5 million $5 million $10 million >$10 million

Tax (individual) 36% 33% 29% 26% 21% 18% 14%

Tax (nonindividual) 23% 25% 25% 25% 25% 22% 23%

Write-ups 12% 13% 11% 12% 8% 7% 4%

Compilations/Reviews 8% 10% 11% 11% 11% 9% 6%

Consulting 8% 5% 5% 6% 6% 7% 7%

Audit/Attest/Assurance 4% 6% 10% 13% 21% 29% 36%


receivable as a percentage of net fees thantheir larger competitors. In other words, soleproprietors are not financing work for clientsat unusual rates, yet the majority also donot accept credit cards. These two conditionscan combine to create undue hardship forclients by increasing their operating cashflow burdens, especially in times of eco-nomic recession. Unlike large corporations,many individual and small business clientscontinue to struggle with meager operatingcash and tight credit markets.

In addition, increasing numbers of indi-viduals and small businesses rely on creditcard statements for documenting transactionsin the same way they used to rely on check-book ledgers. While the simple act of pay-ing by check may be feasible for all, it maynot be convenient for some. The bottomline is that client satisfaction is enhanced bythe ease and fluidity of transactions, whichmay require accounting service providers todo business the way their clients do business.

Another potential competitive disadvan-tage for sole proprietors stems from theirlack of websites and client portals. Theaccounting practice is a service firm wherethe clients’ perceptions of their experiencesare an extremely important predictor offuture fees. One thing that clients univer-sally want from service firms is access. Infact, one of the chief competitive advan-tages of a small practice is its ability to cre-ate a sense of connectedness with clientsand respond quickly to their needs, and thisstrength can be enhanced by how the firmprioritizes spending on technologyresources. Sole proprietors are doing agood job of increasing visibility with theuse of low-cost technologies (e.g., blogsand social media) but might be missingother important opportunities to leveragetechnology for improved client satisfaction.

For example, in addition to their obvious,direct effects on business, websites and clientportals are also likely to positively impactfee growth indirectly by lowering new clientacquisition costs and creating a strongerimpression of access in the minds of clients.The strategic advantages of these two tech-nologies mean that larger firms are 33%more likely to have websites and 20% morelikely to have client portals; the likelihoodof using these technologies increases withfirm size. For example, 100% of firmswith $5 million or more in net fees have awebsite and 80% have a client portal.

The employee’s experience. If clientsare the most important asset of an account-ing practice, then employees are the sec-ond most important. Among the most sig-nificant expenses for firms in the servicesector are employee expenses, whichinclude both the cost of direct compensa-tion and the cost of employee benefits.As previously mentioned, expenses at larg-er firms constitute a significantly greaterpercentage of total fees than at smallerfirms, and it should come as no surprisethat much of the difference is related toemployee costs. Simply put, sole propri-etors find it more difficult to invest in staff.

Paraprofessionals earn salaries 16% high-er working for larger firms than for soleproprietors. Similarly, clerical staff mem-bers earn salaries 14% higher. Besides thedifferences in direct compensation, smallerfirms also offer fewer benefits, which areclosely tied to employee satisfaction. The2012 MAP Survey asked respondents abouttheir offering of fourteen different employeebenefits: accident protection, cafeteria plans,continuing education courses, CPA examfees, CPA exam review courses, graduatedegrees, dependent health insurance, dentalinsurance, health insurance, life insurance,long-term disability insurance, professionaldues, professional licenses, and retirementplans. Sole proprietors were almost 300%more likely than their nearest competitors tosay they offered none of these benefits. Ofcourse, some of this difference is due to the

existence of practices with no employees, butsome may also reflect different priorities instrategic spending. Whatever the reason, smallfirm owners should be aware that an inade-quate investment in employee satisfactionmight impede growth.

Lower investment in employee satisfac-tion reduces profitability in multiple ways.First, it leads to higher turnover; theemployee turnover rate for sole proprietors isalmost 50% higher than for larger firms.While increasing staff compensation maybe difficult, the potential for savings viareduced hiring and training costs might makeit worth the effort. Reducing turnover alsoincreases profitability through gains in effi-ciency that come from having a more expe-rienced staff with greater familiarity with andcommitment to the firm, its clients, and itsstrategic plan.

High-quality support staff can also beleveraged into greater productivity of theowners themselves, providing another impor-tant incentive to increase investment inhuman capital. Larger firms (those generat-ing $200,000–500,000 in net fees) employmore than 300% more paraprofessionals andmore than 150% more clerical staff perpartner than sole proprietors (those generat-ing less than $200,000 in net fees). This extrasupport results in owners/partners beingable to spend more of their time on value-added activities for clients. This affectsprofit in two ways. First, billable hours foran owner/partner increase by 15% without

EXHIBIT 3Relative Importance of Services to Total Net Fees, by Firm Size

30%

25%

20%

15%

10%

5%

0%

<$200,000 $200,000– $500,000– $750,000– $1.5 million– $5 million– >$10 million$500,000 $750,000 $1.5 million $5 million $10 million

Firm Size (in Net Client Fees)

Per

centa

ge

of N

et F

ees

from

Eac

h S

ervi

ce

Tax (nonindividual) Compilations/ReviewsWrite-Ups Consulting


increasing total compensated hours. Second,the billing rate for the owner's time increas-es by 27%, and these values increase as afirm grows. Strategic investment in humancapital is necessary in growing firms, butnewly acquired expertise should do more thanjust increase capacity. It should also expanda firm’s core competencies in ways consis-tent with its strategic plan for growth.

What Does It All Mean?The leaders of a growing practice must

be familiar not only with the most impor-tant sources of revenue, but also withhow these change in importance as a prac-tice grows. Leaders must also developstrategic investment plans that facilitategrowth by increasing client satisfaction andemployee satisfaction.

Growth requires retaining existing clientswhile acquiring new ones, and client reten-tion depends upon their perceptions of value.One area of investment that can signficant-ly improve client satisfaction is technology.For example, websites can not only facili-tate growth by increasing the firm’s visibil-ity to potential clients; they can increase cur-rent clients’ access to the firm both inappearance and substance. Websites can linkclients directly to secure areas (portals) wherethey can upload/download documents andeven enter data directly, including tax, pay-roll, and credit card information. These clientportals, another technological investment,provide a convenient and secure means ofexchanging sensitive information withclients, who are more than likely alreadycomfortable with their use—for example,anyone using online banking. Technologicalinvestment does more than just increase vis-ability and efficiency; it is increasinglyimportant to growth in an age where youngerclients are more comfortable with digitalcommunications.

Strategic investments must also be madeto enhance employee satisfaction; this isespecially important in small firms whereturnover is disproportionately high. Salariesand benefits should be increased as quicklyas is feasible, in order to maintain a firm’sintellectual capital resources. Although smallfirms may have difficulty increasing employ-ee compensation, such problems are notinsurmountable. One way to increase recruit-ment and retention of talent is through fast-track access to profit sharing or partner sta-tus. Another way is technologicalinvestments like remote-access networks,which make it possible for employees towork anywhere at anytime.

Rigorous strategic planning is vital toensuring the sustainability and growth ofany kind of business, and accounting firmsare no exception. Anyone considering start-ing their own practice, as well as those whohave already made the leap, must careful-ly evaluate their personal and profession-al ambitions and the market in whichthey want to compete: the rewards will beworth the effort. q

Charles R. Pryor, PhD, is a an assistant pro-fessor of accounting, and Jack Elfrink, PhD,CPA, is a professor of accounting, both atWestern Illinois University, Macomb, Ill.

EXHIBIT 4Comparison of the Relative Importance of Audit/Attest/Assurance and Tax (Individual)Services, by Firm Size

40%35%30%25%20%15%10%5%0%

Audit/Attest/Assurance Tax (individual)

EXHIBIT 5Comparison of Growth Rates of Tax (Individual), Tax (Nonindividual), and Audit/Attest/Assurance Services, by Firm Size

Per

centa

ge

Gro

wth

500%450%400%300%350%250%200%150%100%50%0%.0

Net Client Fees Tax (nonindividual)Tax (individual) Audit/Attest/Assurance

Per

centa

ge

of N

et F

ees

from

Eac

h S

ervi

ce






The licensure of public accountants enables the professionto declare to society CPAs’ desire to serve the public. Thefirst licensure of CPAs in the United States occurred in1896 in New York (Philip H. Siegel and John T. Rigsby,

“Institutionalization and Structuring of Certified PublicAccountants: An Analysis of the Development of Education andExperience Requirements for Certified Public Accountants,”Journal of Management History, vol. 4, no. 2, 1998, pp. 81–93).

Other states soon added public accountancy laws, with nearly allstates setting requirements for CPAs by the early 1920s.

All U.S. jurisdictions that license CPAs now have some formof experience requirement for licensure. According to Saundra K.Schneider, “Licensing [is] needed to protect the public from theuntrained, the unqualified, and the incompetent” (“Influences onState Professional Licensure Policy,” Public AdministrationReview, vol. 47, no. 6, 1987, pp. 479–484). But because state

The Experience Requirement for CPA Licensure

R E S P O N S I B I L I T I E S & L E A D E R S H I Pr e g u l a t i o n o f t h e p r o f e s s i o n

By Jack Armitage

A Historical and State-by-State Review


law rather than federal statute regulates theprofession of public accounting, much vari-ation exists in the requirements tobecome a licensed CPA. The length andtype of practical experience required, forexample, differs greatly across jurisdictions.It was not until the 1950s and 1960s thatthe profession began to seriously addressthe issues and purpose of experience andeducation requirements for practicingaccountants (Wayne G. Bremser, VincentC. Brenner, and Paul E. Dascher, “TheFeasibility of Professional Schools: AnEmpirical Study,” Accounting Review, vol.52, no. 2, 1977, pp. 465–473).

More recently, this requirement has beenthe subject of scrutiny and change. In con-cert with the requirements for increased aca-demic preparation that have arisen over thepast two decades, many jurisdictions havereduced the duration of experience or broad-ened the type of qualifying experience need-ed to become a licensed CPA. Although U.S.jurisdictions agree that the overall goal is toproduce competent professional accountants,less agreement exists as to the proper mixof education and practical experience nec-essary to achieve that goal.

Many questions must be consideredwhen determining the appropriate experi-ence requirement: What is the purpose ofan experience requirement? Is the knowl-edge obtained in an academic accountingprogram sufficient preparation for licen-sure, without any practical experience, oris practical experience sufficient in itself(or a partial substitute for academic train-ing)? If a period of practical experience isrequired, should the focus be on onlypublic accounting or should a broaderrange of employment be acceptable?How long a period is appropriate?

This discussion examines the experiencerequirement necessary to become a licensedCPA in the United States and makes rec-ommendations about experience require-ments in order to safeguard the public inter-est. The following sections review thehistorical development of the experiencerequirement, the purpose of the experiencerequirement, the AICPA’s and InternationalFederation of Accountants’ (IFAC) currentposition regarding experience requirementsfor licensure, and the current rules in effectin the 55 jurisdictions involved in CPAlicensing. The conclusion covers the poten-tial experience models that could be fol-lowed, including a discussion of the advan-

tages and disadvantages of several differ-ent approaches to experience requirements.

Historical OverviewDetermining the appropriate types and

extent of practical experience needed tobecome a licensed CPA is not a simpleissue. It is helpful to look at the historicaldevelopment of the requirement in orderto better understand the role of experiencein a professional’s development.

Experience requirements evolved duringthe late 19th century, when the practice ofpublic accounting was just beginning in theUnited States. The early years of the U.S.auditing profession were heavily influencedby the existing English system of appren-ticeships; although that system was not adopt-ed, the first U.S. public accountants did obtainmuch of their knowledge from practical expe-rience. Given the development of free pub-lic schools in the United States and the sub-sequent expansion in the number and quali-ty of universities, academic preparation inaccounting and auditing soon became part ofthe foundation for becoming a licensed CPA.This development might have also resultedfrom the desire of the accountancy profes-sion’s founders to more closely follow thedirection of the legal, engineering, and med-ical professions, as well as the fact thatsome of the profession’s founders served asboth college professors and partners infirms (William C. Bruschi, “IssuesSurrounding Qualifying ExperienceRequirements,” Journal of Accountancy,March 1969, pp. 47–54).

By 1915, 26 jurisdictions required a highschool diploma to become a CPA; how-ever, because most of the pre–World War Ipopulation did not have that level of edu-cation, many jurisdictions began to sub-stitute practical experience. The AmericanInstitute of Accountants (AIA, the fore-runner to the AICPA) began to push tolegitimize the experience requirement asthe primary entrance mechanism to the pro-fession. In 1916, the AIA increased itsexperience requirement for membership tofive years (Siegel and Rigsby 1998).

During the middle of the 20th century, theprofession moved to more formal educationas preparation for becoming a professionalaccountant; however, significant variationdeveloped among jurisdictions on theappropriate mix of academic and practicalpreparation. Donald P. Perry, chairman of theAICPA Board of Examiners in 1951, called

for uniform education and experience require-ments (John L. Carey, The Rise of theAccounting Profession: To Responsibility andAuthority, 1937–1969, vol. 2, New York:AICPA, 1970). As a result, the Commissionon Standards of Education and Experiencefor Certified Public Accountants was creat-ed. It recommended the elimination ofexperience as a prerequisite for admissionto the profession. The commission indicatedthat it did not disagree with the value of expe-rience, only with it being required for licen-sure, because the commission believed thedevelopment of a meaningful experiencerequirement was impossible.

The AICPA followed up on the commis-sion’s report by creating a special committeeheaded by George Bailey to recommendaction on the report to the AICPA Council.Despite agreeing with many of the recom-mendations of the commission’s report, thecommittee was in substantial disagreementwith the elimination of the experience require-ment for licensure. It concluded that experi-ence, primarily in the area of third-party reli-ability, was essential for certification (G. D.Bailey, W. H. Holm, C. A. Moyer, J. C. Petteret al., “Education and Experience forCPAs,” Journal of Accountancy, 1959, pp. 67–71).

In 1961, the AICPA created the Committeeon Qualifying Experience to draft a statementdefining acceptable experience. The AICPAestablished the following parameters for thecommittee to work within: n The experience requirement shouldinclude at least two years of experience,with a bachelor’s degree.n A reduction of the experience require-ment of at least one year would be allowedif education extended beyond the bache-lor’s degree.n The experience should be under theguidance of a licensed CPA.n Some of the experience should be in thearea of third-party reliance.n At least one year of the experience mustbe in public practice.

The committee provided a detailed defi-nition of the tasks that should be includedin such experience. Many states adopted thisdefinition for their own requirements;however, the AICPA never formally adopt-ed the report (Patrick H. Heaston, “Towarda Meaningful Experience Requirement forthe Licensure of Certified PublicAccountants: A Delphi Approach,” PhD dis-sertation, University of Nebraska, 1982).


Later in the same decade, the AICPAestablished the Committee on Educationand Experience Requirements for CPAs toreaddress these issues. This committeeissued many recommendations, one ofwhich suggested that no experiencerequirement exist if at least five years ofcollege study were completed—this being,in the committee’s view, the minimumneeded to obtain the common body ofknowledge necessary for a CPA (“Reportof the Committee on Education andExperience Requirements for CPAs” [i.e.,the Beamer Committee Report], AICPA,1969).

In 1971, the American AccountingAssociation (AAA) created a committee toexamine the AICPA’s 1969 report. Thepurpose of the AAA committee was toevaluate the AICPA’s report and issue rec-ommendations to colleges and universities.The AAA committee stated that it valuedexperience and that an experiencerequirement should be in place for thosewho wish to obtain a license to practice;however, the AAA recommended that col-leges and universities begin offering intern-ships as a substitute for experience, in theevent that the experience requirementswere eliminated (“Report of the Committeeto Examine the 1969 Report of the AICPACommittee on Education and ExperienceRequirements for CPAs,” AccountingReview, XLVII, 1972, pp. 237–257).

Two noteworthy contemporary PhD dis-sertations studied the recommendation for theelimination of the experience requirement.James C. Harper surveyed CPAs in Utah andfound that more than 90% of respondentssided against the elimination of the experi-ence requirement (“The Relationship betweenDemographic Attributes and Opinions ofCertified Public Accountants on Educationand Experience Requirements Controversies,”University of Utah, 1975). When analyzed bytype of respondent—public practice, govern-ment, industry, and education—all groupswere strongly against the elimination of theexperience requirement. Sidney B. Johnsonfound in a survey of CPA firm partners andmembers of state boards of accountancy thatabout 83% disagreed with the recommendedelimination of the experience requirement(“An Investigation of the RecommendationsMade by the Committee on Education andExperience Requirements of the AmericanInstitute of Certified Public Accountants,”Mississippi State University, 1978).

In 1984, the AICPA, working with theNational Association of State Boards ofAccountancy (NASBA), created the ModelPublic Accountancy Bill. In 1992, it wasrenamed the Uniform Accountancy Act(UAA); in August 2011, the most recentrevision (the sixth edition) of this docu-ment was released. The UAA addresses allaspects of the public accounting profession,including the recommended experiencerequirement. According to the UAA, anapplicant for licensure should have oneyear of experience that was verified by acurrent license holder; this experience canbe gained through a variety of employmentsituations (UAA fifth edition, 2007).

The Role of the Experience RequirementWhat value does an experience require-

ment bring to the profession? As statedby Bruschi, “personal participation in activ-ities results in the accumulation of knowl-edge and the development of skills andjudgment that cannot be readily obtainedin any other way. People learn by doing.”In a survey of accounting educators, near-ly half strongly agreed that experienceshould be required for licensure (QuintonBooker, Bobbie W. Daniels, and YvonneEllis, “Education and ExperienceRequirements to Become a CPA: AnExamination of Educators’ Views,” TheCPA Journal, August 2013, pp. 61–66).

But that is not the only issue regardingan experience requirement. Before con-sidering its advantages or disadvantages,one must determine its purpose—that is,can it demonstrate the attainment of knowl-edge, skills, or professional judgment need-ed by a practicing CPA? In addition, onemust consider whether awarding a CPAlicense represents acknowledgement thatcandidates have attained the minimum levelof broad-based accounting knowledge orthat candidates are qualified to conduct anaudit on their own. These two positions arenot the same.

Another important purpose of the licens-ing of CPAs is to allow only competent indi-viduals who will do quality work to enter theprofession. The effectiveness of licensing asa control mechanism is an empirical ques-tion that has not been widely studied. Onestudy did find that neither the length of theexperience requirement nor graduate educa-tion was associated with quality audits (GaryColbert and Dennis Murray, “StateAccountancy Regulations, Audit Firm Size,

and Auditor Quality: An EmpiricalInvestigation,” Journal of RegulatoryEconomics, vol. 16, no. 3, 1999, pp.267–285).

Another way to examine the importanceand purpose of the experience requirementis to focus on the benefits that it can pro-vide to others (e.g., employers or mentors),rather than the benefits it provides to anaccountant or auditor (InternationalEducation Practice Statement [IEPS] 3,Practical Experience Requirements—InitialProfessional Development for ProfessionalAccountants). An experience requirementbenefits employers by providing them withthe assurance that their new employeespossess a level of knowledge and skills suf-ficient to meet the licensing standards.Moreover, mentors benefit by better devel-oping their own knowledge and skills(including interpersonal skills) when theyprovide both positive and negative feed-back to trainees. This work could also con-tribute to a mentor’s continuing profes-sional education (CPE) requirements. Therelationship between trainee and mentoralso improves the profession, which bet-ter serves the public interest.

Developing appropriate experiencerequirements can follow differentapproaches—for example, input-based, out-put-based, or a combination of both(IEPS 3). Input-based approaches desig-nate a period of practical experiencedeemed to be adequate for a trainee toachieve competence. Output-basedapproaches require a trainee to demonstrateachievement of competencies attained bysome output measure, such as an exami-nation.

Input-based approaches are much morecommon because they are easier to admin-ister. The trainee completes the requiredtime period, the supervising CPA signs offon the attainment of the experience, andthe requirement is completed. Output-basedapproaches are more challenging to admin-ister, and an appropriate examination orother measurement device must be devel-oped. The advantages of output-basedapproaches, however, are that a verycompetent trainee can meet the requirementmore quickly and that all trainees mustdemonstrate they have achieved the mini-mum competence level; this is not demon-strated under an input-based approach.

An appropriate experience requirementis intertwined with the educational require-


EXHIBITExperience Requirements by Jurisdiction

Jurisdiction Experience Requirement

Alabama 1 year public or 2 years industry, business, government, or college teaching

Alaska 2–4.5 years, depending upon education and type of experience

Arizona 1 year experience in the practice of accounting

Arkansas 1 year public, industry, government, academia

California 1 year public, private, or government, with 150 semester hours of education or 2 years public, private, orgovernment with 120 semester hours of education

Commonwealth of 1 year publicthe Northern Mariana Islands (CNMI)

Colorado 1 year public, industry, government, or academia

Connecticut 2 years public, government, or industry

Delaware 1 year public, government, industry, or academia

District of Columbia 1 year public, government, industry, or academia

Florida 1 year public, academia, industry, or government

Georgia 1 year public or 1 year industry, business, academia, or government that is satisfactory to the board

Guam 2 years public, government, industry, or academia, or 1 year with 150 semester hours of education

Hawaii 1,500 hours conducting audits or 2 years public, private, government, or education

Idaho 1 year public, government, industry, or academia

Illinois 1 year public, government, industry, or academia

Indiana 2 years public, government, industry, or academia

Iowa 1 year public, government, industry, or academia

Kansas 1 year public, government, industry, or academia

Kentucky 1 year public, government, industry, or academia

Louisiana 1 year public, government, industry, or academia

Maine 2 years public or 3 years Maine Revenue Services

Maryland 1 year in an appropriate profession approved by the board

Massachusetts 1 year public, including 1,000 hours in report function on full disclosure financial statements, or 3 years government

Michigan 1 year public, government, industry, or academia

Minnesota 1 year public, government, industry, or academia

Mississippi 1 year of meaningful experience under supervision of a CPA

Missouri 1 year public, government, industry, or academia

Montana 1 year public, private, government, or academia

Nebraska 2 years public or 3 years private, government, or academia

Nevada 2 years public or a length of time sufficient in the opinion of the board in internal auditing or governmentalaccounting and auditing

New Hampshire 2 years with bachelor’s degree or 1 year with master’s degree of public, government, or private accounting

New Jersey 1 year public or its equivalent as determined by the board

New Mexico 1 year public, government, industry, or academia

New York 1 year with 150 semester hours (for candidates grandfathered in under prior law, 2 years with 120 semester hours); experience may be earned through employment in public, government, private, or an educational institution

➥ (Continues on page 66)


ment needed to enter the profession.Candidates must demonstrate that theyhave attained the common body of knowl-edge needed in the profession and that theyhave developed the professional skills, val-ues, ethics, and attitudes required to workcompetently in the profession. Students cangain most of this knowledge and some ofthese skills, values, ethics, and attitudesduring their time in the classroom. Theimportant question is: which knowledge,skills, values, ethics, and attitudes are bet-ter learned during a time of practical expe-rience? The two models for entry into aprofession are 1) education requirementsonly or 2) a combination of educationand practical experience.

Current Views on Experience Requirements

AICPA. The UAA expresses the AICPAand NASBA’s views on the appropriateexperience requirement. It calls for a one-year, broad-based experience requirement forinitial licensure; a current license holder mustbe able to verify this experience. The typeof acceptable experience is broadly definedas experience in all accounting-related fieldsof employment (e.g., public accounting,industry, education, government).

In May 2010, the AICPA Council pro-posed a change in AICPA membership thatwould allow any persons who have passedthe CPA exam to be eligible for AICPAmembership if they meet the UAA criteriafor licensure (including the experiencerequirement definition), even if they do notmeet the licensing requirements in their ownstate (Jeannie Patton, “Ballot Measure WouldModernize and Align AICPA MembershipAdmission Requirements with UAAGuidelines,” Journal of Accountancy, August2010). This proposal was approved by a voteof the membership in October 2010.

IFAC. The federation addressed the rolethat experience should play in the licensingof professional accountants in itsInternational Education Standards (IES) andIEPSs. These pronouncements are issued bythe International Accounting EducationStandards Board (IAESB) and serve as stan-dards for the education and training of pro-fessional accountants for the IFAC memberbodies. Because IFAC member bodies rep-resent diverse cultural, linguistic, educa-tional, legal, and social systems, and becauseof the wide variety of functions that accoun-tants perform, IAESB pronouncements are

intended to serve a wide audience and, thus,are not equally relevant.

IES 5, Practical Experience Requirements,prescribes guidelines on practical experiencefor professional accountants. It should benoted that the term “professional accoun-tants” encompasses the broad range of activ-ities that all accountants are involved with,whereas the term “audit professionals” ismore narrowly focused and refers to thoseinvolved in the audit of historical financialstatements (IES 8, Competence Require -ments for Audit Professionals). IES 5 statesthat the period of practical experience mustbe long enough to permit candidates todemonstrate that they have gained the pro-fessional knowledge; skills; and values,ethics, and attitudes required to perform theirwork with professional competence. Toaccomplish this goal, the standard prescribesa minimum of three years of practicalexperience. This period may be reduced byup to 12 months for an education require-ment beyond the undergraduate level.

According to IES 8, the practical expe-rience needed by an audit professional maycome during or after qualification as a pro-fessional accountant and may include someof the experience required for qualifyingas a professional accountant. This standardprescribes that an audit professional nor-mally needs at least three years of practi-cal experience; two of these years shouldbe spent in the auditing of historicalfinancial statements under the guidance ofan engagement partner.

The IEPSs provide additional guidanceneeded by IFAC member bodies toimplement the IESs. IEPS 3 indicates thatpractical experience may be obtainedconcurrently or after the trainee’s formalaccounting education. It also indicatesthat education programs that include a sig-nificant proportion of practical applicationmay substitute for a portion of the practi-cal experience requirement. IEPS 3 alsoaddresses the role that mentoring plays inthis process, as well as methods for docu-menting and assessing practical experience.

Current Experience RequirementsCurrently, the most common experience

requirement in the United States is oneyear. This length reflects the changes thathave been occurring over the last 100years. In the early part of the 20th centu-ry, the most common experience require-ment was three years; however, wide

variation existed, with some jurisdictionsrequiring up to six years and others hav-ing no requirement (Philip H. Siegel andJohn T. Rigsby, “An Analysis of theDevelopment of Education and ExperienceRequirements for CPAs,” Research inAccounting Regulation, vol. 3, 1989, pp.45–68). In the 1950s and 1960s, most juris-dictions revised their experience require-ments down to two years. Upon the adop-tion of the UAA, many states reduced theirexperience requirements down to one year.But significant variation still exists in thetype of experience required.

There are 55 U.S. jurisdictions that licenseCPAs: the 50 states, the Commonwealth ofthe Northern Mariana Islands, the District ofColumbia, Guam, Puerto Rico, and theU.S. Virgin Islands. Based on a review ofboard of accountancy websites, 37 jurisdic-tions have an experience requirement of oneyear; 12 have a minimum of one year, butin certain cases require more than one year;5 require a minimum of two years or morein certain cases; and 1 requires three years.In jurisdictions where the length of experi-ence varies, it depends upon the type of enti-ty at which the experience was obtained orthe number of semester hours of educationattained. Only 9 jurisdictions require thatexperience be obtained solely in a publicaccounting firm or accept public account-ing or governmental auditing. Most juris-dictions allow experience to be obtained inpublic accounting, industry, government, oracademia.

Some jurisdictions require differentlengths of experience depending on thelevel of education attained by the candi-date (e.g., attaining 150 semester credithours or holding a master’s degree) and onthe type of experience (e.g., public account-ing versus experience obtained in industry,government, or education). A few juris-dictions allow the accountancy board todetermine whether the experience is accept-able on a case-by-case basis. Many of thejurisdictions that accept experience fromfields outside public accounting require alonger experience period than when theexperience is in public accounting.Jurisdictions that differentiate the length ofthe experience requirement require a short-er period of experience for candidates whohave completed additional education.Regardless of the type of experience, alljurisdictions require that it be obtainedunder the supervision of a licensed CPA.

One additional area of differencebetween jurisdictions is that six jurisdic-tions follow a two-tier system of licensing.These jurisdictions separate passing theCPA exam from licensing. A candidatewho passes the CPA exam is awarded aCPA certificate that shows attainment ofthe minimum knowledge to pass the exam;however, in order to receive a license topractice public accounting, a candidatemust meet the experience requirement.

The length of the experience requirementfor the state of New York depends uponthe number of semester credit hoursobtained in the candidate’s educational pro-gram. The experience requirement is oneyear of full-time accounting work experi-

ence in public practice, government, pri-vate industry, or education under the direc-tion of a licensed CPA, if the candidate hascompleted at least 150 semester hours ina baccalaureate or higher program. (Forcandidates grandfathered in under priorlaw, the experience requirement is twoyears of full-time accounting work expe-rience if the candidate has completed atleast 120 semester hours in a baccalaure-ate or higher program.) The Exhibit sum-marizes the experience requirements for the55 previously mentioned jurisdictions.

Comparing Experience ModelsThe question remains: which amount

and type of practical experience best pre-

pares candidates to become CPAs, bothprotecting the public interest and provid-ing a steady supply of qualified and trainedaccountants and auditors?

One model for licensure is to separatelicensing of accountants and auditors, basedon IFAC’s approach. This would allowexperience in a broad range of accountingactivities—including corporate accounting,governmental accounting, and accountingeducation—to qualify for licensure as a cer-tified accountant. Candidates choosing towork in public accounting could meet anadditional experience requirement of work-ing in a public accounting firm that focusedprimarily on third-party assurance. Thisapproach would make the experience


EXHIBITExperience Requirements by Jurisdiction

Jurisdiction Experience Requirement

North Carolina 1 year under supervision of licensed CPA, 4 years experience in the field of accounting, or 4 years teachingaccounting in a 4-year college

North Dakota 1 year public, government, industry, or academia

Ohio 1 year public, government, business, or academia

Oklahoma 1 year public, government, industry, or academia

Oregon 1 year public, or 1 year experience in industry, government, or other services (reviewed on a case-by-case basis by the board)

Pennsylvania 1 year public, government, industry, or academia

Puerto Rico 1 year public, industry, or academia

Rhode Island 1 year public, government, industry, or education

South Carolina 1 year public, government, or private; 5 years teaching accounting

South Dakota 1 year public, government, industry, or academia

Tennessee 1 year public, government, industry, or academia; 2 years experience in preparation of financial statements or reports on financial statements, to sign reports on financial statements

Texas If candidates have 150 semester hours, 1 year work experience under supervision of CPA, otherwise, 2 years under supervision of CPA

Utah 1 year public, government, industry, academia

Vermont 1 year public with 150 semester hours of education or 2 years public with 120 hours

Virgin Islands 3 years public or government auditor

Virginia 1 year public, academia, government, or industry providing relevant services (as determined by the board)

Washington 1 year public, government, industry, or academia

West Virginia 1 year public, government, industry, not-for-profit, or academia

Wisconsin 1 year public or its equivalent as determined by the board; industry, government, or teaching accounting may be considered equivalent

Wyoming 1 year public, government, industry, or academia

(Continued from page 64)➥


requirement relevant to the type of workthe accountant or auditor would be con-ducting in the future.

Although this dual licensing approach hassome significant advantages, it might be dif-ficult to implement in the United States.Because CPA licensing did not develop withthis dual approach, adopting it now wouldrequire significant changes in existing lawsin all jurisdictions; thus, the chances of itbeing adopted nationwide must be consid-ered remote. If this approach were adoptedand only partially implemented, it couldcomplicate the licensing issue even more andmake mobility across all jurisdictions moredifficult. In addition, because a dual approachwould require a candidate to become botha certified accountant and a certified auditor,it is unlikely that the required experiencecould be achieved in fewer than two or threeyears—significantly longer than the one yearthat most jurisdictions currently require.

Another model that could be followed isthe two-tier approach, similar to themethod that a few jurisdictions currently fol-low. As already mentioned, this modelawards a CPA certificate to candidates whomeet the education requirements and passthe CPA exam, and it requires an addition-al experience requirement with a publicaccounting firm from candidates who wantto work in public accounting. This modelachieves some of the benefits of a dualapproach, but in a way that could be prac-tically implemented in the United States. Thiswould also make it easier for the publicand employers to differentiate between some-one who has only passed the CPA exam andsomeone who holds a CPA license.

A third model for CPA licensure isgreater reliance on educational preparation,rather than the current combination of edu-cation and practical experience. Under thismodel, there would be no experiencerequirement for a candidate who holds agraduate degree in accounting. Thisapproach focuses on the question of whatthe requirements for entering the profes-sion should mean: do they mean that a per-son has achieved the level of knowledgerequired by the profession, or do they meanthat the person demonstrates a level ofcompetency in the field of public account-ing? If the educational view of achieve-ment of knowledge is held, then no expe-rience requirement is needed to show thata person has reached this requirement.Following this model does not necessari-

ly mean that the candidate would receiveno practical experience. Graduate academicaccounting programs could incorporatemore practical experience and trainingthrough cases that force students to applythe hands-on skills used by practicingCPAs. Furthermore, internships could bemade a required part of the curriculum, aswell as involving practicing CPAs in cur-riculum design, guest lectures, and caseevaluations. State boards could regulate thisprocess by defining in their regulations thecourses, subject areas, skills, and intern-ships necessary to qualify.

A final approach that could be fol-lowed is the UAA model. The UAA rec-ommends that candidates complete 150semester hours of education in accountingand one year of experience in virtually anyarea of accounting practice that is verifiedby a current license holder. This modelretains the practical experience requirementbut focuses on the purpose of experiencefor entry into the profession. Under thismodel, the experience requirement existsto show that the candidate has demon-strated the ability to work in a profession-al accounting field (broadly defined), butit does not demonstrate that the candidatehas the ability to work in public account-ing or as a sole practitioner.

Some might believe that a CPA licenseshould not be granted until a candidate hasdemonstrated the ability to conduct a third-party assurance engagement independent-ly. It can be argued that certainly oneyear—and probably even two years—doesnot provide the breadth of experiencenecessary to conduct a third-party assur-ance engagement entirely independentlybecause of the heavy use of judgmentrequired in assurance engagements. If aCPA license is intended to show theachievement of the necessary knowledgeand demonstrated ability to work as aprofessional accountant, however, the UAAmodel is an excellent approach.

An Effective ApproachWhen the profession was first estab-

lished, experience played a significant rolein licensing CPAs; however, as the num-ber of academic accounting programsbegan to increase, more emphasis wasplaced on education and less was given topractical experience. Jurisdictions main-tained experience requirements even aseducational requirements increased. The

adoption of the concepts in the UAA hada significant effect on the experiencerequirement to become a CPA; many juris-dictions have broadened the type of accept-able experience to include experience out-side public accounting firms.

In the author’s view, the following arethe two primary questions that regulatorybodies in every jurisdiction must address,with respect to the experience model: n Should CPAs be given a license thatwould allow them to provide attest servicesto be relied upon by third parties, althoughthey have no experience in attest work? n Should CPAs be given a license thatwould allow them to open their own CPAfirm immediately after completing theexperience requirement and begin offeringattest services?

In order for the experience requirement tobe effective, the required experience mustprepare a CPA to provide quality service andprotect the public interest. Clearly, there isa different threat to the public interestposed by attestation services that involvereports relied upon by third parties and otherservices provided by CPAs that will onlybe relied upon by the CPA’s client. Theexperience requirements that jurisdictionsadopt need to reflect this difference.

In the author’s opinion, one way toaddress this issue would be requiring aCPA firm license in order for a CPA firmto operate in a jurisdiction. Then, a require-ment for firm licensing could require atleast one owner of the firm to possess alicense that allows the CPA to provide pub-lic accounting third-party reliance services.Another way to address the issue would beto have a two-tier licensing system, where-by the attest license and the nonattestlicense would have different experiencerequirements. For an attest license, theexperience requirement might include atleast one year of experience in providingattest work to be relied upon by third par-ties, supervised by an attest-licensedCPA. Either approach would address thesignificant obstacles that many CPAs seeagainst broadening the type of qualifyingexperience required to become a licensedCPA, while adequately safeguarding thepublic interest. q

Jack Armitage, PhD, CPA, CFE, is theDistinguished Alumni Accounting Professorat the University of Nebraska at Omaha.

The SEC’s introduction of a state-of-the-art accounting quali-ty model (AQM) has initiated a new era for the detection ofaccounting fraud and improper disclosures. Craig M. Lewis,the director and chief economist of the SEC’s Division of

Economic and Risk Analysis, described the AQM as a robust toolcapable of providing quantitative analytics across the SEC in orderto assess and identify anomalies in the financial statements of aregistered company (“Risk Modeling at the SEC: The Accounting

Quality Model,” speech on Dec. 13, 2012, to the Financial ExecutivesInternational Committee on Finance and Information Technology,http://www.sec.gov/News/Speech/Detail/Speech/1365171491988).

Some have coined the term “Robocop” for the AQM. OneFinancial Times article noted that this early warning system “isone of the boldest uses so far of the computer-readable ‘XBRL[Extensible Business Reporting Language] tags’ and is expectedto be rolled out this year” (Adam Jones, “SEC to Roll Out

The SEC’s Renewed Focus onAccounting Fraud

T E C H N O L O G Ye l e c t r o n i c r e p o r t i n g


By Douglas M. Boyle, James F. Boyle, and Brian W. Carpenter

Insights and Implications for Auditors and Public Companies


‘Robocop’ Against Fraud,” Feb. 13, 2013).XBRL tags are used to identify financialdata included in typical long-form finan-cial statements and related note disclosures.

The SEC initiated a program phasingin the required use of XBRL tagged datain 2009 (SEC Release 33-9002,“Interactive Data to Improve FinancialReporting”). The use of XBRL tagsenhances access to and analysis of finan-cial data by investors, analysts, journal-ists, and SEC staff. In the case of the SEC’sAQM, these XBRL tags provide thefoundation for a renewed, high-techemphasis on the detection of fraud andother accounting irregularities.Computerized analysis of this tagged infor-mation significantly improves the efficien-cy and speed of the examinations of fileddata. One recent article highlighted thesecapabilities of the AQM, noting that themodel “is a fully automated system thateffectively takes a firm’s filing the day itcomes in, processes it, and then keeps itin the database so that somebody who isinterested in looking at a report on thatcompany would be able to do so within24 hours of the filing being posted onEDGAR [Electronic Data-Gathering,Analysis, and Retrieval system]” (“Q&Awith an Expert: The SEC is DevelopingTools That Use XBRL Data to DiscoverAccounting Anomalies and ImproveFinancial Disclosure,” Dimensions: TheCompliance Authority, Apr. 2013, p. 3).

The article “Accounting Fraud Targeted”notes that, in the SEC’s 2003–2005 finan-cial years, accounting fraud and improperdisclosures accounted for more than 25%of the agency’s civil enforcement actions,as compared to only 11% in its most recentfinancial year (Jean Eaglesham, Wall StreetJournal, May 27, 2013). The authorattributed this sharp decline to the SEC’srequired focus on the financial meltdown,which has since waned.

But several signs now indicate that theSEC has refocused its resources onaccounting fraud and disclosure. AsEaglesham noted, “The decision to huntfor wrongdoing by Main Street, as wellas Wall Street, puts America’s corporationsin the SEC’s cross hairs.” One outcomehas been the recent formation of a FinancialReporting and Audit Task Force, a teamof enforcement attorneys and accountantsworking in collaboration with several SECoffices to focus on accounting fraud, dis-

closures, and audit failures (“SECAnnounces Enforcement Initiatives toCombat Financial Reporting and MicrocapFraud and Enhance Risk Analysis,” SECpress release 2013-121, Jul. 2, 2013).This increased emphasis clearly positionsthe AQM as a key component of the ini-tiative, noting that the task force would“focus on identifying and exploring areassusceptible to fraudulent financial report-ing, including on-going review of financialstatement restatements and revisions, anal-ysis of performance trends by industry, anduse of technology-based tools such as theAccounting Quality Model.” Accordingto the chair of the SEC Financial Reportingand Audit Task Force, David Woodcock,“Regulatory oversight cannot remain atrest. … If we do what we did in the past,if we continue operating as if everythingis OK, that’s when trouble comes” (“WhatAccounting Fraud Risk Factors WillAttract SEC’s Attention?,” by Ken Tysiac,Journal of Accountancy, Dec. 13, 2013).

Given this increased emphasis on thedetection of fraud and disclosure anoma-lies, it is critically important that direc-tors, audit committee members, and audi-tors develop a better understanding of theAQM and its key variables in order toimprove financial reporting, disclosure, andaudit quality. This understanding will alsoenable these governance players to betterrespond to a potential SEC inquiry.

Although the SEC does not publish thekey variables considered in the AQM inorder to maintain its effectiveness as asurveillance tool, academic literature onearnings management and detection mod-els, combined with recent interviews andpresentations made by Lewis, offer valu-able insights. This discussion explores theseinsights and provides practical implicationsand useful resources for directors, auditcommittee members, and auditors to con-sider in their future governance activities.

Findings from Recent Interviews and Speeches

Exhibit 1 summarizes some key findingsbased on the authors’ review of recentinterviews and speeches given by Lewis.In December 13, 2012, Lewis referred tothe Jones model, which is widely used byaccounting academic researchers to iden-tify the existence of potential aggressiveearnings management practices (“RiskModeling at the SEC,” speech to the

Financial Executives InternationalCommittee on Finance and InformationTechnology). The Jones model assessesrisk by estimating the extent of discre-tionary accruals included in an entity’sfinancial reports. In contrast to nondiscre-tionary accruals, discretionary accrualsare typically subjective, involve a degreeof accounting judgment, and may or maynot comply with GAAP. Essentially, theJones model uses the change in revenueand total fixed assets as variables to pre-dict the level of nondiscretionary (nor-mal) accruals. Changes in total accrualsbeyond the predicted nondiscretionaryaccruals are considered discretionary(abnormal) accruals.

Exhibit 2 provides a summary of the Jonesmodel and the modified Jones model. Underthese models, discretionary accruals mayeither increase income (e.g., reducing theyear-end allowance for uncollectible receiv-ables) or decrease income (e.g., increasingthe estimated year-end defined benefit pen-sion plan liability). In addition, discretionaryaccruals may either be revenue related orexpense related. An example of a revenue-related discretionary accrual would be theestimation of the amount of revenue to rec-ognize on construction projects in progress.An example of an expense-related discre-tionary accrual would be the accrual of

It is critically important

that directors, audit com-

mittee members, and

auditors develop a better

understanding of the AQM

in order to improve finan-

cial reporting, disclosure,

and audit quality.


estimated warranty expense from current-period merchandise sales.

Under these models, potential earningsmanagement is identified in both directions(i.e., understatement and overstatement ofearnings) based upon the level of discre-tionary accruals. This dual direction con-sideration is important for auditors to

understand, because testing at the account-ing level is often performed in only onedirection (e.g., testing liabilities for under-statement and assets for overstatement). Asa result, auditors should consider testing allsignificant variances, regardless of whetherthey potentially understate or overstateearnings.

The AQM seeks to identify outlier dis-cretionary accruals that might provideevidence of potential attempts by man-agement to manipulate or smooth earningsthrough the use of judgmental and subjec-tive accounting choices. Lewis explainedin his aforementioned speech, “RiskModeling at the SEC,” that the AQM

EXHIBIT 1The SEC’s Accounting Quality Model (AQM): Identifying Outlier Discretionary Accruals

Examples of Risk Indicators Examples of Risk Inducers

n The recording of more bad debt expense in a profitable year n A company losing market shareand less bad debt expense in a loss year to smooth earnings n A company less profitable than its competitorsn Accounting policy that results in relatively high book income n A company experiencing transient performance problems and low taxable incomen Accounting policy with a high proportion of off–balance sheet transactionsn Frequent changes in auditors or delays in the release of financial statements or earnings

Precursors of the AQM

Companies have strong incentives to manage earnings because 1) investors respond to earnings announcements and 2) earningsmanagement by the company influences market information about the firm’s future performance and investment prospects.Earnings management is manifested in the discretionary choices that management can make under GAAP when reporting its financials.

Filers Flagged with High Risk Scores by AQM

n Receive higher priority in the scheduling of an SEC examinationn Generates customized reports that help identify areas of focus

Key Definitions

AQM—a model that provides a set of qualitative analytics that could be used across the SEC to assess the degree to which a regis-trant’s financial statements appear anomalous (i.e., “stick out from the pack” of industry peer companies).

Total accruals—the difference between net income and free cash flows (i.e., what accountants recognize as revenue and expensesand the actual cash flows available to shareholders). Total accruals consist of discretionary accruals and nondiscretionary accruals.

Discretionary accruals—these may be subjective and require considerable accounting judgment. Management’s influence over theaccruals’ values can provide opportunities to smooth income and manage earnings.

Nondiscretionary accruals—accounting adjustments made in strict adherence to GAAP and are relatively objective.

Risk indicators—factors that are directly associated with earnings management.

Risk inducers—factors that are associated with strong firm incentives to manage earnings.

Note:Information obtained exclusively from comments by Craig M. Lewis in the following sources:n “Q&A with an Expert: The SEC is Developing Tools That Use XBRL Data to Discover Accounting Anomalies and Improve FinancialDisclosures,” Dimensions: The Compliance Authority, April 2013n “Risk Modeling at the SEC,” speech by Lewis to the Financial Executives International Committee on Finance and InformationTechnology, Dec. 13, 2012


allows discretionary accrual factors to bepart of the estimation of total accruals and,thus, extends the traditional Jones modelapproach to identifying earnings manage-ment practices. Lewis further elaborated:

Specifically, we [the SEC] take filingsinformation across all registrants andestimate total accruals as a function ofa large set of factors that are proxiesfor discretionary and nondiscretionarycomponents. Further, (the SEC) decom-poses the discretionary component intofactors that fall into one of two groups:factors that indicate earnings manage-ment or factors that induce earningsmanagement. Discretionary accruals arecalculated from the model estimates andthen used to screen firms that appear tobe managing earnings most aggressive-ly. (Lewis 2012)It is important to remember that the goal

of the AQM is to identify outlier discre-tionary accruals—that is, those that “stickout” from a firm’s list of peer companies.In this 2012 speech, Lewis noted that “out-lier discretionary accruals can be a pow-erful indicator of attempts to manage earn-ings.” Furthermore, the AQM is able toquickly compare the financial data ofpeer companies by accessing the SECdatabase of XBRL public company finan-cial report filings. This enhanced accessi-bility of financial data was one of theintended benefits of XBRL tagging, asillustrated by FASB’s taxonomy, whichnotes the resulting increase in “the trans-parency and accessibility of business infor-mation by using a [XBRL] uniformfor mat.” Exhibit 1 includes examples pro-vided by Lewis of earnings managementrisk indicators and risk inducers, precur-sors of the AQM, information related tofilers flagged with high-risk scores, and keydefinitions used in the AQM.

Informing the AQM’s Selection ProcessThe origin of the current SEC division

overseeing the development of the AQMcan be traced back to 2009, when the SECreorganized several of its divisions to cre-ate what was then called the Division ofRisk, Strategy, and Financial Innovation(“SEC Announced New Division of Risk,Strategy, and Financial Innovation,” SECpress release 2009-199, Sep. 16, 2009). InJune 2013, this division changed its nameto the Division of Economic and RiskAnalysis. Lewis underscored the newly

renamed division’s commitment to risk ana-lytics, stating that the division’s new namereflects its twin goals to provide “robust andtransparent economic analyses in support ofCommission rulemaking and policy devel-opment, and enhance data-driven risk ana-lytics to help focus the agency’s resourceson matters presenting the greatest perceivedrisk” (“SEC Renames Division Focusing onEconomic and Risk Analysis,” SEC pressrelease 2013-104, Jun. 6, 2013).

When commenting on the AQM in his2012 speech, Lewis emphasized that themodel’s classification process “should beinformed by staff experience, intellectual cap-ital, and the substantial accounting literature

related to earnings quality and discretionaryaccruals.” One example of how the account-ing literature may inform the AQM can befound in the key findings in the Committeeof Sponsoring Organizations of theTreadway Commission’s (COSO) 2010report, Fraudulent Financial Reporting:1998–2007—An Analysis of U.S. PublicCompanies. This study investigated fraudu-lent financial reporting of U.S. public com-panies during the 10-year period from 1998to 2007. The resulting report revealed thatthe CEO or the CFO was named in 89% offinancial reporting fraud cases; improper rev-enue recognition was the most commonfraud technique, noted in 60% of cases;and fraud filers changed auditors 26% of the

time, as compared to only 12% of nonfraudfilers. The study’s revelation of characteris-tics associated with instances of fraud illus-trates the role that accounting research canplay in identifying potential fraud indicators,which further informs the AQM.

Lewis also indicated in his 2012 speechthat “a poorly conceived model might pro-duce a significant number of false positives.A false positive occurs when the modelincorrectly identifies a filer as an outlier. Theidentification of false positives can be cost-ly, not only for the registrant erroneouslytagged as engaging in earnings management,but for staff who has expended resourcesto investigate further.” In order to helpensure the AQM’s accuracy in predictingaccounting fraud, the SEC tested themodel during its development by evaluat-ing how well it predicted SEC accountingand auditing enforcement releases (AAER).

Implications for Public CompaniesAs more multiple-year public company

financial reports are tagged in XBRL formatand the SEC’s knowledge and experience inthe use of the AQM continues to grow, theSEC’s ability to quickly identify public com-panies with relatively high-risk scores forearnings management will also improve.Such scores can be used to identify filers forimmediate attention. Customized, company-specific reports can be generated to helpthe SEC focus specifically on those finan-cial reporting areas that represent outlier dis-cretionary accounting judgments.

Clearly, the AQM tool provides a sig-nificant opportunity to improve both theeffectiveness and efficiency of the SEC’sreview of financial reporting. But what arethe implications for public company direc-tors, audit committee members, and audi-tors? What actions should public compa-nies and their auditors consider taking inresponse to the AQM?

First, individuals responsible for corporategovernance should be proactive in attempt-ing to identify potential outlier discre-tionary accruals for investigation and furtherscrutiny. Auditors can provide valuableinsights to their public clients by informingaudit committees and boards about therenewed SEC focus on fraudulent financialreporting, as well as the key elements thatmight come under increased scrutiny becauseof the AQM’s implementation.

Second, it is important for auditors tounderstand and potentially test outlier dis-

Auditors can provide valu-

able insights by informing

audit committees and

boards about the key

elements that might come

under increased scrutiny

because of the AQM’s

implementation.


cretionary accruals for both understatementand overstatement of earnings, becauseeither condition may be detected as an indi-cator of potential earnings management andflagged by the AQM for further examina-tion. Analytical review can be performedusing the elements of the Jones model—for example, by measuring the change in

revenue to the change in key noncash(accrual) accounts, such as accounts receiv-able, inventory, and accounts payable. Theratio of these changes may be compared toa group of peer companies of comparablesize operating in the same industry.

Third, the consideration of risk indica-tors and risk inducers—such as the exam-

ples provided by Lewis and outlined inExhibit 1—should be included as an ele-ment of a public company’s corporate gov-ernance process and discussed during theexternal auditor’s planning session as partof its consideration of fraud risk factors, asrequired under Statement on AuditingStandards (SAS) 99, Consideration ofFraud in a Financial Statement Audit.Academic research might also be consult-ed to identify potential risk indicators andrisk inducers. For example, managementtypically has compensation incentives (e.g.,bonuses, stock options) to meet analysts’earnings targets, which might represent arisk inducer. Consistently meeting theseearnings targets by a small margin mightindicate the existence of earnings man-agement or a risk indicator.

In “Executive Stock Options, MissedEarnings Targets, and EarningsManagement,” researchers provided evidencethat just missing analysts’ earnings targetscould also indicate the presence of earningsmanagement when “a missed target couldbenefit an executive via a lower strike pricein subsequent option grants” (Mary LeaMcAnally, Anup Srivastava, and Connie D.Weaver, Accounting Review, 2008).

Next StepsOnce potential discretionary accrual out-

liers, risk indicators, and risk factors havebeen identified, public company directors,audit committee members, and auditorsshould analyze the underlying reasons forthe findings. This review might cause themto reconsider aggressive accounting deci-sions or, at minimum, it might prompt adiscussion regarding the justification ofpotential unfavorable outliers. Even if onlythe latter course of action is taken, thisadvanced knowledge and discussion willassist public companies during any poten-tial SEC financial reporting investigation.Performing these actions might alsoimprove audit and reporting quality andprovide a useful framework for auditorsand their clients to consider. q

Douglas M. Boyle, DBA, CPA, CMA, isa department director and assistant pro-fessor, James F. Boyle, CPA, is a facultyspecialist, and Brian W. Carpenter, PhD,is a professor, all at the University ofScranton, Scranton, Pa.

EXHIBIT 2Jones Model and Modified Jones Model to Measure Discretionary (Abnormal) Accruals

Discretionary (abnormal) accruals are measured by the extent to which total accrualsdeviate from predicted nondiscretionary (normal) accruals.

Jones Model (1991) Modified Jones Model (1995)

Normal accruals are a function of— Normal accruals are a function of—n annual change in revenues n annual change in revenue minusn gross property, plant, and equipment change in receivables

n gross property, plant, and equipment

Timeline

n 1991: Jennifer J. Jones justified the inclusion of changes in revenues and grossproperty, plant, and equipment as a function of normal accruals:

Total accruals include changes in working capital accounts, such as accounts receivable, inventory and accounts payable, that depend to some extent onchanges in revenue. … Gross property, plant, and equipment is included to controlfor the portion of total accruals related to nondiscretionary depreciation expense.(“Earnings Management during Import Relief Investigations,” Journal of AccountingResearch, vol. 29, pp. 211–212)

n 1995: Patricia M. Dechlow, Richard G. Sloan, and Amy P. Sweeney explained theirsuggested modification to the Jones model:

The modified version of the Jones Model implicitly assumes that all changes incredit sales in the event period result from earnings management. This is based onthe reasoning that it is easier to manage earnings by exercising discretion over therecognition of revenue on credit sales than it is to manage earnings by exercisingdiscretion over the recognition of cash sales. (“Detecting Earnings Managements,”Accounting Review, vol. 70, p. 199)

n 2012: Craig M. Lewis stated in his speech to Financial Executives InternationalCommittee on Finance and Information Technology:

Traditional models [on earnings management detection]—often based on the popu-lar “Jones” model or the “modified Jones” model—generally attempt to isolate theeffect of discretionary accruals by regressing total accruals … on factors that proxyfor non-discretionary accruals and treating the unexplained portion (the residual) asan estimate of discretionary accruals. (“Risk Modeling at the SEC: The AccountingQuality Model,” http://www.sec.gov/News/Speech/Detail/Speech/1365171491988)


By Susan B. Anders

The North American SecuritiesAdministrators Association (NASAA)is a voluntary association of state,

provincial, and territorial securities adminis-trators in the United States, Canada, andMexico that aims to provide grassroots pro-tection for consumers who purchase securitiesor investment advice. Members benefit frominformation sharing and participation in mul-tistate enforcement actions. The NASAA’swebsite, at http://www. nasaa.org, presentsnumerous resources for securities industriesand professionals, as well as tools for smallbusiness capital formation, investor education,and fraud prevention.

The homepage is organized around sixmain areas: investor education, issues andadvocacy, regulatory and legal activity, indus-try resources, newsroom, and “contact yourregulator.” It highlights recent regulatoryissues and the latest news and investor alerts.

Industry ResourcesThe NASAA offers useful materials for

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Corporation finance resources include twoNASAA programs developed to aid com-panies in streamlining the process of regis-tering and issuing securities. The SmallCompany Offering Registration (SCOR) pro-gram’s webpage provides a detailed 38-page Microsoft Word template for Form U-7 (Small Company Offering RegistrationForm). Coordinated Review (CR) programsare available for issuers pursuing multistateregistration; these are housed on a stand-alonewebsite, http:// www. coordinated review. org.

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Regulatory and Legal ActivityThe resources in this section include the

NASAA’s policy statements and enforcementstatistics. An example of policy resources isa statement on corporate securities definitionsthat covers terms used in the organization’svarious policies, such as “adjusted net earn-ings,” “equity securities,” and “independentdirector.” The risk disclosure guidelinesaddress the presentation of information onrisk factors. The NASAA’s 2013 enforce-ment report presents the results of an annu-al survey of its members that addresses trendsin securities fraud, investor protection, andregulation. The study, based on data from2012, indicated that investors filed more than10,000 complaints, resulting in almost6,000 investigations and $700 million ininvestor restitution orders. Oil and gas fraudsexceeded real estate investment schemes asthe subject of the top enforcement actions.

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The library section contains a variety ofpublications, ranging from basic pocketguides, to brochures, to podcasts. “The ABCsfor APS [Adult Protective Services]Professionals: How to Identify and ReportInvestment Fraud” is a brief flier designed tohelp adult protective service workers identi-fy when their elderly clients are subject toinvestment fraud. It includes facts about finan-cial abuse of elders, warning signs of fraud,and information on how to report complaints.

“Sandwich Generation: Caught in theMiddle” offers a unique—and often over-looked—perspective on the life cycleapproach to financial planning. Membersof this generation not only have their ownsaving and investing considerations; theyare also involved in teaching money man-agement to children, as well as helpingolder relatives maintain their economicwell-being. The brochure provides a use-ful checklist of action steps.

A podcast archive offers audio record-ings primarily focused on fraud. Theadditional resources feature contains linksto more than 50 organizations.

Fraud CenterThe NASAA’s fraud center presents news,

alerts, tips, articles, and regulator information,as well as an investment fraud awarenessquiz. News, alerts, and tips include the latestfinancial fraud scams, such as “How toSpot a Con Artist,” where rule number onestates that con artists like to blend in.

“Top Investor and Small BusinessThreats” lists the top 10 financial prod-ucts and practices that can snare unwaryinvestors. The threats are categorized aspersistent (continuing) threats, newthreats to investors, and new threats tosmall businesses. An example of a persis-tent threat is fraudulent private placementofferings, which can be sold to investorswithout registration and are the primaryfocus of state securities regulators’ inves-tigations and enforcement activities.Allowing an unlicensed individual to setup and manage a trading account on aninvestor’s behalf is one of the newer threatsto investors. Another is digital currencies,such as Bitcoin, which are not backed bytangible assets, not issued by a govern-mental authority, not regulated, and high-ly volatile. q

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

Website of the Month: North AmericanSecurities Administrators Association

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Selected Interest Rates 12/31/13 11/30/13Fed Funds Rate 0.07% 0.07%3-Month Libor 0.25% 0.24%Prime Rate 3.25% 3.25%15-Year Mortgage 3.69% 3.53%30-Year Mortgage 4.68% 4.49%1-Year ARM 2.56% 2.60%3-Month Treasury Bill 0.07% 0.07%5-Year Treasury Note 1.74% 1.40%10-Year Treasury Bond 3.01% 2.78%10-Year Inflation Indexed Treas. 0.80% 0.60%

E C O N O M I C & M A R K E T D A T A

m o n t h l y u p d a t e

The information herein was obtained from various sources believed to be accurate; however, Forté Capital does not guarantee its accuracy or completeness. This report was prepared forgeneral information purposes only. Neither the information nor any opinion expressed constitutes an offer to buy or sell any securities, options, or futures contracts. Forté Capital’sProprietary Market Risk Barometer is a summary of 30 indicators and is copyrighted by Forté Capital LLC. For further information, visit www.fortecaptial.com, send a message [email protected], or call 866-586-8100.

Forté Capital’s Selected Statistics

U.S. Equity Indexes 12/31/13 YTD Return

S&P 500 1,848 29.60%

Dow Jones Industrials 16,577 26.50%

Nasdaq Composite 4,177 38.30%

NYSE Composite 10,400 23.20%

Dow Jones Total Stock Market 19,413 30.90%

Dow Jones Transports 7,401 39.50%

Dow Jones Utilities 491 8.30%

Forté Capital's Proprietary Bullish Neutral BearishMarket Risk Barometer 10 9 8 7 6 5 4 3 2 1

Market ValuationMonetary Environment Investor PsychologyInternal Market Technicals

Overall Short-Term Outlook 4.51Overall Long-Term Outlook 4.22

43

54

Equity Market Statistics 12/31/13 11/30/13

Dow Jones IndustrialsDividend Yield 2.23% 2.21%Price-to-Earnings Ratio (12-Mth Trailing) 16.63 16.23Price-to-Book Value 3.01 2.94

S&P 500 IndexEarnings Yield 5.53% 5.66%Dividend Yield 1.99% 2.02%Price/Earnings (12-Mth Trailing as Rpt) 18.09 17.67Price/Earnings (Estimated 2012 EPS) 17.24 16.81

Commentary on Significant Economic Data This Month

Pending home sales increased 0.2% in November, on a seasonally adjusted annualized basis, reversing a five-month downward trend. Potential homesales had fallen throughout the summer as interest rates rose and homebuyer confidence declined. With the economy improving, the first monthly gainsince May indicates that homebuyers are adjusting to higher mortgage rates. Although the overall pending home sales were positive, the results were varied in different parts of the country. Pending home sales increased the most in the South, rising 2.3%; in the West, they were up 1.8%. The Northeastdeclined 2.7% and the Midwest declined 3.1% over the previous month. On a year-over-year basis, pending sales are up in the Northeast, Midwest, andSouth by 1.9%, 0.4%, and 0.1% respectively, whereas the West is down by 8.7%.

The housing market is expected to pick up over the course of 2014 as employment and income growth accelerate. In addition, first-time homebuyersshould support housing demand as they reenter the housing market after being out for the past several years. The primary risk to this outlook remains afaster-than-expected rise in mortgage rates.

Most Prior Key Economic Statistics Recent Month

National

Producer Price Index (monthly chg) 0.40% --0.10%

Consumer Price Index (monthly chg) 0.30% 0.00%

Unemployment Rate 6.70% 7.00%

ISM Manufacturing Index 57.00 57.30

ISM Services Index 53.00 53.90

Change in Non-Farm Payroll Emp. 74,000 203,000

New York State

Consumer Price Index - NY, NJ, CT (monthly) 0.10% 0.10%

Unemployment Rate 7.10% 7.40%

NYS Index of Coincident Indicators (annual) 2.30% 3.20%

As of 12/31/13

Chart of the MonthPending Home Sales

Source: Federal Reserve

Dec

12

Jan

13

Feb

13

Mar

13

Apr

13

May

13

Nov

13

Oct

13

Sep

13

Jun

13

Jul 1

3

Aug

136.0%

4.0%

2.0%

0.0%

--2.0%

--4.0%

--6.0%


Applying Technology to Accounting Fraud

E D I T O R I A La m e s s a g e f r o m t h e e d i t o r - i n - c h i e f

When I first heard the term“RoboCop” at a recent confer-ence, I thought I must have mis-

heard. But speakers from the SEC and theCenter for Audit Quality (CAQ) were talkingabout a new weapon in the battle againstaccounting fraud. The new SEC chair, MaryJo White, has been clear about her intent tostrengthen SEC enforcement activities,because “the more successful [the SEC is] atbeing—and being perceived as—the toughcop that everyone rightfully expects, the moreconfidence in the markets investors will have”(speech at the Council of InstitutionalInvestors’ conference, Sep. 26, 2013).

The Accounting Quality ModelThe SEC has introduced a new account-

ing quality model (AQM, or RoboCop), anautomated system that uses registrants’ datato detect fraud and other “accounting irreg-ularities” in a faster, more efficient way. Thisnew model uses XBRL tags of financial dataincluded in SEC filings and creates risk scoresfor SEC staff to use in reviews of companyfilings and investigation activities. (A fur-ther description of the AQM appears on page68 in “The SEC’s Renewed Focus onAccounting Fraud: Insights and Implicationsfor Auditors and Public Companies.”)

In numerous public statements, the SEChas acknowledged that it has had fewerfraud enforcement actions and that there havebeen fewer restatements of financial state-ments overall in the past five to seven years;however, some are attributing the statistic tothe SEC’s focus on other issues related tothe financial crisis overall, rather than to bet-ter behavior by registrants or improvementsin financial reporting as a result of Sarbanes-Oxley reforms. The SEC is devoting addi-tional resources to, among other things, find-ing out whether there has actually been anoverall reduction in fraud. It recently formeda Financial Reporting and Audit (FRAud) taskforce of accountants and lawyers to combatfalse and misleading financial statementsand audit failures. The SEC intends to

develop and use “state-of-the-art methodolo-gies” to identify and investigate financialreporting fraud and to generate newaccounting fraud investigations for SECenforcement staff to pursue; it has categorizedthis as a new way of “crunching data … toisolate potential red flags” (Andrew Ceresney,speech at the American Law InstituteContinuing Legal Education, Sep. 19, 2013).

The SEC is applying modeling, includingthe Jones Model, to assess risk and identifypotential earnings management by estimating“discretionary accruals,” which looks atchanges in factors like revenue and fixedassets to predict “nondiscretionary accruals.”The AQM goes further by identifying “out-lier discretionary accruals” as indicators ofearnings management. I am not an economistbut, as a CPA, it seems to me that labeling adiscretionary accrual as abnormal, or indicat-ing that outliers are an indicator of fraud basedon these types of metrics, could potentiallysend the wrong messages to everyone—pre-parers, auditors, regulators, and investors.

Is Modeling the Answer?No one would argue that fraud should be

targeted, that investors can suffer real harm dueto fraud, that abusive earnings managementshould be prevented, and that audit failures todetect fraud must be mitigated. But there is def-initely debate about whether economic mod-eling and surveillance tools to detect earningsmanagement, such as the AQM, are the rightway to address these issues.

My concern is with the hunt for “disclo-sure anomalies” and the use of technology toidentify company outliers, those whose finan-cial metrics are different from their peergroups. How can anyone agree as to what isan “anomaly,” what standard ratios shouldbe for companies within industry groups, orwhat the key financial drivers are? Is there aneed for “risk indicators” and “risk inducers”and scoring filings across peer groups? Foryears, auditors and companies have beenusing analytics and peer group analysis as atool to assess reasonableness of financial

information. But it is a reasonableness test,used in combination with other procedures.Results fluctuate period to period in the nor-mal course, and GAAP permits estimationsand ranges and judgments to be made.

There are other more useful approaches tocombating fraud, including the CAQ’sAntiFraud Collaboration, the PCAOB’sStanding Advisory Group, and the SECFRAud task force’s collaboration and educa-tion goals. Regulators are focusing on improv-ing internal controls over financial reportingthrough the education of companies and auditcommittees and through the oversight andinspection of auditors, which should have adirect impact on the reduced potential forfraud. Whistleblower programs are provid-ing useful information to regulators to com-bat fraudulent activities and reporting.

Models and metrics might assist SEC staffin reviewing registrant filings and otherenforcement activities to combat fraud. Myconcern is that there is too much data andnot enough analysis, and that registrants willhave to defend their financial statement ratiosin comment letters and SEC investigations.Will this lead to public companies, their auditcommittees, and their auditors trying to antic-ipate what metric will be an anomaly andcrack the RoboCop code? Will companiesfollow their peer group’s accounting poli-cies and make conservative accrual estimates,rather than apply the best GAAP for their sit-uations? Could this not lead to increasedrather than decreased earnings management?Will more boilerplate disclosures result?Hopefully, real improvements in financialreporting and audit quality will prove to havebeen made after all. q

Maria L. Murphy, CPAEditor-in-ChiefAssistant Manager of Peer [email protected]

The opinions expressed here are my ownand do not reflect those of the NYSSCPA,its management, or its staff.

CPA Journal Feb-14

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Transcript of CPA Journal Feb-14