AICPA Plan to Enhance Audit Quality

In May 2014, the AICPA launched the Enhancing Audit Quality (EAQ) initiative designed to promote continuous improvement in the quality of audits. As part of this initiative, this document was issued by the AICPA on May 14, 2015, titled Enhancing Audit Quality, A 6-Point Plan to Improve Audits. It is further described as “The U.S. CPA profession’s answer to quality financial statement audits of private companies, employee benefit plans and governmental entities.”

An outline of the 6-point plan contained in the foregoing document is as follows:

  1. Pre-Licensure.  Next version of CPA Exam is designed to increase assessment of higher-order skills, such as critical thinking and professional skepticism; high school AP accounting course; changes to college-level accounting education; additional doctoral-level audit professors with practical experience.
  2. Standards and Ethics.  Quality control standards implementation support; evaluation of clarified standards implementation; auditor’s report revisions; ethics code codification.
  3. CPA Learning and Support.  Competency models for audits, including employee benefit plan and governmental, competency assessment tools, targeted resources to develop competencies; certificate programs to demonstrate competence; nano, blended and informal learning programs; Employee Benefit Plan and Governmental Audit Quality Centers’ resources, tools and training; Center for Plain English Accounting; audit guides, risk alerts and practice aids.
  4. Peer Review.  Focus on greater risk industries/area, including EBP and Single Audits; more significant remediation including pre-issuance reviews and aggressive follow-up; root cause analysis (for poor and good quality); termination from peer review after repeat quality issues.
  5. Practice Monitoring of the Future.  Long-term initiative for near real-time, ongoing monitoring of firm quality checks using robust technological platform.
  6. Enforcement.  Aggressive investigation of all referrals of deficiencies; enhanced coordination with state boards of accountancy having ability to restrict license to practice; reinforced Code of Professional Conduct rules on Due Care.

Analytical Review Procedures for the Not-for-Profit

Evaluating the operating efficiency of a not-for-profit organization can prove challenging because profit-based measures of performance and profitability either don’t apply, or apply to only a portion of the organization’s activities. Often, the profit-based activities exist to support the provision of services that constitute the real mission of the organization. In addition, not-for-profits tend to have differentiating characteristics associated with their services and societal functions that make industry benchmarking analysis less useful than it is for the profit-making sector.

Certain ratios have been developed that are specific to the not-for-profit sector. A helpful summary of some ratios may be found here:  Nonprofit Financial Ratios

To maximize information value, ratio analysis should be combined with trend analysis and budget analysis, both of which focus on the organization’s own trends and expectations. Good sources of industry benchmarks are associations that support organizations in the industry’s own line of work, such as the National Coalition Against Domestic Violence ( for the operation of a domestic abuse shelter. Another source of information is academic studies, but keep in mind that they are usually not updated regularly.

Book Review: Thinking, Fast & Slow, by Daniel Kahneman (Farrar, et. al., 2013)

Daniel Kahneman received the Nobel Memorial Prize in Economic Sciences for his work with Amos Tversky on Prospect Theory. He is a psychologist who has spent his career working on the psychology of judgment and decision-making, behavioral economics and hedonic psychology. Prospect Theory describes the way people make choices under uncertainty. Its basic premise is that people are loss-averse rather than risk-averse, a finding that challenges the conventional wisdom of expected utility theory.

Kahneman’s Thinking, Fast & Slow is wonderfully enlightening about the way the human mind works. While the author is known for the application of his work to the field of economics, decision-making under uncertainty impacts all aspects of human existence. This is a book that is full of fascinating and entertaining examples and studies. I was particularly struck by the clever construction of many of the psychological studies described in the book – they give new meaning to the adage, “simple is better.” You will enjoy reading this book and will gain insight into the workings of the human mind.

Help for Charitable and Other Exempt Organizations

This post goes out to all my friends in the world of exempt organizations. Many exempt organizations struggle with regulatory and tax compliance due to complexity of the rules, turnover of volunteers, and lack of access to specialized professional advice. Here is a link to a site that the IRS has developed to help exempt organizations remain compliant: There are webinars, videos and written explanations of important topics such as preparing the 990, dealing with employment issues and determining whether you are subject to unrelated business income tax.

Economic Update

Stock prices are trending lower and economic activity appears to be slowing as we move into 4Q2014.  US retail sales for September were 0.3% lower than August, but 4.3% higher than September 2013.  The US Producer Price Index showed a decline of 0.1% in September, while industrial production in Europe has fallen 1.9% over the past year.  The New York Fed’s Empire State Manufacturing Report showed a decline in its index from 27.5 in September to 6.2 in October.  The S&P 500 closed yesterday at 1,862.49, up 0.8% YTD, but 7.4% lower than its high for 2014 of 2,011.36 on September 18.

Update on Private Company Council Activities

The Private Company Council (PCC) met on September 16, 2014, and “voted to finalize an alternative [to US GAAP rules] that would exempt private companies from separately recognizing and measuring non-competition agreements and customer-related intangible assets that are not capable of being sold or licensed independently in a business combination.  The PCC voted to send the alternative to the FASB for endorsement.  The FASB will discuss the alternative in the coming weeks.”

At the meeting, the PCC also discussed accounting for stock-based compensation for private companies and the FASB’s lease accounting improvements project.

Background on the Private Company Council:  The PCC was created in May 2012 by approval of the Financial Accounting Foundation’s Board of Trustees.  The PCC has two principal responsibilities:

1.  The PCC and the Financial Accounting Standards Board (FASB), working jointly, will mutually agree on a set of criteria to decide whether and when alternatives within U.S. Generally Accepted Accounting Principles (GAAP) are warranted for private companies.  Based on those criteria, the PCC will review and propose alternatives within U.S. GAAP to address the needs of users of private company financial statements.

2.  The PCC also serves as the primary advisory body to the FASB on the appropriate treatment for private companies for items under active consideration on the FASB’s technical agenda.

Source: PCC website at  Information relating to the 9/16/14 meeting is from the PCC Media Meeting Recap available on the website.

AU 240 Consideration of Fraud in Financial Statement Audit

AU 240 Consideration of Fraud in Financial Statement Audit is effective for audits of financial statements for periods ending on or after December 14, 2012. While this pronouncement is specifically addressed to financial statement audits, it offers broader lessons for the forensic accountant. It points out that a misstatement may result from either fraud or error and reminds users that fraud is a broad legal concept, with the deciding factor between fraud and error being whether the underlying action that results in the misstatement is intentional or unintentional.

In addition, AU 240 does a good job of describing the role of corporate governance in diminishing the risk of fraud, as follows:

Responsibility for the Prevention and Detection of Fraud

.04  The primary responsibility for the prevention and detection of fraud rests with both those charged with governance of the entity and management. It is important that management, with the oversight of those charged with governance, places a strong emphasis on fraud prevention, which may reduce opportunities for fraud to take place, and fraud deterrence, which could persuade individuals not to commit fraud because of the likelihood of detection and punishment. This involves a commitment to creating a culture of honesty and ethical behavior, which can be reinforced by active oversight by those charged with governance. Oversight by those charged with governance includes considering the potential for override of controls and other inappropriate influence over the financial reporting process, such as efforts by management to manage earnings in order to influence the perceptions of financial statement users regarding the entity’s performance and profitability.

Case Comment: The Nature of Goodwill

The Supreme Court of Arkansas contributes to the debate regarding the nature of goodwill in Brave v. Brave, 2014 Ark. Lexis 232 (April 17, 2014) by focusing on the salability aspect of goodwill as an asset.  The Supreme Court of Arkansas stopped short of directly addressing the issue of whether personal goodwill may contribute value to a business that is not a professional practice as the Arkansas Court of Appeals had done in this matter.  Rather, the Supreme Court of Arkansas found that the husband’s own valuation professional had characterized the goodwill as transferable and referred to its prior decision in Wilson v. Wilson, 294 Ark. 194, 741 S.W.2d 640 (1987), which in turn had referred to the Nebraska case of Taylor v. Taylor, 222 Neb. 721, N.W.2d 851 (1986), quoting as follows:

Where goodwill is a marketable business asset distinct from the personal reputation of a particular individual, as is usually the case with many commercial enterprises, that goodwill has an immediately discernible value as an asset of the business and may be identified as an amount reflected in a sale or transfer of such business. On the other hand, if goodwill depends on the continued presence of a particular individual, such goodwill, by definition, is not a marketable asset distinct from the individual. Any value which attaches to the entity solely as a result of personal goodwill represents nothing more than probable future earning capacity, which, although relevant in determining alimony, is not a proper consideration in dividing marital property in a dissolution proceeding.

Shareholder Loans – Are They Debt Or Equity?

Closely-held businesses frequently have balance sheet items classified as shareholder loans that represent cash transfers with shareholders. These items may be either assets or liabilities, and often they are carried on the books of the entity for many years with little activity or interest payments. In performing a valuation of the subject company, the valuation practitioner must determine whether these balances are truly debt, or whether they are really equity transactions that were initially characterized as loans.  

In order to determine whether the loans represent debt or equity, a “facts and circumstances” approach similar to that taken by the IRS is in order. The Second Circuit set out a widely-used definition of debt in Gilbert v. Commissioner, 248 F.2d 399, 402 (2d Cir. 1957), as follows:

An obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest payable regardless of the debtor’s income or lack thereof.

That is, an examination of both the form and economics underlying the transaction should be made, with the economic substance being the more important of the two. See, e.g., Fin Hay Realty Co. v. U.S., 398 F.2d 694, 697 (3d Cir. 1968). The key questions are:  Are all parties behaving as if the transaction represents an unconditional obligation to repay the amounts transferred? Would an unrelated lender have entered into a similar agreement?

A number of courts have established lists of factors to consider in making the determination. A 13-factor test was developed in the landmark case Dixie Dairies Corp., 74 T.C. 476 (1980), as follows:

  1. Name or label of the transaction
  2. Existence of a fixed maturity date
  3. Source of payments – whether payments are independent of earnings
  4. Right to enforce payments
  5. Participation in management, perhaps as a result of the advances
  6. Status in relation to outside creditors
  7. Intent of the parties
  8. Relationship to equity interests
  9. Adequacy of equity in the capital structure
  10. Ability of corporation to obtain credit from outside sources
  11. Use to which the advances were put
  12. Failure of the debtor to repay
  13. Risk involved in making the advances

The foregoing factors are merely to be considered, with no one factor being deemed determinative. 

Similarly, the Sixth Circuit has applied an 11-factor test when trying to distinguish between debt and equity, as follows:

  1. The names given to the instruments, if any, evidencing the indebtedness
  2. The presence or absence of a fixed maturity date and schedule of payments
  3. The presence or absence of a fixed rate of interest and interest payments
  4. The source of repayments
  5. The adequacy or inadequacy of capitalization
  6. The identity of interest between the creditor and the stockholder
  7. The security, if any, for the advances
  8. The corporation’s ability to obtain financing from outside lending institutions
  9. The extent to which the advances were subordinated to the claims of outside creditors
  10. The extent to which the advances were used to acquire capital assets
  11. The presence or absence of a sinking fund to provide repayments

See Indmar Products, Co., Inc. v. Commissioner [444 F.3d 771 (6th Cir. 2006), rev’g 89 TCM 795 (2005)] and Roth Steel Tube Company v. Commissioner, 800 F.2d 625.

The possible reclassification of shareholder loan balances from debt to equity for valuation purposes adds to the complexity of an engagement. Valuation professionals should be on the lookout for shareholder loan balances early in the process of negotiating the terms of an engagement.  

Case Comment: Expert Opinions Must Be Adequately Explained

In Hardenbrook v. United Parcel Service, Inc., 2014 U.S. Dist. LEXIS 15830 (Feb. 7, 2014), a district court accepted a discount rate of 0% used to value UPS stock. On appeal, the 9th Circuit remanded the case to the district court, which ratified its original finding. This case should be viewed less as an acceptance of a questionable valuation result than a cautionary tale for valuation experts about the importance of presenting adequately supported evidence. The UPS expert called the use of a 0% discount rate “unsound,” but failed to adequately explain and support his chosen discount rate of 10.5% in the eyes of the court. Faced with two competing discount rates, the district court chose to rely on the one that appeared to have the most supporting evidence.