Disclosures July August 2010

8/3/2019 Disclosures July August 2010

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in the

FinancialPlanning

Getting

DisclosuresJuly August 2010 | Vol. 23 No. 4 | www.vscpa.com

PLUS:New Fun with Fund Balances

Portolio Diversifcation

Sarbanes-Oxley: Friend or Fo


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Ive got aN uNeasy feelINg

about thIs clIeNt sItuatIoNBased on an actual conversation between a Senior Partner at a CPA frm and a CAMICO Risk Management Specialist.

cPa: So, my sta member recently noticed some irregularitiesin the trial balance provided by my clients bookkeeper. When I

brought this to my clients attention, he reacted very negatively

asking how we could have missed this beore, implying it was

somehow our ault. I didnt know what to say Im sure weve met

proessional standards and our workpapers should support that.

What can I do?

caMIco: This surprises many CPAs, but ater 24 years oproviding proessional liability insurance, CAMICO has ound

that ollowing proessional standards alone may unortunately not

be enough to avoid a claim.

cPa: Really!? I thought ollowing the rules would keep me sae.

caMIco: That would seem logical, but in addition to meeting

proessional standards, juries expect CPAs to look out or

irregularit ies and advise and warn clients o risks. So, i something

looks unusual, investigate it, document it and communicate it.

Do you have an engagement letter or this client?

cPa: Yes, the on-call CAMICO Risk Management Specialist

helped us tailor the wording to clearly spell out what services we

were providing and what was not included it says our frm isnot responsible or detecting raud and other irregularities and

the client signed it.

caMIco: Great! With the client acknowledging the terms o

your services, you have an excellent frst line o deense. Now

lets ocus on your next steps, so you can help your client with

their issue without putting yoursel at urther risk.

cPa: Thank you. Its good to be able to talk with an expert about

this it gives me real peace o mind.

ATLANTA New York SAN FrANci Sco BAY AreA

cALL 800.652.1772 or emAiL [email protected]

w w w . c Am i c o . c o m

cAmico proFeSSioNAL LiABiLiTY iNSurANce

iS SpoNSoreD BY:

proviDiNg proFeSSioNAL LiABiLiTY iNSurANce To cpA s For NeArLY A quArTer ceNTurY


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DisclosuresVirginia Society o CPAs

4309 Cox RoadGlen Allen, VA 23060

Phone:(804) 270-5344

Toll-ree nationwide:(800) 733-8272

Toll-ree CPE hotline:(800) 341-8189

Fax:(804) 273-1741

E-mail:[email protected]

Website:www.vscpa.com

TDD access throughVa. Relay Center:

(800) 828-1140 (voice)(800) 828-1120 (TDD)

Editorial Sta:Jill Edmonds

Managing [email protected]

Jenny HansenContributing [email protected]

Tina Lambert, CAEVice President, Member &

Public [email protected]

Editorial Task Force:Joan D. Aaron, CPA

William C. Barrett III, CPA/ABVBeth A. Berk, CPA

James D. Cole, CPACheri G. David, CPA, CVA

James P. Davis Jr., CPAWilliam C. Foote, CPA/ABV, CV

Heather L. Judson, CPAClare K. Levison, CPA

Gabriele Lingenelter, CPAHaven S. Pope, CPA, MBA, CF

George D. Strudgeon, CPAPhilip H. Umansky, CPA, Ph.D

Deadlines: Articles and advering or uture issues are due 5 p.m. on the ollowing dates

Nov./Dec. 10 Aug. 16Jan./Feb. 11 Oct. 15Mar./Apr. 11 Dec. 15July/Aug. 11 Apr. 15Sept./Oct. 11 June 15Nov./Dec. 11 Aug. 15

Disclosures is published bimonthly as a service

to members o the Virginia Society o CPAs.

Statements o act and opinion are made by th

authors alone and do not imply an opini on on

part o the ofcers, members or editorial sta.

The Warren Group

Design / Production / Advertising

thewarrengroup.com

[email protected]

July August 2010

Contents

Contents Disclosures July/August 1

Articles

4 Todays CPASet your careerin motion

6 Leaders EdgePoor perormers

22 Sarbanes-OxleyFriend or oe?

Sections

2 Line Items

27 Sel-Assessment

Exam

28 VSCPA Leaders

Summit

28 VSCPA News

35 Member News

36 Classifeds

8

Getting in the FinancialPlanning Game: CPAs andthe Personal FinancialPlanning Market

During a tough economy,individuals are increasinglylooking or fnancial planningresources. CPAs can help andare well positioned to takeadvantage o this market.

By David S. Murphy, CPA,CFP, Ph.D., and Philip H.

Umansky, CPA, Ph.D.

Advertisers IndexAccounting Practice Sales inside

back cover AON Insurancepage 16

Audimation Services, Inc.page 26

Beth A. Berkpage 17 CAMICO

inside ront cover Keiter, Stephens

& Shreaves back cover Robert Half

page 15 VSCPA Insurance Service

Centerpage 1118

Portolio Diversifcation:Where It Goes WrongDiversifcation is one othe undamental ideas ininvesting. However, the waymost portolios are currentlyconstructed violates the verybasic premises o modernportolio theory.

By John Davenport

Features

12

New Fun with FundBalances: ImplementingGASB Statement 54

For the frst time since GASBStatement 34, GASB has

issued a new standard that iscertain to aect the fnancialstatements o every localgovernment in Virginia.

By Paul A. Copley, CPA, Ph.D.,

and M. Loretta Manktelow,

MBA, MST


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The VSCPAs Centennial:A winning year!

We always knew our 100th anniversary wasspecial, and now we have the kudos to prove it.In May, the VSCPA won a CommonwealthAward of Excellence, for its Centennial Celebration inthe extended events and observances category of the 2010

Virginia Public Relations Awards, a statewide awards com-petition sponsored by the Richmond Chapter of the PublicRelations Society of America. The VSCPA celebrated itsCentennial anniversary in 2009, marking 100 years of anorganized CPA profession and statewide organization unit-ing and representing CPAs across the Commonwealth.

We hope you celebrated with us in some way wheth-er it was attending the annual meeting on the cruise toBermuda, participating in the CPA Day of Service or simplyreading the special commemorative issue ofDisclosures.Resources from the Centennial are still available for yourenjoyment at www.vscpa.com/Centennial.

LineItems

2 Line Items Disclosures July/August

T

he Virginia General Assembly session may be over, but is-sues that aect CPAs continue to crop up on Capitol Hill.The VSCPA strives to protect CPAs interests in the Com-

monwealth and beyond; here are a ew ways weve spoken up onthe ederal level in 2010:

Sarbanes-Oxley Section 404: The transparency and accuracyo nancial reporting is essential or ethical accounting. Thatswhy in March the VSCPA expressed strong support or Section404(b) o the Sarbanes-Oxley Act by urging Sen. Mark Warner(D) to oppose any attempt to amend that section during theSenate Banking Committee debate o the Restoring American Fi-nancial Stability Act o 2010. An additional letter on this subjectwas sent to Sen. Jim Webb (D) in April.

Aiding and abetting violations: In April, the VSCPA sentletters to Sens. Warner and Webb voicing opposition to anyamendment to the Restoring American Financial Stability Acto 2010 that would permit a private right o action or aidingand abetting violations under the Securities and Exchange Act o1934. Such an amendment would expand liability in class actionsuits to potentially include CPAs, lawyers and other proession-als who work with publicly traded companies, which could haveextremely adverse eects on CPAs due to astronomical lawsuitdamages. Thanks to the proessions opposition, the Senate re-moved the amendment and passed the bill on May 20.

Solicitation o services: On April 12, the VSCPA respondedto an Internal Revenue Service (IRS) regulation drat on permis-

sible disclosures or uses without consent o the taxpayer, statingthat urther guidance and clarication is needed or CPAs onwhat type o solicitation is and is not appropriate within legaland ethical guidelines.

U.S. comptroller general: The U.S. comptroller general isusually a CPA and the VSCPA thinks that should be a require-ment. In March, the Society joined the American Institute oCPAs and other societies in urging Virginias U.S. senators andrepresentatives to sign on as cosponsors o HR 4410, whichwould require that the comptroller general position be lled by alicensed CPA. At press time, the bill was in the House Commit-tee on Oversight and Government Reorm.

Extend PTIN comment deadline: The deadline or com-ments on the IRSs proposed Preparer Tax Identication Number(PTIN) regulations ell during tax season, leaving many CPAsunable to comment. The VSCPA requested a 30-day deadlineextension.

For an in-depth look at the VSCPAs positions on these issues,check out the ull letters at www.vscpa.com.

Taking sides: VSCPA speaksup on ederal issues


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Line Items Disclosures July/August 3

How will you serve?Sign up now or CPA Day o Service

Aneighborhood cleanup? A oodbank? A shelter? Whatever youdecide, its your choice when you join hundreds o your peersor the 2010 CPA Day o Service on September 24, 2010!

Last year more than 600 participants around the state united onthe rst-ever Day o Service to give back at more than 55 locationsstatewide. From large rms to sole practitioners, VSCPA chapters tostudent groups, VSCPA members were excited to join a common goalor one day and demonstrate the pride CPAs take in serving communi-ties. Getting started is easy. Heres how:

Decide how you or your rm, company, department, etc.1.would like to participate. You can volunteer during the day orater work whatever works or your schedule.

Let us know your plans by logging on to www.vscpa.com/2.DayoService. All VSCPA member participants will receive asnazzy ree T-shirt to wear that day, so make your plans early! Toreceive T-shirts or your group, you must sign up by August 13.

Questions? Visit www.vscpa.com/DayoService or details,3.volunteer suggestions and pictures o the great time membershad at last years event. Still more questions? No problem. Con-tact VSCPA Community Relations Coordinator Tracey Zink [email protected] or (804) 612-9427.

Dont miss outon the MAP

The PCPS/TSCPA National Management o an AccountingPractice (MAP) Survey only comes around every other year, somake sure your rm is in the loop or 2010!One o the largest CPA rm practice management benchmarking

projects in existence, the National MAP Survey allows participants tocompare their rms with others in the state as well as nationwide, anduse criteria such as billing rates, compensation and much more.

Signicant improvements have been made since the 2008 survey,including:

A 40 percent reduction in the number o questions! (Time is nolonger an excuse.)

A ree summary report to all participants

A shit in completion time to earlier in the year

New questions pertinent to the proession in 2010

All participants will receive a ree summary, and VSCPA membersparticipating will also receive a report o Virginias results. To receivecustomized survey data, rms must be members o PCPS.

Hurry deadline to participate is August 13. Visit http://map.pcps.org to participate now.

Bye, bye ree iFileFor 10 years, Virginia has oered ree income tax ling,

but that comes to an end with new legislation signed byGov. Bob McDonnell on April 11. Approximately 300,000Virginians are projected to use the ree service this year, bunext year online ling options will be similar to those o-ered by the ederal government ree or taxpayers whoincomes all under a certain threshold.


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4 Todays CPA Disclosures July/August

TodaysCPA

Full speed ahead

As a young proessional in the wakeo the inclement economic climate

o the past year or so, you may betrying to determine your best strategy orgetting ahead. Whether youre workingor a public accounting rm, becoming asole practitioner, considering a move toindustry, practicing as a consultant or justlooking to think strategically about yourcareer in accounting, this article is oryou.

You may already be thinking: I barelyhad enough time today to pick up this is-sue oDisclosures when will I have timeto plan my uture in accounting? I youre

like a lot o young CPAs, you spend a airamount o time at work, especially dur-ing busy season, but dont despair. Theollowing our tactics are relatively quick,but thoughtul ways to get ahead in yourrst ew years o practice.

Branch outResearch and join an industry-specic

proessional organization in additionto joining accounting-ocused proes-sional organizations, such as the VSCPA,

American Institute o CPAs (AICPA) orInstitute o Internal Auditors (IIA). These

organizations missions are to connectlike-minded proessionals and distributespecic resources and inormation to theirmembers. Such memberships are perector a CPA who wants to learn more aboutthe industry in which he or she is working.

For example, my rm specializes inorensic accounting and litigation consult-ing services, so I joined the American BarAssociation (ABA). I have attended localcommittee meetings and the ABA annualconerence, both o which provided an op-portunity or me to learn more about the

legal landscape as it pertains to orensicaccounting, understand the perspective omy clients and, ultimately, position myselto market my rms services to prospec-tive clients (attorneys).

An added bonus: Most proessional or-ganizations provide a platorm or service-oriented proessionals to contribute to thecommunity. Even i you dont have timeto volunteer year-round, try to select aprogram that allows you to contribute inbursts (when youre not working over-

Four ways to set your CPA career in motionBy Lauren Alexander, CPA

You may not realize

it, but a mentor is an

essential component

o your proessional

network.


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time during busy season) and one thatallows you to turn up and down the ameon your participation as necessary.

Zoom inKeep up-to-date on the happenings o

the accounting world through Continu-ing Proessional Education (CPE) courses,

thumbing through the AICPAsJournal oAccountancy, VSCPAs Disclosures, visitingthe Securities and Exchange Commis-sion and Financial Accounting StandardsBoard websites or just reading The WallStreet Journal. You may still be celebrat-ing successully completing the Exam, butcontinuing to sharpen and reresh yourtechnical skills will set you apart romother CPAs in your department or on yourteam.

Most rms require employees to obtainCPE credits annually anyway, but dont

think o it as a chore. There are hundredso ways to get valuable CPE otenonline or low or no cost and learnsomething relevant to your practice (thatsinteresting too).

These include sel-study courses,webcasts, training events or conerencesand are available through the proes-sional organizations described above, theVSCPA, the Big 4 accounting rms,etc. Many webcasts can be completed orno cost in just an hour during your lunch

break, and can arm you with the basics onan upcoming issue in accounting or thebuzz about a new pronouncement.

It may seem like a simple way to getahead, but just exposing yoursel to newor updated accounting standards or activityin the industry could lead to sharing a tipwith a client or contributing a quick act ina conversation with your boss. The ollow-ing are several resources or learning aboutCPE opportunities:

www.vscpa.com

http://vscpa.acpen.com

www.cpelink.com/?s=8ave3p7

http://cpe.cpacrossings.com/vscpa

www.cpa2biz.com

www.deloitte.com/us/dbries

http://www.kpmginstitutes.com/events

Look backIn your rst ew years as a CPA, you

may not have kept in touch with youralma mater, but its a relationship worthcultivating.

Proessors and organizations on cam-pus, like Beta Alpha Psi, are oten seekingyoung alumni to speak on job panels, share

experiences with students about what itslike to work as an accountant in the realworld, or give a talk about a specic areao accounting or technical issue. Contactone o your proessors or an organizationon campus to see how you can contribute.

These opportunities are threeold: Theyadd valuable experience to your CV, orexample, in public speaking; allow you tooster relationships on campus (build yourpersonal network); and provide your rmexposure to upcoming graduates in ac-counting (a strong contact at your under-

graduate or graduate accounting programcould help you or your rm have accessto the best new hires). Even i youre notdirectly involved with the recruiting unc-tion at your rm, most schools have youngalumni boards and other satellite organiza-tions designed to connect young alumniand promote networking.

Your alma mater also has a stake in yoursuccess, as it hopes to see alumni developand prosper, contribute to the school andprovide mentoring relationships to even

younger alumni, among other things.Many Virginia colleges and universitiesprovide career services to alumni, such asmaking sta available to review rsumsby e-mail or in person, and providingalumni access to job postings and network-ing events, such as career airs.

Make a connectionYou may not realize it, but a mentor

is an essential component o your proes-sional network. Mentors provide a wealtho experience and knowledge about your

workplace, industry and even ofce poli-tics. And mentors arent just importantor individuals beginning their careers;a mentor can be there throughout yourcareer to coach you through promotions,career moves and the occasional proes-sional blunder.

Many rms assign ormal mentorson your rst day o work, which can behelpul navigating those rst ew monthsat new job. However, nding the idealmentor may not be obvious. I your ormal

mentor assignment wasnt a match madein heaven or your rm does not oer amentoring program, consider seekingout an alternative. Many universities andproessional organizations such as theVSCPA oer mentorship programs. Beoreyou begin your search, evaluate your ownproessional goals, so that you can seek a

mentor who has chosen a similar path.Once you have ound a mentor, osterthe relationship by contacting your mentoron an ongoing basis to keep the relation-ship resh. Remember that mentoringrelationships involve trust and chemistry,neither o which occurs overnight. Espe-cially at the beginning o the mentoringrelationship, be clear about your inten-tions by sharing with your mentor speciclong- and short-term goals. However, beconscious not to monopolize your men-tors time. Instead, e-mail your mentor

an occasional update, drop by with coeeor send your mentor an article he or shemight nd interesting.

Finally, once you have an establishedmentor relationship, consider becoming amentor yoursel; sharing your own experi-ences and insight is not only rewarding,but motivates you to reassess your owngoals.

To conclude, there are a variety o waysto get ahead as a young proessional Ihave only outlined a ew in this article. But

its worth noting that the most successulproessionals in my workplace think stra-tegically about getting ahead, and dontollow blindly down the career path.

Lauren Alexander,

CPA, is a senior

manager at Veris

Consulting, Inc., a

Virginia-based consulting frm that

specializes in orensic accountingand litigation consulting services.

She is a recent graduate rom the

University o Virginias McIntire

School o Commerce. Contact her at

[email protected].

To oer another recent graduate

perspective, Beth Helle, a senior

consultant at Veris Consulting, Inc.,

also contributed to this article.

Todays CPA Disclosures July/August 5


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6 Leaders Edge Disclosures July/August

LeadersEdge

Dealing with poor perormersStart with the enablers

By Brian Kush, CPA, CISA, CITP

In his book, Good to Great, author JimCollins says a transormational com-pany rst got the right people on thebus (and the wrong people o the bus) andthen gured out how to drive it. Think oall the biggest challenges your organization

aces:Creating a great customer serviceexperience

Cutting costs

Uncovering innovative ideas

Aligning your organizations energy andactions with its mission and core values

Now think about the most important

resource needed to ace those challenges:great employees a.k.a. the right peopleon the bus. But we dont always get theright people. Sometimes we have the

wrong people doing the right things or the

right people doing the wrong things, andsometimes even the right people under-perform.

Underperormance not only aects yourcustomers and your bottom line; it canperpetuate i let unchecked. When poor orsubstandard perormance is present, some-thing must happen or else it will continue:change.

The perormance has to change or theperormer has to change. In short, some-body needs to practice new behaviors, bered or be moved. Beyond the individual

poor perormer, an organization that wantsto ensure it has all the right people on thebus must ask some questions:

How are we, as an organization,enabling poor perormance?

I you want to lead an organization thatattracts and cultivates poor perormancerom its employees, do all o the ollowing:

Ensure your star perormers take upthe slack or any poor perormers. Do

this by steadily increasing their work-load. The poor perormers survive, andi you are lucky, your star perormerswill burn out quickly rom the extrawork they are awarded. You receivebonus points i you can make sure thatthe star perormers directly take up theslack or the poor perormers and bothparties know it.

Label all o your poor perormers asalways poor. The best way to do thisis not to their aces, but instead behind

their backs to everyone else. Now thatthey have been labeled poor, every-one will be able to view all their workthrough that lens. That will motivatethem to live down to that label.

Hesitate in providing poor perorm-ers with the rank eedback they need.I they do not understand what is atstake or how much their perormanceis aecting everyone else, then they willundoubtedly continue it.

Leaders Edge is a six-part Disclosures column by Brian Kush, CPA, CISA, CITP,ocusing on management, leadership and interpersonal skills essential or CPAs. Brianis a eatured VSCPA speaker who travels the state oering in-house CPE courses. Wantto learn more or book Brian or your rm or company? Contact VSCPA CustomizedEducation Manager Lydia Sartori at [email protected] or (804) 612-9425.

Labeling somebodya poor perormer

is oten unair and

indicative o poor

management or

leadership.


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Labeling somebody a poor perormer isoten unair and indicative o poor manage-ment or leadership. It is unair because ac-ceptable perormance has not been dened,monitored and continuously evaluated.

Have we defnedpoor perormance or

underperormance?I you have not dened it, and i youcannot describe it and provide examples,then it certainly is not clear to others.

Here is one way to ocus on this:Identiy expectations that have been

specically provided, that an employee hasagreed to and has not met. That is poor per-ormance! Many times a manager does notclariy expectations rom the start, so itsmuch harder to identiy poor perormancesbecause the agreement itsel was poor ornonexistent.

Expectation and perormance agree-ments are so underrated, mostly becausethey are so rare. This is not about annualperormance evaluations either.

Poor perormance becomes enabledwhen...

Requests or demands are not made.

Expectations and standards are not com-municated.

Mutually understood agreements are not

made.

Complaints are not provided ater agree-ments are broken.

And once poor perormance is not justenabled, but it is allowed to THRIVE, lead-ership has ailed.

Dealing with a specic poor perormeris one thing, but uncovering why poor per-ormance has been allowed to continue isanother thing all together it is a culturalissue, and i let unchecked, it will permeatethroughout your organization.

How does this stop?

How do we ensure we identiy andconront poor perormance?There is one word that describes a cul-

ture in which poor perormance strugglesto continue: honest. When an organizationdemands honest eedback and communica-tion, then questions will be asked such as:

What are the standards we demand?

How have other team members, manag-ers and the organization contributed to aspecic instance o poor perormance?

How has mentoring and supervising (orlack thereo) contributed?

What specically was the reason thatsubstandard perormance occurred?

Where is this persons growth in relationto where we know he or she should be?

And nally, what must be done now toensure this will not repeat?

In Fierce Conversations, author SusanScott details how individuals and organiza-tions that are serious about setting and hit-ting goals master the courage to interrogatereality. Success can be averted easily whenwe do not say what we should and we avoidreality by not being honest.

Generally, someone is perorming at

unacceptable standards because o one otwo issues:

They do not have the aptitude to accom-plish what their role requires.

They do not have the desire to accom-plish what their role requires.

Other things come into play like supervi-sion and support (resources, training, etc.).Assuming all those other things have beentaken care o (a massive assumption), ireality is ercely interrogated and honesty isdemanded, then poor perormance and thestructure that allows or it will always beidentied.

That is the most difcult step to makingnecessary changes and getting the rightpeople on the bus.

Healthy complaints

How many times have you seen somebody make a healthy complaint aboutanother persons perormance? What is a healthy complaint? It is a complaint that isexpected because a specic clear agreement was made between two parties and oneperson did not live up to their end o the agreement. It is not a surprise. It moves theperson orward by helping them to see what should have happened and what MUSThappen, or it moves them closer to being out . out to another role within thecompany, or out o the organization all together.

When agreements are made and then broken, your trust may be damaged. How-ever, i you want to work together to regain that trust, le a healthy complaintwith the employee and work togetherto see how the behavior can be strengthened.Your relationship will grow. You both will grow. Courage is present.

Establishingexpectations

An employee is not perorming upto standards. He or she is not doingwhat he or she should. Here is acommon response:

I should not have to tell them to dothat. They should know.

Guess what. Maybe they really donot know.

Second, even i they do know, theydont understand what is at stake andthey certainly never bought into whatyou eel should happen.

It is easy to want to be right aboutwhat they should do. Instead, as aleader, ensure it is crystal clear whatyou expect them to do. Poor peror-mance does not coexist very well withhonest and clearly communicated andagreed-to expectations.

Brian Kush, CPA,

CISA, CITP, is a

leadership coach

and president at

Moxie Partners, and

author o Auditing

Leadership (Wiley,

July 2009). Contact him at

[email protected]

or (571) 313-1735.

Leaders Edge Disclosures July/August 7


10/40

8 Financial Planning Disclosures July/August

in the

FinancialPlanning

Getting

By David S. Murphy, CPA, CFP, Ph.D.,

and Philip H. Umansky, CPA, Ph.D.


11/40

Financial Planning Disclosures July/August 9

With the current economic downturnsignaled by a major drop in the stockmarket in 2008, declining home values,high unemployment, rising health care costs, com-plex individual income tax law changes and Mado-type rauds, individuals are increasingly looking ornancial planning resources.

And CPAs can help.On the national and local level, the American

Institute o CPAs (AICPA) and VSCPA respectivelyhave done much to provide ree nancial literacyresources and programs to consumers. The AICPAhas its 360 Degrees o Financial Literacy and Feedthe Pig initiatives. The VSCPA has its Financial Fit-ness initiative, which includes ree nancial planningseminars and webinars, Speakers Bureau, Ask-a-CPA E-mail Program, tax call-ins in Richmondand Roanoke, television interviews, e-newslettersand more.

The VSCPA has also been very involved withpromoting nancial literacy in the Virginia second-ary education system and general public awareness

o the importance o nancial tness through thegovernors declaration each year o Virginia FinancialLiteracy Month.

The more ocused issue, however, is that whilethe CPA proession and the current economic en-vironment have created both exposure and impetusor nancial literacy and planning, how is the pro-ession developing this market in terms o businessopportunities?

What is driving the market?There are several macro trends that show the

market is expanding and that CPAs are well posi-tioned to take advantage.In a 2010 Consumer Financial Literacy Survey o

2,028 adults in the United States, conducted by Har-ris Interactive, 34 percent o American adults gavethemselves a grade o C, D or F on their knowledgeo personal nance. This extrapolates to about 77million persons in the United States. In the samesurvey, 78 percent o adults agreed or stronglyagreed that they would benet rom the services oa nancial proessional.

Though many questions in the survey indicatedthat Americans are underprepared in terms o nan-

cial planning, perhaps most concerning was that 56percent o respondents said they do not have a budgetand 33 percent save 0 percent o their householdincome or retirement.

While persons who indicated such would not beprospective clients o CPA nancial planners, thereis some evidence that even those with some degreeo nancial sophistication may need help.

In a survey o 206 MBA students (Murphy andYetmar, 2009), participants were asked: 1.) i theythought preparing a personal nancial plan was im-portant; 2.) i they were interested in preparing w


12/40

such a plan; 3.) i they had time to do so;and 4.) whether they elt that they had thenecessary skills and knowledge to prepare apersonal nancial plan.

While 76 percent o respondents indi-cated that they thought preparing a nancialplan was important and 67 percent wereinterested in preparing a nancial plan, only40 percent elt they had the time to prepare a

plan. Most surprisingly, only 33 percent eltthey had the nancial expertise to preparea plan. Given that the participants averageage was 29, they had 6 1/2 years o workexperience and had an average income o$47,500 and obviously had a degree o

nancial sophistication, as MBA students the latter statistic in terms o expertiseis surprising.

Charles Overbey, a Richmond-basedCPA/Personal Financial Specialist (PFS)and Certiied Financial Planner (CFP),sees some generational dierences in terms

o the need.Younger persons tend to have challengeswith cash low and credit management,while the older persons are more ocusedon retirement and many have been soldinappropriate investments, Overbey said.He agrees that skills, knowledge and timeare actors that send clients to him.

There is growing body o evidence thatthe typical American may not have thetechnical knowledge to perorm nancialplanning. When 1,984 Baby Boomers werepresented with a problem to compute the

balance o a $200 investment that earnsinterest o 10 percent compounded annu-ally ($242) ater two years, only 18 percento respondents could do it (Lusardi andMitchell, 2008).

CPAs who perorm nancial planning areseeing a degree o pessimism in their clients,which may make the CPA services evenmore important. In a 2010 AICPA survey oits Personal Financial Planning membership,72.2 percent o the 421 CPA respondentsindicated that their typical client has become

more risk averse over the last year, and 54percent said the typical client is not verycondent in the stock market.

Seizing the marketTrust

Charles Coker, a sole practitioner CPAwho operates in Northern Virginia, has seena 20 to 25 percent increase in his number o

personal nancial planning clients over thelast two years, many o whom come romhis traditional base o personal income taxclients.

A big part o my job is educating clients,Coker said. They do not have the time,

and the CPA designation provides the trustactor.

The trust actor is important. In 2006,Amplitude Research conducted a survey o1,007 investors to determine who rated thehighest as the most trusted nancial advi-sor. CPAs were rated the highest, ollowed

in order by CFPs

and attorneys. Thosenancial advisors who sell nancial productsor services, such as stock brokers, insuranceagents and real estate brokers, were urtherdown the list.

The trust associated with a CPA obviouslystems rom the independence and objectivitythat are at the oundation o the core CPAunctions o accounting, auditing, taxes andmanagement consulting. However, the trustactor can easily be leveraged to personalnancial planning and to the existing clientbase o medium- to high-net worth business

owners, managers and tax clients.Compounded with the act that most

CPAs work on a ee-only basis and are notinvolved in selling nancial products, theCPA has a natural competitive advantage inmany respects.

ExpertiseIn terms o expertise, currently the

AICPA has a specialty designation, thePersonal Financial Specialist (PFS), whichis designed or CPAs who work in personal

nancial planning. Among the requirementsto be a PFS, CPAs must work in the personalnancial planning eld or two years, andbeginning ater December 31, 2010, pass thePFS, CFP or Chartered Financial Consul-tant exam. Per the AICPAs PFS list, thereare currently 110 PFSs in Virginia.

CFP, the other major specialty desig-nation related to nancial planning, can be

held by both CPAs and non-CPAs, and tosome extent it is a competitor to the CPA/PFS. There are ar more CFPs than CPA/PFSs, and CFPs can work in a number odierent types o rms, rom banks to wealthmanagement rms.

Proper planningIn 2007, Moss Adams, LLP, CPAs, in co-

sponsorship with the AICPA, surveyed CPArms involved in personal nancial planningto determine best practices. The studyshowed that at that time, the typical CPAs

personal nancial planning services weregrowing aster than the broader nancialplanning market and had higher operatingmargins than non-CPA peer nancial advi-sors o the same size. The study identiedour successul operating models:

Solo practitioner: The CPA perormsa number o traditional CPA servicesor clients including personal nancialplanning.

Single entity:

The CPA rm has aseparate division within the rm thatperorms just personal nancial planning.

Stand-alone business: The CPA rmeither partially or ully owns a subsid-iary that does personal nancial plan-ning, to which reerrals are made.

Preerred reerral partner:Thepartner can be an independent busi-ness to which the CPA reers potentialnancial planning clients, with the CPA

either receiving or not receiving reer-ral revenue.

There are many nuances in each o themodels identied, and they all can be suc-cessul though they have common andunique challenges. No matter the modelused, the study identied our best practices:1.) develop plans and goals; 2.) develop aprocess or monitoring perormance o thenancial planning business; 3.) ormalize thecompensation system; and 4.) devote time


Younger persons tend to have challenges with

cash fow and credit management, while the older

persons are more ocused on retirement and

many have been sold inappropriate investments. Charles Overbey


13/40


and resources to marketing.The most common challenge is deter-

mining the type o client the CPA wouldaccept in terms o either net assets, incomeor some other client acceptance criteria.James Shepherd, CPA/PFS, CFA, o KuehlShepherd, Kozlowski and Associates, hasbeen doing personal nancial planning or28 years. He says, Developing a philosophy

o which personal nancial planning clientsto take is important.This is reected in the philosophy o many

CPA rms, where they strive to serve thoseclients to which they can provide real value-added services.

For example, Cherry Bekaert & Hollandindicates on its website that it works exclu-sively with a limited number o prominentamilies or whom it is able to add signicantvalue and make a dierence in their nanciallives. Wesley Watkins, CPA/PFS, partnerwith the rm, says that while there is a lot

o nancial awareness, someone needs tobring it all together in a plan.

Other common challenges include thecompliance part o the business in terms obeing registered investment advisors. Theunique challenges associated with the solopractitioner mode were how to not becomeoverworked, and the greater propensity orthe client base to have lower income and lessinvestable assets than other models.

Challenges or the single-entity and stand-alone business models include ensuring that

non-nancial planning proessionals marketand reer potential clients to the nancialplanning side o the business, and that auditor tax clients who are reerred receive thesame high level o service they receive withtraditional CPA services.

The challenge with the preerred partnerreerral model is ensuring that the inde-pendent business did not steal the clientby oering services such as tax complianceand planning, which the CPA had initiallyprovided.

John Napolitano, CPA/PFS, CFP,

chairman and CEO o U.S. Wealth Man-agement, based in Braintree, Mass., helpstransition CPA rms into personal nancialplanning over a three- to ve-year period.His clients see personal nancial planningas a mechanism to move away rom billablehours and charge based upon value, so rmscan actually work ewer hours and makemore prot.

As mentioned previously, CFPs are themajor competition or CPAs who want to getinto nancial planning, at least or potential

clients who do not already have an existingrelationship with a CPA. In the study o MBAstudents, 75 percent o respondents said theywould seek the services o a CFP, with 16percent seeking a CPA/PFS and 4 percentseeking a non-PFS CPA. Obviously, CPAscan also hold the CFP certication andmany in the nancial planning eld do.

ConclusionThe current economic environment mayprovide an excellent opportunity or CPAsto provide personal nancial planning servic-es or their clients. Because CPAs are ratedvery highly in the trust actor, and because oclients excellent results in other traditionalCPA services, CPAs who hold a PFS or CFPhave excellent opportunities.

Transitioning into this service is notwithout risks and challenges, but manyCPA rms have made the transition and aresuccessul.

Lusardi, A., and O.S. Mitchell. (2008) How Much DoPeople Know about Economics and Finance? Ann Arbor, MI:University o Michigan Retirement Research Center PolicyBrie.

Murphy, D. and S. Yetmar. (2009) Personal FinancialPlanning Attitudes A Study. Forthcoming in ManagementResearch News, issue to be selected.

David Murphy, CPA, CFP, CFS, Ph.D.,

is proessor o accounting at Lynchburg

College, where he also serves as the

chair o the Accounting Department

and as director o the fnancial planning

track in the colleges MBA program.

Beore earning his doctorate in

accounting and fnance at Washington

State University, he was in private

practice in Seattle, Wash. Contact him

at [email protected].

Phil Umansky, CPA, Ph.D., is associate

proessor o business at the Sydney

Lewis School o Business at Virginia

Union University and chairman o the

Accounting and Finance Department.

He is a CPA Ambassador, a regular

contributor to the WTVR Virginia

This Morning TV Show on money

management topics, and a member othe VSCPA Editorial Task Force. Contact

him at [email protected].


14/40

new funwih

FUNDBALANCES:ImpLEmENtINg gASB StAtEmENt 54

12 Government Accounting Disclosures July/August


15/40

Government Accounting Disclosures July/August 13

Ten years ago, the Governmental Accounting Standards Board(GASB) issued Statement 34, which dramatically changed stateand local government reporting by requiring accrual basis,government-wide statements.

For the rst time since that noteworthy standard, GASB has issued a

new standard that is certain to aect the nancial statements o every local

government in Virginia. In the paragraphs that ollow, we review GASBStatement 54, Fund Balance Reporting and Governmental Fund Type

Denitions, which is required or scal years ending June 30, 2011.

The new standard is GASBs response to credit market participants

who sought greater inormation about the availability o reported und

balances. In particular, bond investors and rating agencies wish to under-

stand the extent to which the nancial resources o governmental unds

are constrained and how binding those constraints are.

By Paul A. Copley

CPA, Ph.D., and

M. Loretta ManktelowMBA, MST

For example, und resources may berestricted by creditors, donors or grantingagencies. Resources may also be ormallycommitted by elected ofcials to specicactivities. Alternatively, constraints maymerely be nonbinding indications o manage-ments intent to use resources or a particularpurpose. Statement 54 establishes new undbalance classications to reect these varyinglevels o constraint.

FUND BALANCECLASSIFICAtIoNS

GASB Statement 54 establishes ve newund balance categories while eliminatingthe previous categories o reserved and un-reserved. The new standard aects only theequity section o the balance sheet o govern-mental unds. It does not change the report-ing o net assets o proprietary and duciaryunds or the government-wide Statement oNet Assets.

The rst step in applying Statement 54 isto identiy those und resources that are non-spendable. Inventories and prepaid items

typically appear in governmental unds be-cause they are current assets. However, theseresources are nonspendable because they areused in operations rather than converted intocash. The principal (corpus) o a permanentund that is required to be maintained wouldalso be classied as nonspendable.

The remaining resources (net o liabilities)o the und include cash and items expectedto be converted into cash in the next period.These spendable resources are urtherclassiied according to the nature o any

constraints imposed on their use, using a hi-erarchy o constraints. The hierarchy rangesrom restricted or the most constrained tounassigned or the least.

Restricted und balance representsthe net resources o a governmental undthat are subject to constraints imposed byexternal parties or law. Restrictions arisingrom external parties include debt covenants(such as a requirement or a sinking und) orconstraints imposed by legislation or ederaland state agencies on the use o intergov-

ernmental revenues. Restrictions may alsoresult rom legally enorceable requirementsthat resources be used only or specic pur-poses.

For example, Virginia cities and countiesmay impose taxes on the sale o prepared oodand beverages. I approved by the voters, thereerendum commonly restricts the use o thetax proceeds (typically to capital projects).The (unexpended) resources derived romthis tax would be displayed as restrictedund balance.

The equity section o the government-

wide Statement o Net Assets in GASB 34classies net assets within three categories,including restricted net assets. With one excep-tion, those resources classied as restrictednet assets in the government-wide statementswould also be classied as restricted undbalance in the und basis statements. Theexception is permanent und principal. Theseresources are classied as restricted net assetsunder GASB 34 and nonspendable und bal-ance under GASB 54.

Committed und balance represents the

net resources o a governmental und that thegoverning body has specied or particularuse. To be classied as committed, the re-sources should have been designated throughordinance or resolution by the governmentshighest level o authority (e.g. city councilor county board o supervisors). Commit-ted resources dier rom restricted in thatthe constraint is imposed by a governmentupon itsel.

Statement 54 also provides that amountsrepresenting contractual obligations o a

government should also be classied as com-mitted und balance. The statement oersno examples o such contractual obligations,but it seems reasonable that they would beo sufcient signicance to involve the ormalaction o the governing board. For example,board approval o large construction con-tracts would typically represent commitmento the unds.

Assigned und balance represents thenet resources o governmental unds thatthe government intends or a specic pur-pose. Assigned resources dier rom com-

mitted in that they do not require a or-mal action by the governing body. Con-straints imposed on assigned resourcesare more easily modiied or removed.For governmental unds other than the Gen-eral Fund, this is the category or all (posi-tive) residual und balances. The rationale isthat the act o recording resources in specialrevenue, capital projects, debt service orpermanent unds is evidence o the govern-ments intent to use the resources or aspecic purpose.w


16/40


Resources in the General Fund may also beassigned to a specic purpose i that is the intento the government. Intent may be expressedthrough the governing body by means otherthan ordinance or resolution. Alternatively,committees or individuals may assign resourcesto specic activities. Assignment within theGeneral Fund implies an intended use that is

more limited than merely support o the gen-eral purposes o the government.Unassigned und balance is the residual

category or the General Fund. Within theGeneral Fund, governments should not report

assigned und balance amounts i the assign-ment or specic purpose results in a negativeunassigned und balance.

NEgAtIvE BALANCESNegative und balances could occur i ex-

penditures or a specic purpose exceed theresources available in the und. However,

Statement 54 does not permit the reporting onegative restricted, committed or assigned undbalances. I this occurs, the government shouldreduce any assigned und balances (in that und)by the amount o the negative balance.

The rationale is that i expenditures exrestricted or committed resources, then have in eect been reallocated to the purused. I a decit remains once all assigund balances are zero, the remaining ntive amount should be reported as unassiund balance.

ENCUmBrANCESUnder past reporting practices, outstanencumbrances at year-end were reportethe governmental unds as und balance: r

or encumbrances. Statement 54 requires

Table 1: City Government Balance Sheet

Governmental Funds as o June 30, 2011

GeneralFund

Special RevenueFund

Capital ProjectsFund

Debt ServiceFund

PermanentFund

Total GovernmentalFunds

ASSETS

Cash and cash equivalents $6,433,214 627,837 895,300 230,000 366 $8,186,717

Investments 3,287,992 25,000 3,312,992

Taxes receivable(net) 2,872,611 2,872,611

Accounts receivable 679,215 14,177 693,392

Due rom State Government 1,085,184 243,264 1,328,448

Supplies Inventory 23,747 23,747

TOTAL ASSETS $14,381,963 642,014 1,138,564 230,000 25,366 $ 16,417,907

LIABILITIES

Accounts payable 2,628,422 70,000 226,532 2,924,954

Deerred Revenues 4,408,087 4,408,087

TOTAL LIABILITIES 7,036,509 70,000 226,532 - - 7,333,041

FUND BALANCE

Nonspendable

Supplies Inventory 23,747 23,747

Permanent fund principal 25,000 25,000

Restricted

Bond sinking fund 200,000 200,000

School lunch grant 370,000 370,000

School construction 302,000 302,000

Committed

City jail construction 120,000 120,000

Highway construction 450,000 450,000

Rainy day funds 3,000,000 3,000,000

Assigned

School lunch program 202,014 202,014

Capital additions 95,000 40,032 135,032

Debt Service 30,000 30,000

Other purposes 366 366

Library acquisitions 25,000 25,000

Unassigned 4,201,707 4,201,707

TOTAL FUND BALANCE $7,345,454 572,014 912,032 230,000 25,366 $9,084,866

Corpus o

permanent und

Equals suppliesinventory

Restricted by de

covenant, grant

agreement or la

Contractual

commitments

Committed by

City Council

Outstanding purchase orders o the General Fund

Residual balanc

unds other than

General Fund

Residual balanc

the General Fun

}}

}

}


17/40


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encumbered resources be reported within therestricted, committed or assigned categoriesin a manner consistent with the criteria orthose classications. Statement 54 providesno examples as guidance on how to classiyencumbered amounts.

At the very least, the existence o an encum-brance suggests that the government has an ex-

pressed intent to use resources or a particularpurpose and thereore these resources shouldnot be classied as unassigned. Encumbranceaccounting may also be used in the case ocontractual obligations, such as constructioncontracts. Statement 54 requires that resourcesobligated to contractual obligations be classiedas committed.

StABILIzAtIoN(rAINy DAy) FUNDS

Statement 54 also provides guidance on theclassication obudget stabilization or rainy day

unds. Stabilization amounts that meet certaincriteria are classied as committed or (less com-monly) restricted, i imposed externally or bylaw. Stabilization unds are classied as commit-ted i they are created by a resolution or ordi-nance that identies the specic circumstances

under which the resources may be expended.Stabilization amounts that are available inemergencies or in periods o revenue short-alls would not be classied as committed unlessthe emergency or shortall condition is speci-ed and o a magnitude to distinguish it romevents that occur routinely. Stabilization undsnot meeting these conditions are reported

as unass igned und ba l ance in theGeneral Fund.

SAmpLE BALANCE ShEEtTable 1 presents an example balance sheet

or a city governments governmental undsusing the und balance classications requiredby Statement 54. Note that und balance (theshaded segment o the table) is no longerpresented as reserved or unreserved and thatencumbrances are not separately displayed.Explanations ollow:

Nonspendable: The $23,747 in theGeneral Fund equals the supplies balancereported within asset section o the balancesheet. Additionally, the city has a PermanentFund in which the principal o $25,000 mustbe maintained.

Restricted: The Debt Service Fund reectsa sinking und balance o $ 200,000 that isrequired by bond covenant. The city receiveda grant rom the state government that is re-stricted or use in a school lunch program. Theunexpended portion ($370,000) o this grant isreported in a Special Revenue Fund. The Capi-

tal Projects Fund includes $302,000 o oodand beverage tax revenues restricted by ballotreerendum or new school construction.

Committed: The Capital Projects Fundincludes amounts committed by contractualobligation with contractors building a newcity jail ($120,000) and highway improve-ments ($450,000).Additionally, the GeneralFund reects a rainy day und ($3,000,000)established by city council resolution withspecic circumstances under which the undsmay be expended.

Assigned: The residual balances o the SpecialRevenue, Capital Projects, Debt Service andPermanent Funds are classied as assigned undbalance. Within the General Fund, outstand-ing encumbrances o $95,000 or capitalw


18/40


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additions and $25,000 or library acquisitionsare classied as assigned und balance, reectingmanagements intent to use the resources or aparticular purpose.

Unassigned: The $4,201,707 residual balanceo the General Fund is reported as unassignedund balance.

FUND DEFINItIoNSStatement 54 also modiies the existing

governmental und denitions to ensure con-sistency with the classications o und balances.For most o the unds, the revised denitionshave little eect on current practice. The ex-ception is special revenue unds. Specically,the standard requires that special revenue undsbe used only i a substantial portion o the re-sources are provided by one or more restrictedor committed(not assigned) revenue sources.

Although other resources may supplement a

special revenue und, assignment o resourcesis not sufcient or the establishment o one.Further, i the government expects that asubstantial portion o the resources will nolonger be derived rom restricted and commit-ted revenue sources, the government should

discontinue the use o a special revenue undand report the unds remaining resources inthe General Fund.

CoNCLUSIoNThe und balance reporting requirements

o GASB Statement 54 go into eect or scalyears ending in June 2011. However, State-

ment 54 requires governments to restateund balances or all periods presented in acomparative balance sheet. Governments thatpresent two years comparative balance sheetswill eectively need to identiy und balanceclassications as o June 2010.

In the coming year, CPAs may nd clientservice opportunities by alerting local gov-ernment clients to the standard, identiyingimplementation issues ahead o time and sug-gesting actions that may ease the transition.For example, the dierences between the undbalance classications are based on degree o

constraint. Since committed and assigned undsare both sel-imposed, the distinction betweenthese two categories is particularly ambiguous.To distinguish between these categories, gov-ernments will need to note the level o author-ity that approved the designation o resources

to a particular purpose.Some local governments may wish to report

rainy day reserves. These governments shouldveriy whether the reserves were created byormal action o the board and whether theconditions under which the government maydraw on these resources are sufciently detailedand unusual to warrant classication as commit-

ted und balance.Finally, governments should examine theirexisting governmental unds to ensure theymeet the und denitions provided by State-ment 54.The new standard is expected tolimit the use o special revenue unds, and insome cases governments will be required todiscontinue the use o special revenue undsand report those resources in the GeneralFund.

Paul A. Copley, CPA, Ph.D., andM.

Loretta Manktelow, MBA, MST, are onthe aculty o the School o Accounting

at James Madison University. Contact

Paul at [email protected] and Loretta at

[email protected].


19/40

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20/40


Where It Goes Wrong

Portolio Diversifcation:

The way most portolios are constructed violatesthe very basic premises o modern portolio theory.

By John Davenport


21/40


Diversication is one o the undamental ideasin investing. However, the idea o diversication aswe know it in the nancial services industry is onlya little over hal a decade old.

The concept o asset allocation, in which onebuilds a portolio o dierent investments in orderto maximize return and minimize risk, was originallyproposed by Harry Markowitz in 1952 in his classic

paper Portolio Selection.Since that initial paper, asset allocation, whichis ormally known as Modern Portolio Theory(MPT), has become the very backbone o portolioconstruction in the nancial services industry. Thebelie is that by combining assets that are not highlycorrelated to one another (meaning that they actdierently than one another in response to marketorces), one can help control risk.

However, ollowing years like 2008, publicoutcry arises, pronouncing that asset allocation andbuy-and-hold portolio strategies are dead.

Its not hard to concede these arguments i you

look at how most portolios are constructed. Look-ing at the major asset classes included in the typicalportolio, we see that nearly every one o the assetclasses posted negative returns in 2008 (see Table1). A similar phenomenon happened in 2001 and2002, in which most asset classes posted negativereturns.

Given the negative returns in most o the majorasset classes, client portolios as a whole suered

similarly painul losses. As mentioned, the cry hasgrown louder with 2008 serving as proo that assetallocation does not work.

I would argue, however, that it was not that assetallocation did not work, its that the way most port-olios are constructed violate the very basic premiseso modern portolio theory.

In particular, most portolios are constructed o

highly correlated asset classes. Remember, one othe core tenets o modern portolio theory is thatthe portolio comprises assets that are not highlycorrelated to one another. I you look at Table 2,you will see that with respect to correlations, theassets that make up most portolios provide little inthe way o real diversication.

As you will note, every one o the asset classesrepresented in Table 2 are positively correlated tothe S&P 500. All domestic equity asset classes aremore than 80 percent correlated to the S&P 500.International equities (as represented by the MSCIEAFE) are more than 60 percent correlated and

bonds are still positively correlated at 24 percent.This means that all the elements o the portolio

are highly dependent on the S&P 500 experiencingpositive returns to also perorm well.

Without becoming too academic, there are threebasic aws in the way that traditional portolios areconstructed that result in portolios behaving as theydid in 2008.

The rst aw is the process o selecting and ex-cluding various asset classes. The second elementis the articial constraints that are then placed onthe included asset classes. The third element con-

cerns the constraint to long-only investing in mostportolios.

Asset class selectionIn Modern Portolio Theory, portolios should

be constructed o a variety o non-correlating assetclasses. However, when looking at the distributiono investments across asset classes in most retail port-olios, the vast majority o assets are concentratedin large cap, mid cap, small cap, international andaggregate bonds (ICI Factbook, 2007).

According to the Investment Company Institute,

at the close o 2007, approximately 40 percent oU.S. mutual und assets were in domestic stockunds. Twenty-six percent o assets were in moneymarket unds, while international equities and bondunds each represented 14 percent o U.S. mutualund assets.

Many in the industry would call those distribu-tions a well-diversied portolio. However, giventheir high correlations to one another, the resultingportolios constructed using these basic asset alloca-tions are then by deault directionally dependenton the S&P or its returns. Essentially, these w


22/40

20 Practice Management Disclosures July/August

portolios are not as diversied as they mayappear.

The underlying problem with this gen-eralized approach to asset allocation is theexclusion o numerous other viable assetclasses (commodities, currencies, managedutures, structured notes, long/short equi-ties, ination-linked assets, etc.), which can

increase the diversication o the portolio.Many o these non-traditional asset classesoer much lower correlations to both the S&P500 and the other traditional asset classes.

Eliminating available asset classes orcesthe optimization process to create an opti-mal solution o only those things put into

the system. It is not constructing an efcientrontier based on all available investmentchoices. It is, rather, optimizing a portolioo preerences.

Artifcial constraintsThe second issue that distorts the results

o optimizing portolios is the practice o ap-plying articial constraints to the asset classesthat have been included in the optimizer. Iyou think through how portolios are beingconstructed, you can begin to see the truelimitations that are being placed on the abilityto optimize the portolio.

First, only a ew asset classes are usedor consideration in the optimizer. Then theoptimizer is told to put limits on how muchcan be invested in any one o those select ewasset classes. Again, this is more in line withcreating portolios o preerence rather thanprocess.

As stated above, most asset allocation

portolios or U.S. investors will be largelybiased to the domestic asset classes (whichalso biases the portolio to the U.S. dollar

but thats another discussion), with in-ternational investing relegated to a smaller,satellite allocation. However, researchershave demonstrated that when an uncon-strained optimization is perormed, even themost conservative o portolios will allocateportions o the portolio to the most risky assetclasses (small cap and international equities).They also note that in an unconstrained opti-mization, large cap U.S. stocks are relegated

to a supporting role.This is oten the exact opposite o how

client assets are deployed. The articial con-straints that are applied in the optimizationprocess will essentially dictate the outcomesin line with the constraints, not along a trueeicient rontier. This process essentiallyconstructs portolios along the lines o theinvestors or advisors preerences, not inaccordance with a true mean-variance opti-mization.

As an example, an unconstrained portolio

built to mimic the standard deviation (risk)o the S&P 500 would be constructed osmall cap equities and bonds. Using historicalreturns and standard deviations, neither theS&P 500 nor the MSCI World Index lies onthe efcient rontier so they are completelyexcluded rom the unconstrained optimizedportolio (see Table 3).

Most investors would simply be uncom-ortable with a portolio made up o onlybonds and small caps. Common sense dic-tates that they urther diversiy the portolio.However, most o the time investors will not

include additional asset classes to solve or theefcient rontier; they will simply apply con-straints to the existing asset classes, restrictingallocations to those perceived as riskier.

Following this logic, i the efcient ron-tier is constrained with a limit o 10 percentto small caps, the resulting portolio is thenorced to include large cap and internationalstocks asset classes that do not reside onour original efcient rontier.

Further, this process o orcing large capand international stocks into the portolio


Table 1: A typical portolio

Table 2: Wheres the diversifcation?

Table 3: Unconstrained optimized portolio

2000 2001 2002 2003 2004 2005 2006 2007 2008

S&P 500 -9.1 -11.89 -22.1 28.68 10.88 4.91 15.79 5.49 -37

Russell 2000 -3.02 2.49 -20.48 47.25 18.33 4.55 18.37 -1.57 -33.79

Russell Mid Cap 8.25 -5.62 -16.18 40.06 20.22 12.65 15.26 5.6 -41.46MSCI EAFE -14.17 -21.44 -15.94 38.59 20.25 13.54 26.34 11.17 -43.38

BarCap US Agg Bond 11.63 8.44 10.26 4.1 4.34 2.43 4.33 6.97 5.24

Russell 2000 Growth -22.43 -9.23 -30.26 48.54 14.31 4.15 13.35 7.05 -38.54

Russell 2000 Value 22.83 14.03 -11.43 46.03 22.25 4.71 23.48 -9.78 -28.92

Russell 1000 Value TR 7.01 -5.59 -15.52 30.03 16.49 7.05 22.25 -0.17 -36.85

Russell 1000 Growth -22.42 -20.42 -27.89 29.75 6.3 5.26 9.07 11.81 -38.44

ML US HY Master II -5.12 4.48 -1.89 28.15 10.87 2.74 11.72 2.24 -26.39

1/1979-7/2009 S&P 500 Russell

1000

Growth

Russell

1000

Value

Russell

Mid Cap

Russell

2000

Growth

Russell

2000

Value

MSCI

EAFE

US Agg

Bond

Wilshire

US REIT

S&P 500 1

Russell 1000 Growth 0.96 1.00

Russell 1000 Value 0.95 0.83 1.00

Russell Mid Cap 0.94 0.91 0.91 1.00

Russell 2000 Growth 0.81 0.86 0.72 0.91 1.00

Russell 2000 Value 0.80 0.74 0.84 0.91 0.87 1.00

MSCI EAFE 0.63 0.60 0.61 0.62 0.56 0.56 1.00

BarCap US Agg Bond 0.24 0.21 0.26 0.24 0.11 0.19 0.18 1.00

Wilshire US REIT 0.55 0.48 0.63 0.65 0.56 0.75 0.44 0.19 1.00


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Practice Management Disclosures July/August 21

moves the efcient rontier down and to theright on the risk return spectrum, assumingmore standard deviation (risk) or less return.However, in the eyes o many investors andadvisors, this portolio is more palatablebecause it seems more diversied.

This process o applying constraints mayresult in portolios that are more intuitively

appealing, but they are by no means an op-timal solution. Unortunately, this processo portolio construction is to orce into theportolio the existing set o asset classes,whether or not they oer a compelling risk/return trade-o.

Long-only investingMost portolios are constrained to long-

only investments, which by deault excludesthe use o short sales within the portolio.Despite the evidence that short sales can im-prove the risk/return prole o the optimal

investment mix, strategies that employ shortsales are allocated very little space within thevast majority o portolios. This can impedethe ultimate efcacy o a portolio; limitingportolios to long-only investments doesnot allow portolios to take advantage o allavailable market inormation.

In a traditional long-only investing ap-proach, the investor only has two options:hold a security or not hold a security. Even inthe ace o compelling negative evidence (badnews), the only thing the long-only investor

can do to take advantage o adverse news isto not hold the security (sell it). However,by removing the long-only constraint andallowing short sales, the investor can nowalso short a security in the ace o negativenews and has the opportunity to realize anabsolute positive return on the trade eventhough the stock or security may decline inprice. Again, the ability to employ shortingstrategies allows investors to take advantageo all available inormation.

The historical returns rom the Ibbotsondatabase also suggest that the inclusion o

shorting strategies within a portolio couldimprove the risk/return prole o an overallportolio. Comparing the S&P 500 Index,which is a long-only index, to indices thatdo allow shorting o stocks in the large capuniverse, we can see the ability o short salesto shit the risk prole o a portolio.

From February 1993 through January2009, the S&P 500 Index posted an aver-age annualized return o 6.04 percent witha standard deviation o 15.81. The marketneutral index posted a 5.21 percent average

annualized return over the same period witha standard deviation o 3.96. The long/shortindex delivered a return o 9.11 percent witha standard deviation o 8.68. Both indicesdelivered similar to better returns with araction o the risk (see Table 4).

What happens to portolios when these

three constraints are removed rom the opti-mization process? In Table 5, the available as-set classes include shorting strategies and assetclasses that present a better correlation proleto the broad market and bond asset classes.The new array o asset classes in addition tothe domestic asset classes includes long/shortequity strategies, commodities, managedutures and market neutral strategies.

The resulting efcient rontier allows usto construct a portolio o long/short, man-aged utures and the aggregate bond indexthat delivers a ar superior return to the S&P

500 with a standard deviation more in linewith the aggregate bond index. As Table 5indicates, the domestic equity asset classesthat have garnered the bulk o U.S. mutualund assets in traditional portolios do notreside on the efcient rontier and thus areexcluded rom the portolio.

Returning to diversifcationMany advisors have the perception that

alternative investments and shorting strate-

gies increase portolio risk in spite o theevidence to the contrary. This is clearly seenin the portolio construction behaviors thattend to rely more on intuition than sci-ence. In investing, we attempt to maximizereturn while minimizing risk. However,the processes by which most retail investor

portolios are constructed are counter to thisbasic premise.By highlighting these behavioral aws in

the portolio construction process, perhapsinvestors can return to the true essence omodern portolio theory and attempt tobuild truly diversied portolios.

John Davenportis

director o research withthe Actuarial Consulting

Group in Midlothian.

He is also an adjunct proessor,

teaching fnance, investing and

other business courses or several

local colleges. Additionally, John

is a doctoral student. Contact him

at [email protected]

or www.linkedin.com/pub/john-

davenport/5/744/593.


Table 4: Investing comparisons

Table 5: A superior risk/return profle to the S&P 500

Common Period 2/1993-1/2009 Geometric Mean

(%)

Standard Deviation

(%)

Alpha

(%)

Hennessee HF Market Neutral TR USD 5.21 3.96 4.7948

Hennessee HF Long/Short Equity TR USD 9.11 8.68 6.6373

S&P 500 TR 6.04 15.81 0.0006


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22 Sarbanes-Oxley Disclosures July/August

Leveraging

Sarbanes-Oxley

to drive change

and mitigate riskin small and

medium-sized

entities

Sarbanes-Oxley:

Friend


25/40

Sarbanes-Oxley Disclosures July/August 23

By Heather Judson, CPA, CMA

Is the Sarbanes-Oxley Act (SOX) a riend or oe to small andmedium-sized companies (SMEs)? Oten, those entities willanswer oe.

Status quo may generally be the policy ollowed bySMEs, which are those publicly traded companies with

less than $75 million in market capitalization, as dened by theU.S. Securities and Exchange Commission. Typically, SMEs willeither scramble to document their processes just prior to their

nancial audits or will rely on the external auditors to documenttheir processes or them.

Explaining the status quoFor SMEs, SOX can seem to be an exercise in documenting

what actually occurs. This may seem tedious and without merit.Each department knows what they do and may wonder why theyneed to write a narrative explaining their duties.

Oten the answer to this question is because the auditorsasked or it. However, SMEs might do better to engage thevarious departments and show them how they can benet romSOX. The rst step to getting department managers on board

is to present top management with the benets that may be hadrom utilizing SOX, such as driving change and mitigating risk.

PCAOB directionThe Public Company Accounting Oversight Board (PCAOB)

instructs external auditors in Auditing Standard No.5 (AS5)to evaluate the extent to which he or she will use the work oothers to reduce the work the auditor might otherwise perorm

himsel or hersel. Further, the PCAOB allows the external au-ditor to rely on the work o internal auditors, company person-nel (in addition to internal auditors), and third parties workingunder the direction o management or the audit committee.

This statement should pique top managements interest.Any documentation or procedures that are perormed in houseshould save money on the overall audit. Top management shouldencourage external auditors to utilize any viable internal docu-mentation. This alone should have management interested inperorming SOX procedures in house.

In AS5, the PCAOB directs the external auditor to ask him orhersel What could go wrong? in determining likely sourcesw

r Foe?


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24 Sarbanes-Oxley Disclosures July/August

orpotential misstatements in the nan-cials. This is basically asking: What risksare present?

Mitigating riskEnterprise Risk Management (ERM)

has become the best practice or largercorporations. The Enterprise Risk Man-

agement Integrated Framework romthe Committee o Sponsoring Organiza-tions (COSO) o the Treadway Commis-sion, published in 2004, denes ERM asa process, eected by an entitys board odirectors, management and other person-nel, applied in strategy setting and acrossthe enterprise, designed to identiy poten-tial events that may aect the entity, andmanage risk to be within its risk appetite,to provide reasonable assurance regardingthe achievement o entity objectives.

The article urther straties the com-

pany into our categories susceptible torisk: strategic, operations, reporting andcompliance. Strategic risks are those thataect the company at a high level andtend to be external to the company. Manystrategic risks can be explored throughthe entity-level assessment perormedin SOX. Operational risks are those thataect the company at a lower level in itsday-to-day operations. Reporting risksare those risks that aect the reliability onancial reporting, and compliance risks

aect compliance with applicable laws andregulations.Many o the operational, reporting and

compliance risks can be examined and ad-dressed in the various process documentscreated through SOX. See Table 1 ormore inormation on risks.

Best practicesVarious department heads should

be encouraged to go through the SOXprocess o interviews, walkthroughs, gapsand management action plans. A company

employee documenting processes with acritical eye and a sense o the big picturecan help the various departments runsmoother and with less error. Addition-ally, he or she can help the various depart-ments work together to mitigate risk.

Its important to understand bestpractices and potential risks beore start-ing the SOX documentation process.Best practices are the current standard.When researching best practices, you areendeavoring to learn rom the experience

and knowledge o others. You are lookingor the best in the business.

Dont discount the less than best. Thestories o the less than successul will giveyou an idea o the risks that you mightace. For instance, stories o employeethet can help you to understand the prac-tices that lead to that risk materializing.

Perhaps the company ailed to segregateduties surrounding cash or ailed to physi-cally secure assets.

Best practices research is usually inex-pensive. The Internet is a wealth o inor-mation, and you can nd inormation atthe library. You can network and conductresearch through proessional organiza-tions. Furthermore, once you identiyorganizations and people you should talkto, you can initiate inormal chats on thesubject matter.

InterviewsYou can begin your organizations SOX

documentation once you understand thebest practices and key risks surroundingeach process. The rst step is to interviewthe manager o the process, who can ex-plain everyones role in that area. Addi-tionally, he or she will be able to provideyou with a birds eye view o the processand its controls. Keep in mind you are ol-lowing a transaction rom its inception toall the stops it makes along the way prior

to hitting the general ledger.The interview process should eel likean inormal conversation rather than aninterrogation. The interviewee shouldeel comortable and relaxed. Stay incontrol o the conversation and keep theinterviewee on topic. Make sure to useopen-ended questions rather than leadingquestions. You want to know who, what,when, where, how and why. You dontwant to ask yes or no questions. See Table2 or question examples.

Keep in mind that silence is a strong

stimulus or conversation. Typically, yoursilence is an indicator that the other per-son should be talking. People tend to wantto ll silence with conversation. Once theinterviewee is responding to the open-ended questions, you can ollow up withmore direct questions to clariy details.

When you understand the process romstart to nish, make sure to repeat theprocess back to the interviewee. Makesure to mention all the key employeesnames. Repeating the inormation back

Table 1:Exampleso riskStrategic risks

Higher-level risks mainly external to thecompany

Change in interest rates

Customer buying behavior change

Substitutes enter the market

Technological advances

Trade embargos

No business process improvement

Operational risks

Lower-level risks mainly internal to thecompany

Fraud

Workplace saety

Product aws

Business disruption

Damage to physical assets

System ailures

Reporting risksRisks relating to the reliability o fnancialreporting

Transactional errors

Miscommunication

Data entry or loading error

Accounting error

Inaccurate external report

Missing transactions

Compliance risksRisks relating to applicable laws andregulations

Changing or new laws and regula-tions

Inadequate sta training

Miscommunication

Human error


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Sarbanes-Oxley Disclosures July/August 25

to the interviewee ensures that there hasbeen no miscommunication. Leave theinterview with the possibility o ollow-upquestions. Document the interview in anarrative immediately ollowing the inter-view while your memory is resh.

Narratives

You can start the documentationprocess by dividing the process into sub-processes. For cash receipts, this might

be: receive cash, deposit cash, pettycash, bank reconciliation and collections.Use titles rather than employee namesthroughout the narrative so that updatesare easier. You want to identiy key con-trols and gaps.

In the 2008 Sarbanes-Oxley Section404: A Guide or Management by InternalControls Practitioners, the Internal Insti-tute o Auditors (IIA) denes a key control

as a control that, i it ails, means thereis at least a reasonable likelihood that amaterial error in the nancial statementswould not be prevented or detected on atimely basis. In other words, a key controlis one that is required to provide reason-able assurance that material errors will beprevented or timely detected.

Each key control should have keyinormation documented as well. The IIAguide urther recommends documentationsuch as identiying who is perorming the

control, when the control is operatingand at what requency, how the control isperormed, what evidence exists that thecontrol was perormed, and which reportsare used in the operation o the control.

Gaps are missing controls, and bestpractices research helps identiy thesecontrols. For example, a gap may be thatthe bank deposit is prepared by the sameperson who updates customer accounts,updates the general ledger and reconcilesthe bank statement. This would go againstsegregation o duties, which is one o the

best practices surrounding cash receipts.The IIA guide recommends that a nar-

rative enables a reasonably knowledge-able individual this person does nothave to be an expert with experience inthe area, but should have some knowl-edge o the company or its business tounderstand the process; and overall,enables a reasonable person to have a basisupon which to assess the design o thecontrols: Are the controls identied anddocumented sufciently to either prevent

or detect a material misstatement? Atercompleting the narrative process, the nextstep is to perorm a walkthrough.

WalkthroughsSometimes what is perceived as stan-

dard operating procedure isnt what actu-ally occurs. A walkthrough will get you

down into learning and testing the detailswith the person who perorms the day-to-day transactions.

In AS5, the PCAOB explains thatsome types o tests, by their nature, pro-duce greater evidence o the eectivenesso controls than other tests. The ollowingtests that the auditor might perorm arepresented in order o the evidence thatthey ordinarily would produce, rom leastto most: inquiry, observation, inspectiono relevant documentation, and re-peror-mance o a control.

A walkthrough starts by interviewingthe employees who perorm the duties inthe narrative. The interview techniquesdescribed above should be utilized. How-ever, as the person walks through theprocess, they should ask show me oreach control along the way. For example,i the employee says that a check log ismaintained, then the evidence o onedays check log would be asked or.

Furthermore, i the employee saysthat the controller matches the check log

to the days deposit slip and initials thedeposit, then the deposit slip related tothe check log observed would be askedor. I the employee says he or she updatesthe accounting system and must use apassword to log in, then re-perormancewould be utilized to see the control work.

Through this process, it

Documents

Disclosures July August 2010