Jan 2006 cpaj cover · February 2016 | vol. LXXXVI, no.2 56 Departments 42 Accounting & Auditing I Accounting Changes to Going Concern Disclosures Accounting Guidance Shifts Responsibilities

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In this Issue

FEBRUARY 2016 / THE CPA JOURNAL

What is the state of audit qualitytoday? There are a number of differ-ent ways to interpret, as well as an-swer, that question. The variety ofviewpoints presented in this issue

grapple with the regulatory model within which auditwork is performed, the historical context of current is-sues in the discipline, and the recent progress that hasbeen in remediating deficiencies.

Audits have become so encumbered by regulatory requirements that their costs have risen out of line with their benefits, argue Arthur Radin and Miriam Katowitz. While many of the requirements may makesense in isolation, in the aggregate the result has beenauditors preoccupied with completing checklists ratherthan focused on the basics—understanding the businessunder audit.

Has the profession made progress in solving fundamen-tal problems in auditing over the past decades? HowardLevy looks back at some of the problems identified byleading commentators over 50 years and finds that, de-spite the efforts of regulators and standards setters, mostof them have stubbornly persisted to today.

The PCAOB has seen the pursuit of audit quality as akey component of its mission, and, through its inspec-tion process, it has tried to express its priorities to au-ditors of public companies. Authors Thomas G.Calderon, Hakjoon Song, and Li Wang look at selectedaudit deficiencies identified by the PCAOB and assesswhether auditors are heeding the regulator’s advice insubsequent audits.

A pair of differing perspectives are highlighted in ourNews & Views section. Jim Peterson argues that themodels auditors use to assess risk are fundamentallyflawed, and a different approach is needed to find themore subtle indicators of serious potential audit break-downs. Cindy Fornelli points to more positive signs thataudit quality is improving, and she points to the moreprominent role of audit committees, which are becom-ing central to the process of improving quality.

f e b r u a r y 2 0 1 6C O N T E N T S

Contents

▼

6

In Focus5

6

10

14

16

18Publisher’s ColumnA Busy Season that Has Nothing to Do with Filing Taxes By Joanne S. Barry

Viewpoint

Audit Quality and the Expectations GapIt’s Time for a Model that Fits the DataBy Jim Peterson

Viewpoint

Improving Audit Quality through Auditor Communication Charting Recent Progress and Looking AheadBy Cindy Fornelli

Viewpoint

What Auditors Need to Know about SOXSection 404(a) Reports Hidden Risks and Responsibilities By Howard B. Levy

Tax & Accounting Update

Letter to the Editor

24

32

The CPA Journal is a technical-refereed publication aimed at practitioners, educators, regulators, and other financial professionals. Our goal is to provide insight and analysis on developments in the areas of accounting, auditing, taxation, finance,management, technology, and professional ethics.

The reader should not construe the content included in The CPA Journal as accounting, legal, or other professional advice. If specific professional advice or assistance is required, the services of a competent professional should be sought.

The CPA Journal (ISSN 0732-8435) is published monthly by The New York State Society of Certified Public Accountants, 14 Wall Street, New York, NY 10005. Subscription Rate: $98.00; Periodicals postage paid at NY, NY and additional mailing offices.POSTMASTER: Send address changes to The CPA Journal, 14 Wall Street, New York, NY 10005, Attn: Subscription Department.

▼

News & Views▼

18

17

Have Audits Become Too Inefficient and Expensive?

By Arthur J. Radin and Miriam E. KatowitzThe authors posit that the accretion of audit requirementsover the decades has added cost without providing com-mensurate value. They suggest reevaluating procedureswith the goal of a simpler, better, less expensive audit.

Unsolved Problems in Auditing

A Half-Century Retrospective and UpdateBy Howard B. LevyAuditing has been an ever-changing discipline since itsbirth, but how much have the challenges auditors facereally evolved over the last half century? This articlereviews some of the problems in auditing that have stubbornly resisted solution despite the attempts of regulators over the years.

Audit Deficiencies Related to Internal Control

An Analysis of PCAOB Inspection ReportsBy Thomas G. Calderon, Hakjoon Song, and Li WangA major part of the PCAOB’s efforts to improve audit quali-ty have centered on auditors’ assessments of companies’internal controls over financial reporting (ICFR). This articleassesses whether audit quality has improved by looking atPCAOB inspection reports containing ICFR-related auditdeficiencies over the past decade and determining whetherauditors remediated the deficiencies found.

Columns

February 2016 | vol. LXXXVI, no.2

56

▼

Departments▼

Accounting & Auditing I Accounting42

Changes to Going Concern DisclosuresAccounting Guidance Shifts Responsibilities toManagementBy Kayla D. Booker and Quinton Booker

The Going Concern Gap in U.S. GAAPFilling a Hole in Existing StandardsBy Jennifer Edmonds, Ryan Leece, and James Penner

Auditors’ and Management’s New Approach Regardingthe Going Concern AssessmentBy Alan Reinstein and Stefanie L. Tate

Accounting & Auditing I Standards Setting46

It’s Amazing What CPAs Can DoA Career Spent Wearing Many HatsBy Anthony S. Chan

66 Classified Ads

▼

SEC Insights54

Personal Financial Planning60

Tech Talk64

Economic & Market Data71

Guest Editorial | Then & Now72

Accounting & Auditing I Auditing50

42

State & Local Taxation56

European Audit ReformHow It Could Affect U.S. CompaniesBy Allan B. Afterman

State and Local Tax Considerations for Business Acquisitions and DivestituresBy Patrick Duffany, Milo Peck, and Corey Rosenthal

Treating Social Security as an Asset ClassBy Sidney Kess and Edward Mendlowitz

Audit AnalyticsBy Susan B. Anders

PublisherJOANNE S. BARRY

Editor-in-ChiefRICHARD H. KRAVITZ, MBA, CPA

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The CPA Journal welcomes the submission of articles on a wide variety of topicsof interest to CPAs in public practice, industry, education, and government. Arti-cles are evaluated on the basis of the clarity of ideas and writing, contribution tothe profession, relevance, benefit to practitioners, and soundness of point of view.Manuscripts deemed to have potential for publication are reviewed by two refereesprior to acceptance for publication. See www.cpaj.com/guidelines.htm for moredetailed information.

THE CPA JOURNAL (ISSN 0732-8435, USPS 049-970) is published monthly by The NewYork State Society of Certified Public Accountants, 14 Wall Street, New York, NY 10005.Copyright 2016 by The New York State Society of Certified Public Accountants. Sub-

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COLUMN EDITORS:SEC Insights: Allan B. Afterman

Tax Practice & Procedure: Bryan C. SkarlatosState & Local Taxation: Corey Rosenthal, Patrick Duffany

Personal Financial Planning: Sidney Kess, Edward MendlowitzEstate & Retirement Planning: Martin Shenkman

Retirement Plan Advisor: Sheldon M. GellerTech Talk: Susan B. Anders

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Journal” or enter “ISSN 0732-8435.”

Susan B. AndersC. Richard BakerWilliam Bregman

Douglas R. Carmichael Anthony S. ChanRobert H. ColsonRobert A. Dyson

Andrew FairJulie Lynn Floch

Sheldon M. GellerKenneth J. Gralak

Neville GrusdElliot L. HendlerNeal B. Hitzig

Ronald J. Huefner

Julian JacobyPeter A. Karl IIILaurence Keiser

Sidney KessStuart Kessler

Michael KratenJoel Lanz

Mark H. LevinMichele Mark Levine

Howard B. LevyMartin J. Lieberman

David A. LifsonSteve LilienSteve Loeb

Vincent J. LoveNicholas J. Mastracchio, Jr.

Edwin B. MorrisBruce Nearon

Raymond M. NowickiPaul A. Pacter

Lawrence A. PollackArthur J. RadinYigal Rechtman

Richard A. Riley, Jr.Stephen F. Ryan III

Stephen ScarpatiLeslie F. Seidman

Rona L. ShorArthur SiegelLynn Turner

Robert N. Waxman

THE CPA JOURNAL EDITORIAL BOARD

The Voice of the Profession

FEBRUARY 2016 / THE CPA JOURNAL 5

February marks the time of yearwhen a good number of our mem-bers suddenly go quiet. But we

know why: February is the start of tax sea-son. With our conference season over, thecalls slow down, our committees meet lessfrequently, and we try to keep e-mail out-reach to our tax practitioners as limited aspossible.

But the NYSSCPA offices are far fromquiet. Yes, the calls from members lookingfor CPE courses slow down, but our tech-nical hotline lights up with inquiries frommembers looking for busy season technicalguidance. February, for the NYSSCPA, iswhen our government affairs programkicks into full swing. For instance, earlierthis month, NYSSCPA President Joe Falboleft Buffalo for Albany to testify on behalfof the Society during the state’s joint bud-get hearings. He was invited because law-makers from the Senate Finance and theAssembly Ways and Means committeeswanted to know what CPAs think aboutthe tax provisions in the state’s proposedexecutive budget. That testimony led to aFebruary 28 meeting with the office ofAssemblyman Edward Braunstein, chairmanof the Assembly’s Trust and Estates Sub-committee, to discuss amending the state’sestate tax laws, one of the items on theNYSSCPA’s 2016 legislative agenda.

We have other irons in the fire. TheAICPA and the National Association ofState Boards of Accountancy (NASBA)have proposed changes to the UniformAccountancy Act (UAA), a jointly draft-ed legislative blueprint for establishing uni-formity and consistency in the way accoun-tancy laws are applied from state to state.That’s how we brought mobility to NewYork State and it was the basis for thebill we are currently supporting that wouldmake CPA firm ownership more accessi-ble to more professionals.

The proposed changes to the UAAinclude a provision that would help meet

the needs of retired CPAs who want to usetheir expertise to volunteer for not-for-prof-it organizations. The UAA proposes a“Retired-CPA” status with clearly delin-eated guidelines on the scope of workretirees could offer to nonprofit boards. Wewelcome clarity in New York, where manyof our members—primarily due to regu-latory changes brought about the accoun-tancy reform law enacted in 2009—cur-

rently face the choice to either maintainCPE hours in order to serve on a volun-teer board in a role that may have tenu-ous connection to the scope of practice,or step down from the position. Enactingthis provision would require an amendmentto the accountancy reform regulations, andthat’s not the only improvement we needto make to the rules implementing thatlandmark piece of legislation. It’s beenseven years, and professional practice haschanged. It’s our responsibility to makesure these changes are communicated tostate legislators so that the laws regulat-ing our profession remain effective.

The NYSSCPA is the voice of the pro-fession in New York State. We have a vot-ing bloc 28,000 members strong. When itcomes to politics, that’s power. But in orderto wield that power, we need an effectivepolitical action committee. I’ve been driv-ing this message home for the past sixyears, and I know some of you haveheard me, because we have more than 100new members in the PAC this year. Unfor-tunately, we still have fewer than 2,000members overall. It’s my job to changethat, but I can’t do it without your help.

The NYSSCPA cannot fulfill its obli-gation as your advocate in Albany withouta strong PAC. We use those PAC dona-tions to attend legislative fundraisingevents, where we can establish and buildrelationships with lawmakers whose votesdetermine how our members can run theirpractices. It’s our job to make the con-nections and leverage them on behalf ofour members. But it’s our members’ obli-gation to reach out to us when they becomeaware of a legislative or regulatory pro-posal that either harms the profession orhelps it. We can oppose legislation or wecan support it, but we can do neitherwithout a strong PAC.

When we send out dues invoices in April,every member will have an opportunity tojoin the PAC. When you renew yourmembership, check the appropriate box todonate $25 to the PAC. Once you do, youbecome a member. Want to see who elseis a member? Pick up the January/Febru-ary issue of The Trusted Professional. Theissue recognizes the New York CPAs whohave made a proud commitment to a pow-erful profession in New York. Then, oncebusy season is over, we can head to Albanyand make some noise. q

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

PUBLISHER’S COLUMNN&V

A Busy Season That Has Nothing to Do with Filing Taxes

FEBRUARY 2016 / THE CPA JOURNAL6

Leaders of the profession haveconflicting views on the stateof audit quality today. According

to current SEC Chair Mary Jo White,“investor confidence in audited financialstatements and independent auditors ishigh … attributable, at least in part, toimprovements in audit quality”(Remarks at the AICPA annual nation-al conference, Dec. 12, 2015). On theother hand, PCAOB member Steven

Harris has said that “investors and reg-ulators alike do not believe that auditquality is where it should be” (Remarksat PCAOB open board meeting, Dec.15, 2015). Among those more likely toagree with Harris are the devastatedinvestors raising the usual cry (“Wherewere the auditors?”) over examples ofbusiness failures that stretch from thecrisis of 2007/08—Bear Stearns,Lehman Brothers, AIG, and Fannie

Mae, as a few examples—down to suchrecent headlines as ValeantPharmaceuticals and Martin Shkreli.

The cliché—“When I’m right, nobodyremembers, when I’m wrong, nobodyforgets”—applies to auditors: cases ofdifferentiated success are elusive, hardto measure, and underappreciated,whereas the rare, difficult, and inevitablebreakdowns are vilified and punished.Put another way, the “expectations

Audit Quality and the Expectations GapIt’s Time for a Model that Fits the Data

By Jim Peterson

NEWS & VIEWS I viewpointN&V


gap”—between the professed desiresof financial statement users and the con-fessed limitations of the current auditmodel—remains in full view. Ratherthan continue to rely on the episodic andsampling-based techniques used sincethe Victorian era, it is time to considera radically different approach to thesearch for audit quality.

Measurement Models

Although investors had long displayedgeneral satisfaction with the traditionalaudit report and its standardized, com-moditized language, it has more recentlybecome recognized that the “pass/fail”auditor’s report delivers only limited assur-ance—saying, in effect, that a compa-ny’s financial information is more or lessokay, in general, most of the time, so faras the auditors can tell—except with thesudden exposure of large-scale financialimpropriety, when the reporting modelbreaks down and provides no comfort atall! The current model’s shortcomings arereceiving attention from standards settersaround the globe: the PCAOB in theUnited States, the Financial ReportingCouncil in the United Kingdom, and theInternational Auditing and AssuranceBoard internationally—all of whom arelaboring to construct more informativeauditor communications.

But beyond the report’s too-narrowscope, there is an additional key rea-son, similar to the inadequacies of therisk models that failed all tests of use-fulness during the 2007/08 financial cri-sis, for the perception of diminishedutility of the auditors’ work. Namely, thefundamental assumptions that underliethe historical audit process—just as withthe risk models—are those of the com-fortable and familiar “bell curve,” withits attention to so-called tail risks and itsreliance on the regressive principles ofthe law of large numbers.

That model, embedded in Westernculture since the days of Isaac Newton,does have broad and practical applica-bility, where “good-enough” results are

averaged across large and diverse bod-ies of data. But much of the world offinancial information, as elsewhere, fallsentirely outside these rules, instead fol-

EXHIBIT 1Bell Curve versus Power Law Curve

Bell Curve

Power Law Curve

HIGH

LOW

FEWER GREATER

The current model’s shortcomings are receiving

attention from standards setters around the globe—

all of whom are laboring to construct more

informative auditor communications.


lowing a “power law”—when graphed,a distribution shaped like a hockey stick.Many phenomena follow this model,including personal wealth, the sales ofbest-selling books, the number ofFacebook friends or Twitter followers,and the size of companies. (Exhibit 1illustrates the two curves. No formaltraining in mathematics is needed toappreciate that their dramatically differ-ent shapes reflect populations that fol-low very different organizing principles.)

Under power law distributions, mostmembers of a population occupy thelong, low part of the curve at the right

(i.e., the handle of the hockey stick),while very few members make up thetip at the high part in the upper left-handcorner. Consider the huge number ofroutine individual doctor visits, at rela-tively modest cost, compared to thesmall number of hugely expensive car-diac surgeries or organ transplants. Inthe accounting profession, most CPApractices consist of one to five members,while the large-company audit market iscompletely dominated by the Big Four.Exhibit 2 replicates the generic powerlaw curve—graphing the 23 internationalaccounting networks with global annu-

al revenue for 2015 above $100 million.(Note the spike at the left representingthe Big Four, with the dramatic fall-offdown the scale to the right.)

Analyzing Audit Quality

With the contrasts between the twomodels discussed above, we may moveto consider audit quality or audit failure.To start, in general, much noncompli-ance with laws and regulations byoffenders also follows a power law dis-tribution. Examples include the smallnumber of cars and trucks that spewmost vehicular pollution, the concen-

EXHIBIT 2Power Law Curve: Annual Revenue of Large International Accounting Firms

$30 billion

$40 billion

$20 billion

$10 billion

0

(The Big Four)

(The Other Large International Accounting Firms withAnnual Revenue over $100 Million)



tration of police misconduct in the tinynumber of “rogues,” and the demandson social services by a relative handfulof the chronically homeless.

Specifically here, cases of financialstatement malfeasance do not regress;there is no “average” dollar amountamong cases of financial misstatements.Instead, minor cases of misappropriation,employee theft, or manipulation arenumerous, and deemed by auditors andusers alike to be immaterial—that is, theyfall onto the long, flat, and low-conse-quence end of the power law curve. Atthe other end of the curve, there areseveral outbreaks in each businesscycle that are rare, huge, and devastat-ing in their impact. (Anecdotally sup-ported among the large accounting firms’lawyers and risk managers, this propo-sition has not to my knowledge beenresearched, but is testable.)

There is both good and bad news forauditors and financial statement users.First, the bad news: to the extent thetraditional sampling–based auditapproach is designed and expected to sat-isfy the underlying bell-curve assump-tions of a pass/fail report, it is predictablethat the effort will continue to be bothinefficient and ineffective. In this author’sopinion, that approach will continue tofail to address the rare but consequen-tial occurrences that really matter toinvestors and other participants in thecapital markets. (Picture the two curvesas graphically overlaid. The obvious mis-match would illustrate the unsatisfacto-ry design of one to serve the other.)

The good news, on the other hand, isthat audits could be redirected to identi-fy and act effectively on the indicatorsof potentially large-scale breakdowns. Theability to shed needed light on the present-ly ignored or underappreciated symptomsof impending failure is real. Achievingsuccess, however, will require a recali-bration of the tools of audit execution,

because the effort will be subtle anddemanding, pushing the effort away fromthe inconsequential and toward theupper end of the curve, where the fewlarge-scale audit failures reside.

Next Steps

The road to financial statement disas-ter has been paved with unresolvedwarnings and signals that later morphedinto catastrophe—“close calls” that toooften were either ignored, rationalized,or missed altogether. Instead of audit-ing to the “good-enough” approach ofbell-curve, materiality-based sampling(not to mention the nitpicking of PCAOBinspectors), a partial list of issues forredesigned audit scrutiny would includethe following: n Partner performance quality, and thereadiness to recognize that the risk ofrecurring substandard behavior is toohigh to be tolerable.n Partner override, where the informedperceptions and judgments of staff ormanagers in the field with their hands ona problem are ignored, rationalized, orsuppressed.n Elevation of “client service” abovecompliance with standards, especiallywhere firm policies and central expertiseare in tension with “judgment calls”made at the margins.n The impact of revenue, profitability,or economic pressure—where an office,

a geographic region, or an industry sec-tor of a firm’s practice makes compro-mises to meet targets that are in tensionwith firm-wide policies and quality ofwork.

Perfection is never achievable: the pos-sibility of “black swan” events can neverbe either completely excluded or infalli-bly detected in any complex systemdesigned and operated by fallible humanbeings. But the expectations gap betweenaudit performance and user desiresrequires adjustment and recalibration, andit is time for the profession to begin adialogue about these issues. The rolewithin the capital markets of a robust andsustainable audit function is too impor-tant to allow it to languish. Concertedand cooperative efforts by all parties willbe required to create an audit model fitfor the 21st century. q

Jim Peterson, JD, is former corporatecounsel at Arthur Andersen and con-centrates on complex multinational dis-putes, l i t igation, and financialinformation. He has taught RiskManagement at the University ofChicago, DePaul University, theUniversity of Illinois, and the Universityof Cergy-Pontoise in Paris. He is theauthor of “Count Down: The Past,Present and Uncertain Future of the BigFour Accounting Firms,” published byEmerald Books.

Perfection is never achievable: the possibility of “black

swan” events can never be either completely excluded

or infallibly detected in any complex system.


Improving AuditQuality through

AuditorCommunication

Charting Recent Progress andLooking Ahead

By Cindy Fornelli

The state of audit quality is strong—andgetting stronger. Annual tallies of

financial restatements have dropped dra-matically from post–Sarbanes-Oxley Act of2002 peaks and have held steady at lowerlevels for several years, according to theAudit Analytics report “2014 FinancialStatement Restatements” by Don Whalen,Olga Usvyatsky, and Dennis Tanona. Atthe same time, investor confidence in theU.S. capital markets, audited financial state-ments, and public company auditorsremains robust, as indicated by the Centerfor Audit Quality’s (CAQ) 2015 MainStreet Investor Survey. Commenting onthese developments, SEC Chair Mary JoWhite recently stated that “the positive signsare attributable, at least in part, toimprovements in audit quality and theenhanced role that auditors generally nowdischarge in providing an essential check inthe financial reporting process”(“Maintaining High-Quality, ReliableFinancial Reporting: A Shared and WeightyResponsibility,” keynote address, 2015AICPA National Conference).

Improvements in audit quality gohand in hand with efforts to enhance audi-tor communication and transparency. Theauditing profession continues to work con-structively with policy makers and part-ners to respond to audit committees’,investors’, and other stakeholders’ increas-ing interest in gaining greater insight intothe audit process. In multiple areas relat-ed to auditor communication, the profes-sion has stayed proactive and has

endeavored to find practical approachesthat work in today’s global markets. It hasbeen highly mindful of the risk of poli-cies that might produce disclosure over-load, a “check-the-box” mentality, ordisclosure for disclosure’s sake. Capitalmarkets cannot function without goodinformation—information that is accurate,tailored, timely, and meaningful—and thisproposition holds as true in the auditcontext as anywhere else.

Developing Audit Quality Indicators

The global push to develop audit qual-ity indicators (AQI) provides an excel-lent example of striving for a workable

approach to effective auditor communi-cation. Policymakers have been partic-ularly active in this area—for example,in 2015, two years after announcing itwould pursue a project to define key ele-ments of audit quality, the PCAOBissued a concept release seeking publiccomment on 28 potential quantitative

AQIs, including more than 70 illustra-tive calculations. [Regulators and pro-fessional bodies overseas have also beenactive: the International Auditing andAssurance Standards Board (IAASB)has published “A Framework for AuditQuality,” and Singapore issued its“Audit Quality Indicators DisclosureFramework.”]

Leveraging perspectives from an AQIstakeholder advisory panel formed in2012, the CAQ published its “Approachto Audit Quality Indicators” in April2014. The report identified a set ofpotential AQIs and a strategy for com-municating them. In an effort complet-ed in the first quarter of 2015, CAQmember firms (30 issuers and 10 auditfirms of varying sizes) tested theapproach and provided feedback on theefforts required to collect AQI infor-mation. This also generated feedbackfrom audit committees on the usefulnessof the proposed AQIs in fulfilling theiroversight responsibilities.

The pilot testing was illuminating: theresults validated some aspects of theCAQ approach but also showed wheremore work is needed. To further evalu-ate the approach, the CAQ convened aseries of roundtable discussions withaudit committee members in Chicago,New York, London, and Singapore insummer 2015. There, participants sharedtheir views on the potential benefitsand challenges of identifying and devel-oping a set of AQIs.

Key findings from the roundtablesincluded the following (“Audit QualityIndicators: Journey and Path Ahead,”CAQ, January 2016):n Participants expressed desire for infor-mation that can assist audit committees inassessing an audit’s more qualitative aspects(e.g., an engagement team having the rightmind-set to bring forth professional skep-ticism and auditor judgment). n Audit committee members recognizedthat AQIs can help them oversee the

Improvements in audit

quality go hand in hand

with efforts to enhance

auditor communication

and transparency.



quality of their external audit, even ifthis is just one aspect of quality finan-cial reporting.n Most participants endorsed a flexibleapproach that would allow an audit com-mittee, working with the external audi-tor, to tailor the selection and portfolioof AQIs to best suit specific informationneeds. They agreed that the process ofidentifying and evaluating AQIs willrequire continuous assessment andrefinement in order to meet audit com-mittees’ changing information needs.n While supporting the concept ofAQIs, some roundtable participants saidthey already have the tools necessaryto gauge the quality of their audit.n Audit committee members agreedthat AQIs alone—without the context thatcomes from a dialogue with the engage-ment team—cannot adequately commu-nicate the factors relevant to any particularaudit engagement or audit firm. n Audit committee members expressedconcerns that public disclosure ofengagement-level AQIs could lead tounintended consequences. A strong con-sensus emerged that any disclosures ofengagement-level AQI informationshould be voluntary.

Despite this progress, further dialogueand collaboration are required to deter-mine an approach to audit quality thatworks for all stakeholders.

Enhancing Audit Committee Disclosure

As illustrated by the discussion aroundAQIs, the audit committee has becomea hub for key activity related to thefinancial reporting process. Recognizingthe importance of strong audit commit-tees, regulators have shown increasinginterest in their work—for example,the PCAOB has conducted outreach toaudit committees, including its AuditCommittee Dialogue project, launchedin May 2015 (http://pcaobus.org/sites/digitalpublications/audit-committee-dialogue). Two months later, the SEC

published a concept release seeking pub-lic comment on possible revisions toaudit committee reporting requirements,focusing on the audit committee’soversight of independent auditors.

The profession in recent years hasmade the case that the best route topromote informative and relevant auditcommittee disclosures is through a vol-untary, market-driven approach. In a

comment letter on the SEC’s conceptrelease, the CAQ cited the continuingpositive trend of enhanced audit com-mittee disclosures, pointing to encour-aging findings from the 2015 edition ofthe Audit Committee TransparencyBarometer, an annual publication by theCAQ and Audit Analytics. Among otherfindings, it showed that, in 2015, 25%of Standard & Poor’s (S&P) 500 com-panies had enhanced discussion of theaudit committee’s considerations in rec-ommending the appointment of the auditfirm, up from 13% in 2014.

As efforts around audit committee dis-closure continue in 2016, all must keepabreast of these positive trends. Imposingprescriptive requirements could stifleinnovation and interfere with theprogress being made.

Updating the Auditor’s Report

Standards setters have also beenactively trying to update the auditor’sreport. Presently, the PCAOB is work-ing on reproposals for its project andanticipates issuing one focused on dis-closure of “critical audit matters” in2016. A recommendation for changesrelated to the auditor’s responsibilityover “other information” is also

expected this year. Meanwhile, theIAASB has finalized its revised rules(effective for 2016 audits). In addition,the new U.K. auditor reporting require-ments have been in place for more thantwo years. As noted recently by PCAOBChairman James Doty, these rules “havebrought new relevance to the audit”(http://pcaobus.org/News/Speech/ Pages/Doty-AICPCA-2015-keynote.aspx).

The U.S. auditing profession hasprovided substantial input to help informthe policy process around the auditor’sreport. This has included multiple com-ment letters with concrete suggestionsfor a workable approach, as well as find-ings from a comprehensive initiative thatfield-tested the critical audit mattersincluded in the PCAOB’s 2013 pro-posal on the auditor’s reporting model.

As illustrated by the discussion around AQIs,

the audit committee has become a hub for key activity

related to the financial reporting process. Recognizing

the importance of strong audit committees,

regulators have shown increasing interest in their work.


Throughout this work, the CAQ hasemphasized several principles thatshould guide changes in this area. Forexample, it has stressed that auditorsshould not be the original source ofinformation about a company’s financialstatements and other financial informa-tion or its system of internal control overfinancial reporting (ICFR); the respon-sibility to consider such information fordisclosure belongs squarely to compa-ny management.

Of course, given the activity of poli-cy makers worldwide on this issue and

the increasingly global nature ofeconomies and markets, internationalcoordination and regulations that workacross borders are key to updating theauditor’s report.

Audits Related to ICFR

ICFR audits represent another areathat demands coordination among stake-holders. The PCAOB has repeatedlyexpressed concerns about the numberand significance of deficiencies identi-fied in firms’ ICFR audits. Many ofthe board’s recent inspection findingsfocus on an auditor’s failure to providepersuasive evidence that ICFR is oper-ating effectively.

ICFR audits are a multifaceted chal-lenge, and robust communication is anessential part of effective execution. Toenhance their ICFR audit work, auditorsmust communicate successfully with man-

agement and internal audit, working toidentify a set of controls that are proper-ly responsive to audit risk. Auditors alsomust maintain an active dialogue with reg-ulators. To this end, the CAQ has estab-lished an ICFR task force that engagesin discussions with the PCAOB and SEC.

The centrality of audit committees isalso evident here, as regulators havestressed. “I strongly encourage regulardiscussions among management, audi-tors, and audit committees on existingand emerging issues in assessments ofICFR,” said SEC Deputy Chief

Accountant Brian Croteau. “After all,ICFR is an area subject to audit com-mittee oversight as part of its financialreporting oversight responsibilities”(AICPA National Conference on CurrentSEC and PCAOB Developments,December 2015, http://www.sec.gov/news/speech/croteau-2015-aicpa.html).

Future Challenges and Opportunities

As an indispensable part of today’sdynamic financial system—with changedriven by innovation, technologicaladvances, evolving investor needs, andemerging business practices and chal-lenges—auditors must respond to mar-ket developments, adapting as necessaryand communicating with stakeholders toensure clarity on roles and responsibil-ities. One especially important issue iscybersecurity; educating the public onthe auditor’s role with respect to cyber-

security should be one of the profes-sion’s priorities.

When performing a mandated audit,an auditor must obtain an understandingof how the company uses informationtechnology (IT), the effect of IT on thefinancial statements, and the extent ofthe company’s automated controls (asthey relate to financial reporting). Whena cyber-breach occurs, the external audi-tor must assess its potential impact onfinancial reporting and ICFR, includingmanagement’s financial statement disclosures. (For more information, seethe CAQ resource, “UnderstandingCybersecurity and the External Audit,”http://bit.ly/20BOgSB.)

The continuous evolution of cyberse-curity has implications for public com-pany auditors. Separate and apart froma mandated audit, audit firms can be avaluable resource for attestation servicesrelated to cybersecurity. These servicescould include providing independentinsights to management, the audit com-mittee, and others charged with gover-nance. Working closely with theAICPA, which is currently updatingthe existing framework of attestationstandards to accommodate auditor workin this area, the CAQ is exploring audi-tor assurance services around cyberse-curity. These services have greatpotential to benefit investors, audit com-mittees, and other stakeholders.

To echo SEC Chair White once more,auditors provide an essential check inthe financial reporting process. The ini-tiatives discussed above are severalamong many that promise to strength-en and enhance that role. q

Cindy Fornelli has served as the exec-utive director of the Center for AuditQuality since its establishment in 2007.Formerly, she served as deputy direc-tor of investment management at theSEC and senior vice-president at Bankof America.

The continuous evolution of cybersecurity

has implications for public company auditors.


WRITE ABOUT TECHNOLOGY FOR THE CPA JOURNAL

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The CPA Journal

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May 2016 March 15, 2016.

Journal

June 2016: July 2016: August 2016:


What Auditors Needto Know about SOX

Section 404(a) Reports Hidden Risks and Responsibilities

By Howard B. Levy

Since the PCAOB’s Auditing Standard(AS) 5, now reorganized as AS 2201,

replaced AS 2 in 2007, auditors for pub-licly held companies (i.e., issuers) nolonger attest to the fairness of manage-ment’s Sarbanes-Oxley Act of 2002(SOX) section 404(a) reports. Rather,when reporting under SOX section 404(b),they attest directly to the effectiveness ofinternal control over financial reporting(ICFR). Nevertheless, the auditing stan-dards confer certain responsibilities onauditors that apply even for smaller andother issuers that are exempt from theICFR audit requirements of SOX section404(b). This article is intended to alertauditors to the not-so-obviously applica-ble guidance in the auditing standards andhelp them avoid risks related to thoseresponsibilities.

SOX section 404(a) was phased inbased on an issuer’s size; implementa-tion began in 2004, and by 2007 allissuers were subject to its provisions.Section 404(a) requires management toconduct an annual evaluation of theoperational effectiveness of its ICFRwith documentation of both the con-trols and the mandated testing thereof,and to report the results publicly in itsannual report on Form 10-K. SOX sec-tion 404(b) required independent audi-tors to report on the effectiveness of acompany’s ICFR; however, the SECissued a series of releases temporarilydeferring applicability of SOX Section404(b) to non-accelerated filers untilJuly 2010, when Congress provided apermanent exemption to section 404(b)for non-accelerated filers as part of

the Dodd-Frank Wall Street Reformand Consumer Protection Act. Section989G(a) of Dodd-Frank amended SOXby adding section 404(c). Because ofthese actions, almost half of issuerswere, in fact, never subject to thoserequirements (49% as of the mostrecent filings for years ended through2015, according to Audit Analytics,an independent data research servicethat tracks and analyzes public com-pany disclosures).

Non-accelerated filers are issuers withless than $75 million in public float (i.e.,

the value of shares held by the public).This category includes, but is not limit-ed to, all issuers also known as “small-er reporting companies.” Also includedin the 49% are emerging growth com-panies (EGC), a category of issuer cre-ated by the Jumpstart Our BusinessStartups (JOBS) Act of 2012, whichare also exempt from SOX section404(b) unless and until they lose theirEGC status.

Auditors’ Hidden Responsibilities

Auditors’ responsibilities regardingcompliance with SOX section 404(a) are

hidden in three sections of the PCAOB’sreorganized Auditing Standards (AS)1305, 2405 and 2710:n AS 1305 (AU section 325). Under AS1305, auditors must report any signifi-cant deficiency or material weaknessregarding ICFR to audit committees.Any material event of noncompliance bymanagement with the ICFR evaluationand testing requirements of SOX section404(a) would likely be deemed to resultfrom such a significant deficiency ormaterial weakness. This would be trueeven if the misstatements discovered in

the draft SOX section 404(a) reportintended for inclusion in the annualreport were corrected before filing. n AS 2405 (AU section 317). AS 2405requires auditors to report known or sus-pected illegal acts to the audit committeeand to consider their possible effects onthe financial statements and audit scope.In addition to representing a reportableICFR deficiency, any instance of noncom-pliance with SOX section 404(a), or anymaterial, public misrepresentation of com-pliance would constitute such an illegal act. n AS 2710 (AU section 550). AS 2710obligates auditors to read an issuer’s

This article is intended to alert auditors to

the not-so-obviously applicable guidance

in the auditing standards and help them

avoid risks related to those responsibilities.

NEWS & VIEWS I auditingN&V


entire draft annual report on Form 10-K, and to take certain actions inresponse to management statementstherein that are believed to be materi-ally false and misleading. Such mis-statements in section 404(a) reportsordinarily would be identified within thecourse of obtaining an understanding ofICFR as part of the risk assessment pro-cess performed. This would includereading the scope and results of man-agement’s control tests conducted pur-suant to SOX section 404(a) whenplanning a financial statement audit pur-suant to AS 2110.18–.25. As providedspecifically under AS 2710.05 and .06,if any suspected material misrepresen-tation [such as in the SOX section404(a) report] is identified and not cor-rected after discussing it informally withmanagement and, if necessary, propos-ing that management consult with“some other party whose advice mightbe useful to the client,” the auditorshould “communicate the materialmisstatement of fact to the client andthe audit committee, in writing, and con-sider consulting his legal counsel as tofurther appropriate action in the cir-cumstances” (emphasis added).

Risks and Consequences of Issuer

Noncompliance

Because the responsibilities imposedby the above PCAOB standards do notinclude any clear language that direct-ly refers to an issuer’s compliancewith SOX section 404(a) and the con-nection of these standards to manage-ment’s ICFR reports is therefore rathersubtle, there may be considerable riskthat an auditor will fail to recognizesuch connection.

Moreover, as a direct result of leg-islative action that permanently removedthe threat of audit oversight underSOX section 404(b), there is an espe-cially heightened risk that non-acceler-ated issuers or EGCs may not take

their SOX section 404(a) complianceseriously. Non-accelerated issuers orEGCs might take shortcuts in their eval-uation and testing process in the beliefthat noncompliance (or poor compli-ance) is unlikely to be caught. Aspointed out above, because the SOX sec-tion 404(a) evaluation process for anissuer is an inherent and significantpart of the monitoring component of

ICFR, management’s failure to take itseriously would likely constitute a mate-rial weakness that, if omitted from itsSOX section 404(a) report, would cre-ate a second misrepresentation—name-ly, that there were no known materialweaknesses. As also pointed out above,failing to comply with the requirementsof SOX section 404(a) or, perhapseven more significantly, issuing a false“boilerplate” report in Form 10-K thatmisrepresents management’s compliancewith SOX section 404(a) would consti-tute a violation of federal securities law;the latter would also likely constitute

securities fraud, which has potentiallyserious consequences.

Therefore, auditors should not belulled into the erroneous belief that theyneed not be concerned with manage-ment’s mandated SOX section 404(a)report when they are not required to auditand report on an issuer’s ICFR pursuantto SOX section 404(b). To the contrary,auditors should be wary of the PCAOB

standards detailed above, which effec-tively say otherwise. Careful attentionis necessary to protect auditors (andissuers) from serious consequences. q

Howard B. Levy, CPA, is a principaland director of technical services atPiercy Bowler Taylor & Kern, LasVegas, Nev. He is a former member ofthe AICPA’s Auditing Standards Boardand its Accounting Standards ExecutiveCommittee and a current member of theCenter for Audit Quality’s Smaller FirmsTask Force. He is also a member of TheCPA Journal Editorial Board.

Auditors should not be lulled into the erroneous belief

that they need not be concerned with management’s

mandated SOX section 404(a) report when they

are not required to audit and report on an issuer’s

ICFR pursuant to SOX section 404(b).


Tax & AccountingUpdate

Tax & Accounting Update is pro-vided by Thomson Reuters and

based on material published onCheckpoint, its online news and researchplatform. The Update is a quick-refer-ence guide to the most pressing issuescoming down the regulatory and admin-istrative pipeline. Visit https://tax.thom-sonreuters.com/daily-newsstand/ forfurther information and daily updates.

Tax News

Federal court rules employment-dis-crimination settlement doesn’t triggercapital gains tax. The Court of Appealsfor the Federal Circuit, affirming theCourt of Federal Claims, concluded thatthe settlement payments received by anindividual from an employment dis -crimination suit were not capital gainsincome. The court ruled that paymentsreceived by the individual, JamesDuffy, did not represent gains from thesale or exchange of goodwill associat-ed with a capital asset, but rather werefor the ex clusive purpose of avoidingthe expense and inconvenience of fur-ther litigation.

SEC News

Update planned for banking indus-try guide. The SEC is revising itsindustry guide for banking companies,which was last updated in 1986. Theplanned revisions are part of a broad-er effort to revise the disclosure rulesfor U.S. companies and make themsimpler to follow. The SEC plans toissue a draft for public comment by fall2016.

Senior enforcement lawyer to stepdown. On January 11, the SECannounced that Julie Riewe, co-direc-

tor of the Enforcement Division’s assetmanagement unit, will step down inFebruary. Riewe oversaw a number ofinitiatives during her tenure, includinga targeted program to investigate hedgefunds suspected of falsely inflating theirinvestment performance. She also pur-sued enforcement actions through col-laborative efforts with other SECoffices.

FASB News

Community bankers campaignfor changes to planned credit lossstandard. Community bankers arepressuring FASB to make its forth-coming accounting standard on writ-ing down bad loans and securitieseasier to understand. The accountingboard announced a public roundtablemeeting with community bankers,auditors, and regulators in Februarynot long af ter the IndependentCommunity Bankers of America(ICBA) publicly urged all sevenFASB members to participate in anopen exchange with executives fromsmall banks. “We’ve had tons ofoutreach with the FASB and variousboard members and staff, but neveranything in front of the full board sothey can all hear about all the vari-ous concerns we have,” said JamesKendrick, vice president of account-ing and capital policy at the ICBA.

Clarifications to revenue standard’sguidance on licenses. On January 6,FASB instructed its research staff toclarify two aspects of tallying revenuesrelated to licenses of intellectual prop-erty. Questions about how to accountfor licenses have dogged FASB and theIASB both before and after their jointstandard was published in May 2014.FASB intends to publish an updatebefore the second quarter of 2016.

PCAOB News

Chinese auditors may face disci-plinary actions. The PCAOB ispreparing to punish some Chineseauditors that have resisted its effortsto inspect the audit firms and reviewtheir workpapers. After the latestround of negotiations with Chineseregulators stalled, the PCAOB request-ed that the Chinese affiliates of the BigFour firms hand over certain data byearly December 2015. Chinese gov-ernment officials generally do not per-mit companies to provide certain datato foreign regulators because of nation-al security concerns. The disciplinaryproceedings could be stayed if U.S.and Chinese officials can agree toinspections and PCAOB inspectors aregiven access to the documents.

IASB News

Chairman defends financial instru-ments standard. On January 11, IASBChairman Hans Hoogervorst defend-ed the board’s high-profile account-ing standard requiring banks and otherfinancial businesses to acknowledgelosses on loans earlier in the creditcycle. Speaking before the EuropeanParliament’s committee on economicand monetary affairs in Brussels,Hoogervorst conceded that thechanges outlined in IFRS 9, FinancialInstruments, will require more judg-ment than companies currentlymake, but he said that the finalaccounting outcome will better reflectthe economics of most lending andtrading activities. “The whole purposeof why it was written so strictly …was to limit judgment and to limit lee-way for management to create hiddenreserves or whatever. It was to limitearnings management,” Hoogervorstsaid. q

NEWS & VIEWS I tax & accounting updateN&V


In Defense of CPAs inPension Planning

Ifound it puzzling The CPA Journalwould publish a guest editorial like

the one in the November 2015 issue(“It’s Amazing What CPAs Can Do:Pension Consulting Is an Old Practicebut a New Specialty,” Matthew Gaglio,p. 72). Here we have a registered rep-resentative and financial advisor talk-ing down to CPAs about the benefitsthat can be derived for their businessclients by advising on plans that enablethem to salt away pension contribu-tions under the tax law and thereby min-imize their tax liability.

I know of few CPAs servicing smallbusiness clients who were unaware of thesections of the tax code that pertain toqualified retirement planning. Many CPAsI know have recommended such plansto clients and have done so workingwith actuaries and pension consultants.

Yet Gaglio makes the following state-ment: “In 1992, CPAs did not view a qual-ified retirement plan as a resource for taxplanning because they were not taught to.”

That's a put-down if I ever read one.Leaving aside the glaring generality, theauthor doesn't cite any authoritativesource for such a statement. Were theresome CPAs not as knowledgeable asthey should have been about the tax pro-visions dealing with qualified retirementplans? Of course there were. However,to make that broad knock on CPAs isunwarranted, and out of place in our pro-fessional journal.

Elsewhere, the author implies that thetax act known as the “Economic Growthand Tax Relief Reconciliation Act of2001” is gibberish to many of today’sCPAs. On what basis does he make sucha comment? A CPA serving businessclients would not survive for longbeing ignorant of the act cited.

To call the article a guest editorial isto dignify what amounted to an adver-tisement for pension consultants and abroadside at CPAs. The best that canbe said of it is that it added nothing ofvalue to the discussion.

Joseph V. Bencivenga, CPA (retired)Valhalla, N.Y. q

The Author Responds

My article was not meant as a “put-down,” but rather the exact oppo-

site. For the past 60 years, IntegrityAdvisors Pension Consultants has beenworking within the CPA community.My sister and I were groomed by myfather in this pension firm, and now so aremy sons. We have spent our careers ser-vicing the advisor community. I haveoffered seminars, lunch-and-learns, andone-on-ones with CPAs and their clients,trying to raise the level of awareness.

So while I respect and commendJoseph Bencivenga for his level ofknowledge and am assured that he advo-cated these qualified plan attributes to hisclients, I must respectfully disagree thattoday’s CPA/advisor community as awhole is advocating these valuable taxstrategies as common practice. I saythat not as criticism, but as a challengefor CPAs to educate themselves on whatthey can offer to their clients by recog-nizing the enhancements in theEconomic Growth and Tax ReliefReconciliation Act (EGTRRA) and thePension Protection Act (PPA) of 2006,which I alluded to in my article.

Of course I am not referring to all CPAs,and the tone of the article does not implythat. It is very challenging as an advisorwhen speaking to business owners who arein need of real tax shelter but have beentold by their CPA that they need to pur-chase more unneeded equipment/invento-ry, that they should open up a Simple or

SEP IRA, or worse yet that they shouldjust “pay the tax.” Clearly they needed amore sophisticated qualified retirementplan, such as a defined benefit plan or acombination/bifurcated defined bene-fit/401(k) profit-sharing plan based on theIRC section 404(a)(7) combined deductionlimits under the PPA, but their CPA wasunaware of this nuance. We are often askedto show a design to the client, he bringshis advisor, and time and time again, theclient sees a total contribution of not$50,000–$60,000, but several times high-er than the defined contribution limits perplan owner. He turns to his CPA andsays, “Why didn’t we do this sooner?”It’s frustrating to see.

My comment that, beginning in 1992,CPAs were not taught to view qualifiedretirement plans as resources for tax plan-ning, refers to a shift in focus from actu-arial design based on employeedemographic understanding, job classifi-cation, compensation limits, non–highlycompensated status, new com parability,and cross testing to the new, commodi-tized style of financial industry–spon-sored, payroll-sponsored, product- andmarket-driven retirement planning, a one-size-fits-all approach. When EGTRRAwas passed in 2001, the new breed ofCPA/advisor was so embedded in thatstyle of retirement plan that they did notrealize the annual changes that had beenphased in with the new law. EGTRRAchanged the face of retirement, but mostwere so focused on the usual way ofdoing things that they missed the oppor-tunities we were given. These provisions,made permanent by the PPA, allow us tocreate sophisticated designs for our clientsand business owners, thus allowing themlarger contributions and bigger deductionsand a way to catch up on retirement.That’s what I was talking about.

Matthew Gaglio, CPAPort Chester, N.Y. q

LETTER TO THE EDITORN&V

24 FEBRUARY 2016 / THE CPA JOURNAL

InFOCUS


Unsolved Problemsin AuditingUnsolved Problemsin AuditingBy Howard B. Levy

IN BRIEF

By Howard B. Levy

In 1961, Robert K. Mautz, a highly respected and accom-plished university professor and prolific author (and even-tual member of the Accounting Hall of Fame), wrote ThePhilosophy of Auditing, together with coauthor HusseinA. Sharaf, an Egyptian educator. The monograph (as it

was characterized by its publisher, the American AccountingAssociation) was a scholarly, intellectual analysis that advo-cated development of the then-elusive, integrated, conceptualframework or theory—a philosophy, if you will—to supportand guide the activities of auditors. In revisiting this work dur-ing the preparation of this article, this author was once againimpressed with its insightfulness and amazed at how little ofits content is obsolete, even though the work is now over 50years old.

Auditing was seen by many in 1961 as less of a professionalactivity and more of a “completely practical … series ofpractices and procedures, methods, and techniques” with lit-tle need for support from any cohesive, underlying theory or

IN BRIEFAuditing has been an ever-changing discipline since itsbirth over 100 years ago, but how much have the chal-lenges auditors face really evolved over the last half cen-tury? This article will review some of the problems inauditing that have stubbornly resisted solution sincethey were identified decades ago in The Philosophy ofAuditing, a 1961 landmark work by Robert K. Mautzand Hussein A. Sharaf. Despite the attempts of regula-tors and other efforts to address these issues over theyears, they remain familiar to auditors today, in the 21stcentury.

A Half-Century Retrospective and Update


set of principles. In seeking a unified phi-losophy, Mautz and Sharaf identified andlater explored what they called “some ofthe most vexing,” “perplexing,”“unsolved problems” that “plagued”auditing at that time.

Some of the Persistent ProblemsThe problems selected for discussion in

this article stand out among several thatstubbornly persist in auditing today andcontinue to get substantial attention frominvestors, reporters, auditors, standards set-ters, and regulators alike. Consider the fol-lowing short list of questions selectedfrom the monograph that should still seemquite familiar to today’s auditors: n Should a set of minimum proceduresbe required to be performed in everyaudit? Have not auditors, standards set-ters, and regulators long been debating(philosophically, one might say) whetherauditing standards should merely guideand encourage auditors as to the properuse of professional judgment in mattersof scope determination or should bemore rigid, prescriptive, and precise (likea “cookbook”) to preclude errors in judg-ment in such matters? In other words,should auditing standards be more prin-ciples based or rules based?n Are the tests and samples customari-ly relied upon sufficient to support anopinion? How many test items areenough?n What should be the auditor’s respon-sibility with regard to asset devaluations(impairments)? Have auditors not beenchallenged more than ever with problemsauditing fair value and other accountingestimates?n How far may the auditor go advocat-ing for a client’s interests in tax workor giving operating and financial adviceand still be independent? Is performingconsulting and other nonaudit servicesfor an audit client inconsistent with inde-pendence and, therefore, incompatiblewith auditing?

These are just a few of the manyissues about which Mautz and Sharaf stat-ed “the existence of so many fundamen-tal questions implies the absence ofaccepted principles which might serve asguides for their solution.” And there areothers mentioned or not mentioned in ThePhilosophy of Auditing (for example, thecontent of an audit report, the extent ofinternal control reporting, and the auditor’sresponsibility for discovering fraud).

Consulting Services and IndependenceIn the opinion of this author, the

independence question is the issue onefurthest from a resolution. Independencehas long been recognized as the corner-stone of the auditing profession.Moreover, it has long been universallyacknowledged that auditors must be inde-pendent not only in fact but also inappearance. Independence is the prima-ry—if not the sole—source of valueascribed by society to audit activity.

Foremost among the independencequestions explored philosophically byMautz and Sharaf in a chapter devotedentirely to the subject is whether the per-formance of consulting and other nonau-dit services is inconsistent with auditorindependence. For example, Mautz andSharaf examined doubts expressed bysome in the 1950s whether auditors try-ing to obtain favorable tax treatment forclients, thus acting as de facto clientadvocates before the IRS, was consistentwith the audit function.

The issue, in essence, is whether the per-formance of such nonaudit services cre-ates a mutual interest with clientmanagement, places the auditor in theposition of serving as part of management,or leads to the auditing of one’s own work.Mautz and Sharaf articulated the principalarguments of their day that supported thepractice (and that continue to prevail inlarge respect): 1) that there is a “real andsubstantial difference between givingadvice to management,” which manage-

ment is, of course, “at liberty to accept,modify, or reject,” and 2) that “becauseindependence is a state of mind, thecompetent auditor can maintain his per-sonal independence” (the weaker argu-ment, because it does not overcome anappearance of lack of independence).

From a regulatory standpoint, the sub-ject was approached cautiously by the SECin 1978 when it adopted a requirement forregistrants to disclose the dollar volume ofaudit fees versus fees earned by their audi-tors for tax and other nonaudit services,including consulting (Accounting SeriesRelease 250). In 1990, the SEC PracticeSection of the AICPA prohibited its mem-ber firms from providing SEC audit clientswith certain limited types of consulting ser-vices, consisting of psychological testing,public opinion polls, merger and acquisi-tion assistance, executive recruitment andactuarial services. In 2002, section 201 ofthe Sarbanes-Oxley Act (SOX) expresslyprohibited eight other nonaudit services forSEC issuer audit clients that would impaira firm's independence: 1) bookkeeping; 2)internal audit outsourcing; 3) valuation andrelated services; 4) financial informationsystem design and implementation; 5) ser-vice as a director, officer or employee, orin any decision-making, supervisory, orongoing monitoring function; 6) servicesas a broker or dealer, investment adviser,or investment banker; 7) legal services;and 8) expert or other advocacy services.These remain the only specific regulatoryprohibitions against consulting services byauditors of SEC registrants. Subject to cer-tain limitations imposed by the PCAOBon certain services previously performedinfrequently, tax services remain virtuallyuntouched.

Feeling the pressure to avoid threatsto its independence, also in 1990, oneof the then Big Six firms, ArthurAndersen, spun off its highly profitableand still-growing consulting division intoa separate partnership (see the August 4,2003, speech by retired Andersen part-

InFOCUS



ner Arthur R. Wyatt, “AccountingProfessionalism—They Just Don’t GetIt,” https://www.usi.edu/business/cehlen/WyattSpeech.pdf). Except for Deloitte,the others soon took steps to avoid offer-ing consulting services to their SEC auditclients. And then, between 2000 and2002, four of the then remaining BigFive (again, except for Deloitte) soldoff their IT consulting practices. Butsince late 2006, the largest accountingfirms have been rebuilding and expand-ing their consulting businesses, accord-ing to Francine McKenna, a reporterfor MarketWatch (published by DowJones & Co.). In 2011, she reported that,despite the foregoing list of prohibitedservices, the “level of enforcement ofthese independence prohibitions is prac-tically nil” (http://retheauditors.com/2011/03/02/auditors-and-consulting-claims-of-no-conflict-strain-credibility).

In 2012, McKenna cited “numerousexamples of audit firms still earning atleast as much of their fees from auditclients, or multiples of their audit fees,from what were, in my mind, supposedto be prohibited services to those com-panies.” She added, as an example,“auditors provide non-audit relatedadvice on GAAP and SEC reportingfor specific transactions and get paidextra for it. Who goes back to check andsee if they audited their own advice?”(h t tp : / /www. fo rbes . com/s i t e s /francinemckenna/2012/11/27/consulting-by-auditors-nyu-stern-ross-roundtable-explores-post-enron-reemergence). This author notes,however, that McKenna was incorrect inthat providing clients with “advice onGAAP and SEC reporting” is not a “pro-hibited service” and in fact, subject to cer-tain limited constraints, it is encouragedby the SEC staff:

The staff recognizes that questions arisein certain circumstances as to the prop-er application of accounting standards.… The staff believes that as long as man-agement, and not the auditor, makes the

final determination as to the accountingused, including determination of esti-mates and assumptions, and the auditordoes not design or implement account-ing policies, such auditor involvementis appropriate … [and] may positivelyimpact audit quality and the quality offinancial reporting” (Division ofCorporation Finance, Office of the ChiefAccountant, “Staff Statement onManagement’s Report on InternalControl Over Financial Reporting,”May 16, 2005; see also speech by V.Karapanos, Associate Chief Accountant,December 10, 2007, https://www.sec.gov/news/speech/2007/spch121007vk.htm).Despite the foregoing appearance of

inattention since 2006, the question ofpotential conflicts for auditors providingconsulting services continues to surfaceevery now and then. As recently asOctober 2015, former SEC ChairmanArthur Levitt wrote: “In recent decades,consulting assignments have served todiminish the aura of integrity and inde-pendence that is vital to public confidencein the profession. … The perception—ifnot the reality—of a conflict has createdtension between auditors, firms, and reg-ulators” (The CPA Journal, “Putting thePublic First,” October 2015, p. 16).

Auditors’ Judgment in Determining ScopeIn recent years, we have seen debates

among standards setters and their con-stituents and critics about whether the oper-ative professional standards should bemore rules based, governing and pre-scriptive, or principles based, allowingroom in more circumstances for the exer-cise of professional judgment. The earlyseeds of this controversy are evident inMautz and Sharaf’s 1961 analysis, inwhich they discuss the pros and cons ofstandardized audit programs and point toalternate views that either 1) express con-cern that rigid standards “may have a sti-fling effect on the individual judgment of

the practitioner” or 2) advocate unques-tioning acceptance of “inherently morereliable” products of careful deliberationsby an authoritative body. Julian E.Jacoby and Neal B. Hitzig point out in aJuly 2012 letter to the editor in The CPAJournal that “when ordered to bow to pre-vailing … ‘judgment’ that the Earth wasstationary, Galileo famously muttered,‘Nevertheless, it moves.’”

Like Mautz and Sharaf’s early obser-vations, the public debate over princi-ples-based versus rules-based standards,at least since Enron and SOX, havefocused more on accounting than audit-ing. According to FASB, “many assertthat the standards have become increas-ingly detailed and rules based (with‘bright-lines’ and ‘on-off’ switches)”(FASB Report, November 27, 2002). Thesame, however, may be (and has been)said about auditing standards.

Rules-based or prescriptive auditingstandards prevail in a regulatory frame-work and are characterized with many“unconditional” or “presumptivelymandatory” requirements that are to befollowed with little or no considerationhow the rules may be relevant to a par-ticular situation. In contrast, principles-based auditing standards arecharacterized by consistent guidelinesthat auditors are obligated to considerhow to apply in a given situation.While no body of auditing standards canbe said to be wholly one or the other,U.S. GAAS as issued by the AICPA’sAuditing Standards Board (ASB) areseen by many as more principles basedthan those standards recently issued orproposed by the PCAOB, which arefrequently seen by many as being toorules based (presumably in the perceivedinterest of protecting investors).

Those in favor of more prescriptive,rules-based auditing standards see themas improving the clarity and under-standability of auditing standards andaffording less risk of missing the proce-

dures necessary to ensure that all com-mon audit risks are adequately addressed.It is often argued that having more pre-cise requirements in auditing standardsleads to a higher level of uniformity inauditing and a corresponding improve-ment in audit quality, as well as makingit easier to monitor audit performanceagainst the standards.

On the other hand, the main argumentin favor of principles-based audit stan-dards is that more prescriptive stan-dards afford little or no opportunity orincentive for tailoring audit proceduresto a client’s particular situation. Overlyrules-based standards do not sufficient-ly encourage or allow for auditor judg-ment consistent with risk assessmentprinciples; this can be inefficient, lead-ing to the performance of mandatory pro-cedures when unwarranted by the risksand circumstances (i.e., overauditing, par-ticularly in audits of small entities withrelatively simple transactions). It can alsobe ineffective, because audit staff oper-ating in an overly prescriptive environ-ment will not gain the experiencenecessary to make sound judgments, andrules-based standards often do not pro-vide adequate guidance to auditors as tohow to apply such judgment with respectto determining scope. Furthermore, thereis a risk of underauditing attributable tothe low probability that auditors trainedand operating under an overly prescrip-tive system will have the skills necessaryto identify circumstances that should leadthem to perform audit procedures notexpressly mandated by the standards.

Among the primary characteristics ofa professional are the ability and accep-tance of responsibility to exercise soundprofessional judgment. Those opposed tomaking auditing standards too prescrip-tive argue that, in the long term, a grow-ing pattern of inflexible rules will causeaudit work to become mundane and rou-tine and ultimately result in a future gen-eration of less talented, checklist-driven

auditors capable only of a roboticapproach to auditing. Better candidatesfor entry into the profession will seekalternative careers that afford themgreater intellectual stimulation, challenge,and the opportunity to call upon one’sknowledge and experience to exerciseprofessional judgment.

How Many Are Enough?It has always been accepted that an

audit consists primarily of a series of testsof less than 100% of the items within anaccount balance or class of transactions.If this were not the case, it would beimpossible to complete financial auditstimely and at a reasonable cost. So in1961, Mautz and Sharaf stated that“auditing is also concerned with sam-pling and should naturally resort to astudy of the theory of statistics.”

But until the ASB’s Statement onAuditing Standards (SAS) 39, AuditSampling (now AU-C section 530 andthe PCAOB’s reorganized AS 2315),was issued in 1981, most auditors tend-ed to avoid statistical sampling in favorof relying indefensibly on their “profes-sional judgment”—generally based sole-ly on their number of years’experience—to determine how manyitems to test in what was generally called(incorrectly) a “sample.” Some termedthis inappropriately “judgmental sam-pling.” Others relied on a concept knownas “coverage”, wherein they tested thelargest dollar items in a population untiltheir professional judgment told themthat they had tested enough; this wasordinarily conducted without regard towhether the results of the test could prop-erly be projected to the untested portionof the population or whether it was toolarge to allow it to remain untested.These approaches—also generally inde-fensible if challenged—were probablyattributable to most auditors’ natural dis-comfort with statistical sampling, trace-able, most likely, to a lack of familiarity

with the underlying probability theory. SAS 39 effectively limited the use of

sampling (and the term “sampling”) tothe “selection and evaluation of less than100 percent of the population of auditrelevance such that the auditor expectsthe items selected (the sample) to be rep-resentative of the population and, thus,likely to provide a reasonable basis forconclusions about the population.”Because many auditor judgments mustbe made to enable proper sampling(including, but not limited to, determin-ing the proper sample size), the term“judgmental sampling” could no longerbe correctly used to describe audit pro-cedures that failed to meet the forego-ing definition; such procedures are moreproperly termed “nonsampling” proce-dures (see sections 1.21–.25 of the2014 edition of the AICPA audit guide,Audit Sampling). SAS 39 also showedthat if an auditor chose not to apply sam-pling, whether statistical or nonstatisti-cal, the untested population had to besubjected to other auditing proceduresif it was large enough to present a sig-nificant risk of material misstatement.

Following SAS 39, the use of samplingin auditing increased substantially for awhile. Nevertheless, there is evidence thatmany auditors continued to shy awayfrom it, most likely because they believedit often required sample sizes that weretoo large. Instead, they continued to pre-fer their “professional judgment” to deter-mine how many items to test. Critical oflanguage which suggests that “experienceand judgment” may be a valid basis fordetermining a minimum sample size(Audit Sampling, section 3.62), Jacobyand Hitzig maintain that this kind ofthinking amounts to “little more than avariation on an argument for guesswork,disguised as “judgment,” as a substitutefor [objective] measurability. … [thus]guesswork has been embedded in ageneric approach for determining theextent of testing, without any supportable


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basis in theory or fact” (“Letter to theEditor,” 2012).

In recent years, the PCAOB hasfocused on, observed, and criticizedpre–SAS 39 behavior in many firminspections, and it is now receiving atten-tion in peer reviews as well. Often, whenobserving the foregoing, PCAOB inspec-tors have typically concluded that por-tions of a population that remaineduntested were too large and so-called“sample” sizes were inadequate becausethey were not determined based on “(1)the relationship of the sample to the rel-evant audit objective, (2) tolerable mis-statement, (3) the auditor's allowable riskof incorrect acceptance and (4) charac-teristics of the population,” as dictatedby accepted statistical probability theo-ry and required by the PCAOB’s AUsection 350.16 (now AS 2315.16).Accordingly, the “sample” size was not“comparable to, or larger than, the sam-ple size resulting from an efficient andeffectively designed statistical sample,”as required by the PCAOB’s AU section23A (now AS 2315.23A).

Auditing Fair Value and Other Accounting Estimates

As Mautz and Sharaf touched uponbriefly in 1961, primarily with regard toasset impairments, auditing accounting fairvalue measurements and other account-ing estimates has long been a challengefor auditors. This has been particularlytrue over the past decade for several rea-sons, including the introduction of morecomplex financial instruments; theincreased volatility in economic condi-tions raising questions about the realiz-ability of asset carrying values; and,primarily, the proliferation of accountingstandards that caused a marked increasein the use of fair value estimates, both inmeasuring financial position and operat-ing results and in measuring required dis-closures. Examples of accountingestimates include allowances for doubtful

accounts, impairments of long-livedassets, valuations of financial and nonfi-nancial assets, and estimates of revenuesfrom contracts with customers. Whilesome accounting estimates may remaineasily determinable, others are inherently

subjective or highly complex and oftenentail considerable judgment, as well asgrowing reliance on the work of valua-tion or other specialists.

Auditing standards and practice guid-ance addressing, to varying degrees, the


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auditing of accounting estimates(broadly or narrowly) have been issued,superseded, and reissued frequently overthe years. Most recently, in a 2014Staff Consultation Paper (SCP), AuditingAccounting Estimates and Fair ValueMeasurements, the PCAOB sought pub-lic comment on proposed revisions to itscurrent standards in response to a per-ceived need for change for the follow-ing reasons: 1) increased use of estimatesas described above, 2) “significant auditdeficiencies in this area” observed withrespect to extant standards, and 3) con-cerns expressed by some auditors overperceived inconsistencies in existing stan-dards. The SCP contains the preliminaryviews of the PCAOB staff for replacingseveral extant standards with a singleauditing standard.

As evidence of the proposal’s contro-versy, the PCAOB received 42 letters ofcomment in response to the SCP.Significant among the responses was aletter from the AICPA-affiliated Centerfor Audit Quality (CAQ), which was crit-ical of the SCP because it saw it as “a‘one-size-fits-all’ solution to the issuesin these complex areas, and it may bechallenging to develop a single auditingstandard that would address all issuesrelated to auditing accounting esti-mates, including fair value measure-ments.” Many of the staff’s otherpreliminary views regarding the specif-ic, substantive changes needed were alsoaddressed by the CAQ’s letter; in thisauthor’s view, these issues should be ofsubstantially greater concern.

For example, the CAQ letter statedthat “it may be more appropriate to cre-ate overarching principles related toauditing accounting estimates, includ-ing fair value measurements, and addresscertain specific auditing issues or topicalareas (e.g., third-party pricing services)in a more targeted manner (possiblythrough the development of supplemen-tal guidance).” More significantly, the

CAQ advocated that a final standard givegreater recognition to an auditor’s riskassessment for determining the suffi-ciency and appropriateness of the auditscope and the cumulative nature of evi-dence to be sought and obtained. Theseviews are tantamount to advocating amore principles-based approach, as dis-cussed above.

Consistent with other views expressedby the CAQ, the Institute of ManagementAccountants (IMA) and several other com-mentators called for greater recognition ina final standard of the following realities:1) many accounting estimates, includingfair value measurements, could be subjectto a significant degree of estimation uncer-tainty, and 2) such inherent uncertainty willexist no matter how much audit effort isexpended. Accordingly, in various ways,many commentators suggested that anyfinal standard should not imply that anunrealistic level of precision should beexpected in an inherently imprecise mea-surement. These commentators believe thatneither auditors, users, nor regulators shouldbe encouraged to hold a view that there isor should be a single correct or most cor-rect estimate.

For example, Ernst & Young statedthat an auditor could not reasonablybe expected to eliminate inherent esti-mation uncertainty through the perfor-mance of additional audit proceduresnor conclude that “the subsequent out-come of a fair value measurement oran accounting estimate that deviatessignificantly from the recorded amountis an indicator of an audit failure.” Andthe IMA pointed out that an auditor’sobjective in auditing estimates shouldbe directed at obtaining evidence thatmanagement made appropriate use ofall available relevant information insupporting an estimate that is, there-fore, reasonable in the circumstancesand not seek a conclusion that therecorded estimate is the only reason-able or supportable estimate.

What Now?Although auditing standards have been

codified several times over the years, theprofession does not yet have a singleset of consistent auditing standards thatcould serve as an underlying philoso-phy to guide professional judgments andactivities in all circumstances. Instead,we are now dealing with multiple sets ofauditing standards—three in the UnitedStates alone, namely those promulgatedby the ASB, PCAOB, and the GAO (i.e.,the “Yellow Book”)—that still divergein many significant respects despite allthe efforts in recent years directedtowards international convergence.

The purpose of this article, however,was not to philosophize, as Mautz andSharaf did in 1961, but rather to brieflyrevisit a few of the more significant ofthe issues they raised to see whatprogress (if any) has yet been made toresolve them now that more than a halfcentury has passed. A great deal of time,energy, and thought has been expendedby bright and dedicated professionalsover that half century. But we still havea long way to go.

It is unfortunate that The Philosophyof Auditing is out of print because, in theopinion of this author, this resource isone of the best places to obtain a trueunderstanding of what auditors do (orshould do). Ideally, it should be read byevery auditor and every auditing stan-dards setter, educator, and regulator. TheAICPA library, housed at the Universityof Mississippi, has 10 copies availableto lend out. Get one and read it. q

Howard B. Levy, CPA, is a principaland director of technical services atPiercy Bowler Taylor & Kern, LasVegas, Nev. He is a former member ofthe AICPA’s ASB and its AccountingStandards Executive Committee, and acurrent member of the CAQ’s SmallerFirms Task Force and The CPAJournal’s Editorial Board.


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Audit DeficienciesRelated to InternalControlBy Thomas G. Calderon, Hakjoon Song, and Li Wang

The Sarbanes-Oxley Act of 2002 (SOX) created thePCAOB to oversee public company audits in theUnited States by establishing auditing standardsand registering and inspecting public company audi-tors. By the end of 2012, the PCAOB had registered

2,363 audit firms—1,452 U.S. firms and 911 foreign firms.In addition, the board conducts annual inspections ofaccounting firms that provide audit reports for more than 100public issuers, and at least one inspection every three years ofthose that provide audit reports for 100 or fewer publicissuers (SOX section 104 and PCAOB Rule 4003). In 2012,the PCAOB inspected nine annual firms (all U.S. auditors) and244 triennial firms (167 U.S. audit firms and 77 foreign auditfirms). These inspections evaluated the quality of audit workperformed on selected audit engagements and the accountingfirms’ quality control system. The PCAOB publishes an inspec-tion report for each inspection it conducts.

SOX section 404(a) requires management of public compa-nies to assess and report on the effectiveness of its internal con-trol over financial reporting (ICFR). In addition, SOX section

IN BRIEFAs part of its oversight mission, the PCAOB has soughtto improve the quality of U.S. public company audits.A major part of its focus has centered on auditors’assessments of companies’ internal controls over finan-cial reporting (ICFR), as required under the Sarbanes-Oxley Act of 2002. This article assesses whether auditquality has improved by looking at PCAOB inspec-tion reports containing ICFR-related audit deficienciesover the past decade and determining whether auditorsresponded to PCAOB criticism and remediated the defi-ciencies found. This review can provide independentauditors, management, internal auditors, and audit com-mittees with insight into the PCAOB’s evaluation ofproblem areas in internal control audits. In addition,auditors can avoid becoming targets of inspection reportswith ICFR-related audit deficiencies by paying closerattention to such areas.

An Analysis of PCAOB Inspection Reports


404(b) requires auditors to provide an inde-pendent opinion of clients’ ICFR. AuditingStandard (AS) 5, An Audit of InternalControl over Financial Reporting That IsIntegrated with an Audit of FinancialStatements, effective since November 2007,requires auditors to integrate audits of inter-nal control and financial statements, andprovide opinions on the effectiveness of acompany’s ICFR. It also requires auditorsto adopt a top-down risk-based approach

that emphasizes such vital areas as entity-level controls and high-risk items.

The PCAOB has continued to monitorthe implementation of AS 5 and pays closeattention to the quality of internal controlaudits (PCAOB Staff Audit Practice Alert11, http://bit.ly/1T1Mrft). Against this back-drop, the PCAOB publishes its findings dur-ing the inspection process and providesguidance and alerts for auditors regardinginternal control audits (PCAOB 2012Annual Report, “Report on 2007–2010Inspections of Domestic Firms that Audit100 or Fewer Public Companies,”http://bit.ly/ 1S2cHWe). Furthermore, 58%of the accounting-related federal class actionlawsuits filed in 2014 cited internal con-trols—the most frequently mentioned prob-lem in such cases—as an issue (Cominginto Focus: 2014 Litigation Study,PricewaterhouseCoopers, http://pwc.to/1Wrv4Vt). By contrast, 38% of the cases

mentioned revenue recognition (the sec-ond–most frequently cited item).

A Study of Inspection Reports

This article investigates audit deficien-cies related to ICFR, as documented in131 PCAOB inspection reports publishedfrom August 2004 to November 2013for inspection years 2002 through 2012.Using the Audit Analytics database, theauthors analyzed 2,047 completed

PCAOB inspection reports submitted bythe end of 2013. Of the 1,025 inspectionreports with audit deficiencies (about 50%)during this period, the authors identified131 ICFR-related deficiencies, composedof 89 U.S. inspection reports (40 U.S. audi-tors) and 42 foreign inspection reports (31foreign auditors).

The PCAOB found audit deficienciesamong a wide array of auditors. Big Fourauditors as a group, which audit thevast majority of listed U.S. companies,dominated the count with 35 inspectionreports (26.7%) that contained ICFR-related audit deficiencies. Other annual-ly inspected U.S. auditors followed (23inspection reports, 17.6%), includingsuch firms as BDO, Crowe Horwath,Grant Thornton, MaloneBailey, andMcGladrey. The remaining 73 inspec-tion reports disclosed ICFR-related auditdeficiencies for triennially inspected U.S.

auditors (23.6%) and auditors from 16different foreign countries (32.1%). Ofthose foreign inspection reports,Canada had the highest number (9.1%)with ICFR-related deficiencies, followedby India (4.6%) and Mexico (3.0%). Theresults seem to suggest that, in thePCAOB’s judgment, ICFR-relatedaudit deficiencies are prevalent, regard-less of auditor type.

Deficiencies in the Inspection Reports

The authors used Audit Analytics tocategorize each report into five types ofICFR-related audit deficiencies, thenhand-collected detailed descriptions fromthe inspection reports (http://pcaobus.org/Inspections/Reports/Pages/default.aspx).In some cases, the authors observed mul-tiple types of audit deficiencies in a sin-gle inspection report. Deficiencies intesting of design of controls or operatingeffectiveness of controls (94) were themost frequently cited, followed by defi-ciencies in the application of the top-down risk-based approach to the audit ofinternal control (53); information tech-nology (IT) consideration (40); the useof the work of others (28); and evaluat-ing identified control deficiencies (21).Exhibit 1 provides disclosure examplesof such deficiencies from the inspectionreports to highlight the nature of theissues observed by the PCAOB; how-ever, detailed descriptions about specif-ic problematic audit procedures andrelated remediation processes are notavailable in the inspection reports.Exhibit 1 also summarizes the PCAOB’ssuggestions to address each audit defi-ciency area (PCAOB Staff Audit PracticeAlert 11). The sections below briefly dis-cuss each major ICFR deficiency area.

Testing of design or operating effec-tiveness of controls. The PCAOBinspection reports document numerousdeficiencies in the testing of design of con-trols or operating effectiveness of con-trols of various accounts. AS 5 and AS 12,

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The PCAOB has indicated that auditors sometimes

fail to test all the relevant assertions of

significant accounts and disclosures.


EXHIBIT 1Audit Deficiencies Related to ICFR and PCAOB Guidance

PCAOB Guidance *

n Pay close attention to identify and sufficiently test relevant controls in the areas of revenue recognition, inventorypricing and reservation for excess and obsolete inventory, fair value of financial instruments, and pension planassets valuation. n Understand and evaluate whether the control satisfies the control objective, the factors affecting the precision of thecontrols, the steps involved in resolving significant differences from expectations, and the competence and authority ofthe person who performs the control to test the design effectiveness of a management review control (AS 5, para. 42).n Evaluate whether the control is working as designed, the competency and authority of the person performing the con-trols, the steps conducted to investigate significant differences, and the conclusions reached by reviewer to test the oper-ating effectiveness of a management review control (AS 5, para. 44).n Consider a few important factors in determining the amount of evidence needed for the roll-forward procedures—forexample, the nature and the risks associated with the control, results of the tests and the sufficiency of the evidence obtainedat an interim date, length of the roll-forward period, and significant changes since the interim date (AS 5, paras. 55, 56).

n Obtain a sufficient understanding of each component of internal control (control environment, risk management process,information and communication, control activities, and monitoring of controls) to identify likely sources and types of potential misstatements and design relevant test of controls and substantive procedures (AS 12, paras. 18, 21, and AS 15, para. 13).n Focus on entity-level controls, including the control environment and period-end financial reporting process, and controls thatare important to the auditor's conclusion about whether the company has effective ICFR (AS 5, paras. 22, 23, 26, 39, 41).n Select and test different controls when the components of a significant account or disclosure are subject to different risks of potential misstatement (AS 12, para. 63).n Plan and execute walk-throughs carefully to lead to adequate risk assessments and effective selection and testing of controls. n Evaluate whether entity-level controls provide sufficient evidence in lower risk locations and consider using the work of othersin determining the business units to perform test of controls in multi-location engagements (AS 5, paras. B11, B12).n Perform tests of controls directly to obtain evidence about effectiveness (i.e., cannot infer that a control is effec-tive because no misstatements were detected by subsequent procedures) (AS 5, para. B9).

n Obtain an understanding of the extent of manual controls and automated controls used, including IT general controls important to effective operation of the automated controls (AS 12, para. B1).n Obtain an understanding of specific risks to a company's ICFR resulting from IT (AS 12, para. B4).n Test IT-dependent controls and IT controls on which the selected control relies to support a conclusion aboutwhether it assess the risks of material misstatements when the effectiveness of the selected controls depends on system-generated data or reports (AS 5, paras. 39–41, 47).n Assess the effect of an IT control deficiency on important IT-dependent controls and the risks of material misstatements that could result, individually or in combination, when evaluating the severity of the deficient IT control.

n Use the work of others, depending upon the risk associated with the control being tested and the competence and objectivity of others (i.e., as the risk of control increases, the need for testing of control increases) (AS 5, paras. 18–19).n Consider complexity of the control, significance of judgments, and the inherent risks of the related account or assertion for assessing the risk associated with the control (e.g., in high-risk areas, such as complex controls,controls that address fraud risks, or controls that require significant judgment, use of work of others would be limited) (AS 5, para. 47).n Test and evaluate quality and effectiveness of others’ work when using it and perform more extensive testing of others’ work as risk increases or level of competence or objectivity decreases (AS 5, para. 16).

n Evaluate the effect of audit findings of substantive procedures in the financial statement audit on the effectiveness of internal control (i.e., identify and evaluate any specific control deficiencies related to identified misstatements) (AS 5, para. B8).n Evaluate the severity of each control deficiency to determine indicators of material weaknesses, potential magnitude of misstatements, and whether there is a reasonable possibility that the company’s controls will prevent or detect a misstatement (AS 5, paras. 62–65). n Evaluate whether compensating controls associated with identified deficient control address the risk of material misstatement to the relevant assertion.

Selected Disclosure Examples

n Failure to perform sufficient procedures to test design andoperating effectiveness of issuer's ICFR related to loansn Failure to perform sufficient procedures to test oper-ating effectiveness of an important management reviewcontrol related to a reinsurance assetn Procedures to extend the interim conclusions onaccounts receivable to year-end were insufficient, asthey failed to identify that the roll-forward analysisincluded an incorrect adjustment in excess of theestablished level of materiality and excluded certainother adjustments that should have been included

n The firm relied on certain entity-level controls toreduce extent of its testing at individual locations; how-ever, it failed to test the controls. It also failed to assessthe risks of material misstatement associated with loca-tions at which no testing was performed and determinewhether those locations presented a reasonable possi-bility of a material misstatement.n Failure to identify and test the design and operatingeffectiveness of internal controls for purposes of itsaudit of internal control over financial reporting toaddress the assessed risk of misstatement to the valua-tion of equity instruments issued by the issuer

n Failure to perform and document test of an issuer'selectronic data processing general and application controls in a complex environmentn Failure to test adequately IT controls

n Failure to evaluate the quality and effectiveness of aninternal auditor's work sufficiently to support the use ofthat workn Failure to perform and document audit procedures totest the effectiveness of controls identified by a serviceauditor's report as required by user organization con-trols; failure to evaluate control effectiveness for theperiod not covered by the service auditor's report

n Failure to perform sufficient procedures to evaluatethe severity of identified control deficienciesn The firm concluded that the related deficiency in the issuer's control over the reporting of oiland gas assets was a significant deficiency, noting thatthe control activity had occurred and that the error didnot have any effect on cash or cash flows. It failed,however, to perform an appropriate evaluation of theseverity of the deficiency.

Types of Audit

Deficiencies

(Numbers of Times

Cited)

Testing of design of controls or operating effectiveness of controls(94)

Top-down risk-based approach (53)

IT consideration(40)

Use of work of others(28)

Evaluating identified controldeficiencies(21)

* Note: PCAOB guidance on the audit deficiencies is adapted from “Considerations for Audits of Internal Control over Financial Reporting,” PCAOB Staff Audit Practice Alert 11, 2013,http://pcaobus.org/Standards/QandA/10-24-2013_SAPA_11.pdf.



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Identifying and Assessing Risks of MaterialMisstatement, require auditors to firstobtain an understanding of internal con-trols designed to prevent and detectmaterial misstatements, which should thenhelp them select relevant controls to testfor the identified risk. AS 5 cautions thatauditors cannot infer effectiveness becauseno misstatements were detected by sub-stantive procedures; instead, they shouldobtain direct evidence about a control’soperating effectiveness. The PCAOB iden-tified several cases where auditors didnot perform important assessments.Furthermore, the PCAOB has indicatedthat auditors sometimes fail to test all therelevant assertions of significant accountsand disclosures (PCAOB Staff AuditPractice Alert 11).

Management review controls. Insome cases, the inspection reports havedisclosed audit deficiencies related todesign or operating effectiveness of man-agement review controls. Managementreviews are usually performed to com-

pare actual results with forecasted or bud-geted revenues and expenses and toinvestigate significant differences fromexpectation. Auditors often test man-

agement review controls in internal con-trol audits to obtain evidence about thecontrols’ design and implementation toprevent or detect misstatements. The

PCAOB points out that CPA firmshave placed undue emphasis on testingmanagement review control in someinstances without considering whetherthese controls adequately addressed therisks of material misstatements (PCAOBStaff Audit Practice Alert 11).

Roll-forward procedure of controls.In other cases, the PCAOB has disclosedaudit deficiencies related to roll-forwardof controls tested at an interim date. Theboard noted instances where firms didnot perform any testing or used inquiryalone for assessing the effectiveness of roll-forward procedures, despite high inherentor fraud risks associated with these con-trols. AS 5 requires auditors to performroll-forward procedures to update theresults of interim testing to year end. Italso notes that inquiry might be a suffi-cient roll-forward procedure for low-risksituations but is unlikely to be sufficientwhen the evaluation of the above-men-tioned factors suggests otherwise. This isparticularly true when—n the control is related to items that arehigh risk, complex, subjective, or nottested extensively at the interim date;n exceptions were identified in the inter-im testing; n the roll-forward period is long; or n significant changes occurred duringthe roll-forward period.

The findings suggest that auditorsshould perform more thorough evalua-tions of the design and operating effec-tiveness of management review controls.In particular, such evaluations shouldassess and draw inferences about proce-dures involved in resolving significantdifferences from expectations, the com-petence and authority of the personwho performs related test controls, andthe conclusions reached by the review-er. Furthermore, auditors need to assessthe risk associated with roll-forward pro-cedures and use evaluation approachesthat go well beyond mere managementinquiries when an auditor considers risk

EXHIBIT 2Types of Audit Deficiencies Related to ICFR and Auditor Type

Big Four Other Annually Triennially

Types of Audit U.S. Inspected U.S. Inspected U.S. Foreign

Deficiencies Auditor Auditor Auditor Auditor Total

Testing of design 28 17 20 29 94of controls or operating effectiveness of controls

Top-down risk- 20 16 10 7 53based approach

IT consideration 23 11 3 3 40

Use of work of 12 9 5 2 28others

Evaluating 11 7 0 3 21identified controldeficiencies

The findings suggest that auditors should

perform more thoroughevaluations of the design

and operating effectivenessof management review controls.


to be high. Such closer attention to high-risk rollovers is consistent with AS 5,which requires auditors to use more per-suasive evidence as risk increases.

Top-down risk-based approach. AS 5requires the use of a top-down risk-basedapproach for the internal control audit. Thisapproach, which is important for per-forming effective internal control audits,refers to the sequential thought process thatauditors should employ in identifying risks.A top-down risk-based approach beginsat the financial statement level and focus-es on entity-level controls, then on signif-icant account–level controls, andaccount-level controls. Examples of enti-ty-level controls include controls of the con-trol environment, risk-management process,monitoring control, and period-end finan-cial reporting processes (AS 5).

PCAOB inspection reports haveidentified many audit deficiencies in theauditors’ use of a top-down risk-basedapproach. Disclosure examples showthat auditors failed to test entity-levelcontrols and period-end financialreporting processes. In addition, sev-eral auditors failed to properly assessthe risk of misstatements in variousaccounts.

Risk assessment is a key element ofthe audit of internal control: identifyingthe risks of material misstatement isessential for the auditor in planning andselecting relevant controls to test and inappropriately evaluating those controls(PCAOB Staff Audit Practice Alert 11).The risk assessment process includesunderstanding the company, its busi-ness processes, and related internal con-

trol and assessing the likely sources, thetypes, the likelihood, and magnitude ofpotential misstatements based on theidentified risks (AS 12; PCAOB StaffAudit Practice Alert 11). Employing atop-down mindset is challenging becausean auditor frequently performs an auditin distinct steps built around financialstatement components and might notdevelop the mindset to think sequential-ly about risk, starting at the highest leveland working down to specific asser-tions that might point to the likelihoodof material misstatements.

IT consideration. Many companiesrely on IT, such as enterprise resourceplanning (ERP) systems to processaccounting data—and the role of IT iseven more important in internal controlaudits. Auditors should identify IT risks

EXHIBIT 3Areas of Audit Deficiency by Auditor Type

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Big Four U.S. auditor Other annually inspected U.S. auditor Triennially inspected U.S. auditor Foreign auditor

Evaluating identifed control deficiencies

Use of work of others

Information technology consideration

Top-down risk-based approach

Testing of design of controls or operating effectiveness of controls



and assess general and application ITcontrols as an integral part of the top-down risk-based approach used in thefinancial statement audit. The PCAOBexpects auditors to understand how ITaffects a company's flow of transactionsand “obtain an understanding of specif-ic risks to a company's internal controlover financial reporting resulting fromIT” (AS 15, Audit Evidence, para B4).

Inspection reports have identified sever-al audit deficiencies related to the IT con-sideration. According to the PCAOB inStaff Audit Practice Alert 11, some auditfirms failed to 1) “test information tech-nology general controls (ITGC) that areimportant to the effective operation of theapplications that generated the data orreports,” 2) “test the logic of the queries (orparameters) used to extract the data orreports,” or 3) “address control deficienciesthat were identified with respect to the

ITGCs over either the applications that pro-cess the data used in the reports or the appli-cations that generated the reports.”

The use of work of others. Auditors canmore extensively use the work of compe-tent and objective third parties in low-risk areas because as the risk decreases,the necessary level of competence andobjectivity decreases (AS 5). On theother hand, auditors should performmore extensive testing of the work doneby third parties in high-risk areas involv-ing significant judgment and fraud risk,particularly when the competency of thosethird parties is judged to be low.

The PCAOB disclosed several auditdeficiencies related to the use of the workof others (e.g., internal auditor and ser-vice auditor). These auditors relied ontests of controls performed by third par-ties without a sufficient basis for usingthese works. The PCAOB commented,

in some instances, “the extent to whichfirms used the work of internal audit inhigher risk areas involving significantjudgment, such as aspects of revenue andthe valuation of complex, hard-to-valueinvestment securities, was inappropriate”(PCAOB Staff Audit Practice Alert 11).The board also noted that some audi-tors did not redo any of the tests ofcontrols performed by the clients’ inter-nal auditor and did not have documen-tation of the nature, timing, and extentof that control testing. In addition, thePCAOB reports disclosed that someauditors did not perform sufficient testsof controls of service organizations whenrelying on the service auditor’s reportand did not assess an interaction betweena service organization’s control and acompany’s control.

Evaluating identified control defi-ciencies. Auditors should perform suffi-

InFOCUS

EXHIBIT 4Audit Deficiencies Related to ICFR by Year

Year Period

Types of Audit Before After

Deficiencies 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 AS 5* AS 5† Total

Testing of design of 1 9 4 4 2 2 9 12 19 27 5 20 74 94controls or operating effectiveness of controls

Top-down risk- 1 5 6 0 4 3 6 5 11 9 3 16 37 53based approach and audit of internal control

IT consideration 1 4 6 2 0 2 4 2 9 6 4 13 27 40

Use of work of 0 4 2 1 0 0 3 5 7 5 1 7 21 28others

Evaluating identified 0 0 1 2 1 2 2 3 5 5 0 4 17 21control deficiencies

* 2002–2006† 2007–2012


cient evaluations to determine whetheraudit findings related to the substantiveprocedures in the financial statementaudits are indicators of the existence ofcontrol deficiencies. They should alsoevaluate the severity of identified con-trol deficiencies to the existence of mate-rial weaknesses of internal controls andthe related magnitude of material mis-statements.

PCAOB inspections indicate that audi-tors fail to evaluate the severity of iden-tified control deficiencies. The PCAOBprovided examples of failure in evaluat-ing identified control deficiencies, includ-ing that auditors did not 1) “sufficientlyevaluate whether audit adjustments andexceptions identified from substantiveprocedures were indicators of the exis-tence of control deficiencies”; 2) “con-sider all of the relevant risk factors thatshould have affected the determinationof whether there was a reasonable pos-sibility that a deficiency, or a combina-tion of deficiencies, could result in amaterial misstatement”; 3) “consider allof the relevant factors that should haveaffected the determination of the mag-nitude of potential misstatements”; or4) “sufficiently evaluate compensatingcontrols, including identifying and test-ing those controls and determiningwhether they operated at a level of pre-cision that would prevent or detect a mis-statement that could be material” (StaffAudit Practice Alert 11).

Deficiencies by Auditor Type

Exhibits 2 and 3 present ICFR-relatedaudit deficiencies by auditor type. BigFour auditors were relatively more fre-quently cited for deficiencies related tothe evaluation of identified control defi-ciencies and assessment of IT issues.Surprisingly, no triennially inspected U.S.auditors were cited for shortcomings inevaluating identified internal control defi-ciencies. Another interesting observa-tion is that foreign auditors were cited

relatively more frequently for deficien-cies in testing of design of controls oroperating effectiveness of controls.

Deficiencies by Year and Period

Exhibit 4 presents the various types ofICFR-related audit deficiencies by yearand period (defined as before and after AS5). The PCAOB generally inspects auditengagements one year after completion ofthe audit; thus, clients’ financial statementsin the year before inspections were usedfor classification by year and period. Auditdeficiencies related to ICFR of all typesoccurred more frequently in the period fol-lowing AS 5 (2007–2012) than in the peri-od before (2004–2006). This might beattributed to auditors applying the salientfeatures in AS 5 (top-down risk-basedapproach, using work of others, and test-ing of design of controls or operating effec-tiveness of controls) improperly(Observations from 2010 Inspections ofDomestic Annually Inspected FirmsRegarding Deficiencies in Audits ofInternal Control over Financial Reporting,http://bit.ly/1U9UNA4). In an alternativeinterpretation, the PCAOB might havestrengthened its processes for inspectionsof internal control audits and identifiedmore audit deficiencies related to ICFRafter AS 5.

Remediation of Deficient Audits

In general, it appears that auditorswere not responsive to the PCAOB’sfeedback on their audits of ICFR anddid not remediate observed deficien-cies by the next inspection. Of the 131inspection reports containing deficientaudits related to ICFR, 16 auditors—8 annually inspected U.S. auditors and8 foreign auditors, representing 75inspection reports—had multipleinspection reports containing ICFR-related audit deficiencies. In compar-ison, 10 inspection reports withICFR-related audit deficiencies wereremediated by the next PCAOBinspections. Of the 10 subsequentreports, 6 were clean reports withoutany audit deficiencies and 4 containedother audit deficiencies that are notrelated to ICFR. No information aboutthe outcomes of subsequent inspec-tions was available for the remaining46 deficient ICFR audits as of the endof the period examined (December 31,2013). Based on the available infor-mation, it seems that auditors do notadequately address the ICFR-relatedaudit deficiencies pointed out by thePCAOB inspections and improve thequali ty of subsequent audits ofICFR.

In general, it appears that auditors were not

responsive to the PCAOB’s feedback on their

audits of ICFR and did not remediate observed

deficiencies by the next inspection.



InFOCUS

Next Steps

Audit deficiencies related to ICFRseem to be prevalent among all auditortypes, including both U.S. and foreignauditors. The data indicate that defi-ciencies in testing design or operatingeffectiveness of controls (94) are themost frequently cited deficiency, fol-lowed by deficiencies in applications ofthe top-down risk-based approach (53),IT considerations (40), the use of work

of others (28), and evaluating identifiedcontrol deficiencies (21). In general,auditors were not responsive to thePCAOB’s feedback on their ICFR audits,and many did not remediate identifiedICFR-related deficiencies by the subse-quent inspections. The reasons for theinadequate response by auditors areoutside the scope of this article.Nonetheless, this issue merits furtherresearch—both the PCAOB and the pro-fession would benefit a great deal fromunderstanding the dynamics that lead thisaspect of the regulatory process to fail.

This review and discussion of theaudit deficiencies identified in the inspec-tion reports should benefit external audi-tors as they plan the audit and test ICFRproperly to avoid receiving inspectionreports with ICFR-related audit deficien-cies in the future. Management, audit com-

mittees, and internal auditors can benefitas they plan, execute, monitor, and assessICFR systems. AS 16, Communicationswith Audit Committees, emphasizes theimportance of two-way communicationsbetween the auditor and the audit com-mittee in order to enhance the relevanceand effectiveness of those communica-tions. Audit committees can consider dis-cussing problem areas related to internalcontrol audits with the external auditor and

use the PCAOB’s guidelines as a frame-work for assessing how problems arebeing addressed. The agenda for conver-sations between the auditor and the auditcommittee could, among other things,highlight 1) assessment of the design oroperating effectiveness of controls; 2) themethods used to assess controls, includinga top-down risk-based approach; 3) ITconsiderations; 4) use of and reliance onthe work of others; and 5) the auditor’sassessment of the nature and significanceof identified control deficiencies.

PCAOB inspection reports do not dis-close a detailed remediation process ofICFR-related deficiencies, though audi-tors, internal auditors, and managementwould likely benefit from such disclo-sures. At the very least, disclosures couldassist with identifying the issues andminimizing the risk of repeating defi-

ciencies. In the authors’ opinion, it wouldbe helpful to the profession as well asregistrants if the PCAOB discloseddetailed remediation processes for ICFR-related deficiencies.

Recently, many companies have expe-rienced changes in auditors’ approachesto internal control audits as a result ofPCAOB inspections; in some cases,auditors have performed additional pro-cedures related to previously issued auditopinions on ICFR (Jeanette M. Franzel,“Effective Audits of Internal Control in the Current ‘Perfect Storm,’”http://bit.ly/23cSwu2). Such changes ofaudit methodologies and additional auditstaff training could increase audit fees.On the other hand, the PCAOB’s con-tinuous efforts on identifying problemsof internal control audits and encourag-ing remediation of ICFR-related auditdeficiencies could improve the quality ofinternal control audits and financial state-ments. Further investigation is needed asto whether PCAOB inspections ofinternal control audits affect audits ofinternal control as well as the fees asso-ciated with the audit. The Committee ofSponsoring Organizations of theTreadway Commission (COSO) issueda new internal control framework in2013, with the original 1992 COSOframework being superseded onDecember 15, 2014. It will be interest-ing to see whether any meaningfulchanges in the quality of auditors’ eval-uations of internal control systems resultfrom the new COSO framework—aswell as how it might affect the PCAOB’sapproach to inspections. q

Thomas G. Calderon, PhD, is a pro-fessor of accounting & chair, HakjoonSong, PhD, CPA, is an assistant pro-fessor of accounting, and Li Wang, PhD,CPA, is an associate professor ofaccounting, all in the George W. DaverioSchool of Accountancy at the Universityof Akron, Akron, Ohio.

Both the PCAOB and the profession would benefit a

great deal from understanding the dynamics that lead

this aspect of the regulatory process to fail.


FEBRUARY 2016 / THE CPA JOURNALIt’s Never Too Early to Reserve Your Seat!

Attend Live or OnlineVisit nysscpa.org/gaac16 or call 800-537-3635 to Register

Register for the

Government Accountingand Auditing Conference

Tuesday, 5.10.16


ACCOUNTING AND AUDITING I accountingA&A

Changes to Going ConcernDisclosuresAccounting Guidance Shifts Responsibilities to Management

H istorically, auditors of financial statements havebeen charged with the assessment of an entity’sability to continue as a going concern (see AU

341, “The Auditor’s Consideration of an Entity’sAbility to Continue as a Going Concern”). Butnowhere in U.S. GAAP was management specifical-ly charged with this responsibility, even though man-agement has overall responsibility for the financialstatements. Some would assert that encumbering theauditor with primary responsibility for monitoringgoing concern creates a serious lack of auditor inde-

pendence, because the auditor is charged with assum-ing a management-type responsibility. This is about tochange.

In August 2014, FASB released ASU 2014-15,Disclosure of Uncertainties about an Entity’s Ability toContinue as a Going Concern [Accounting StandardsCodification (ASC) 205-40]. This new standard specif-ically requires management to evaluate going concernand make disclosures in the notes to the financial state-ments when appropriate. The auditor will, in turn, auditmanagement’s disclosures.

By Kayla D. Booker and Quinton Booker

This article covers the major provi-sions of this new standard, which will beeffective for fiscal years (and interim peri-ods) ending after December 15, 2016, withearly application permitted. ASU 2014-15does not replace existing auditing guid-ance on going concern. Moreover, the newaccounting standard is not totally alignedwith the existing auditing standards, andthe independent auditor must addresswhether it is appropriate to add an empha-sis paragraph to the audit report regard-ing going concern. The PCAOB and theAICPA Auditing Standards Board(ASB) both have projects on their agen-das that have the potential to address dis-closure differences and related auditorreport issues before the effective date. Thisarticle highlights several major differencesbetween the accounting standard and exist-ing auditing guidance.

Overview of ASU 2014-15ASU 2014-15 includes a decision

flowchart that provides a high-leveloverview of amendments to the ASC madeby the new guidance on going concern.As indicated earlier, this standard providesguidance to management—not auditors.

The initial step in the process is for man-agement to ensure that the entity is not oper-ating within the scope of ASU 2013-07,Presentation of Financial Statements:Liquidation Basis of Accounting. Per ASU2013-07, once liquidation is deemed “immi-nent,” an entity must adopt the liquidationbasis of accounting. An entity would beoperating within the scope of ASU 2013-07, for example, if a plan of liquidationhas already been approved by the board ofdirectors of the entity and the probabilityis remote that the entity will return fromliquidation. Hence, once an entity has adopt-ed the liquidation basis of accounting, goingconcern is no longer at issue.

Assuming that liquidation is notimminent, ASU 2014-15 mandatesthat management ask whether there

are conditions or events, considered inthe aggregate, that raise “substantialdoubt” about the entity’s ability tocontinue as a going concern within

one year after the date financial state-ments are issued. An affirmative answerto this question triggers the requirementfor disclosures. The specific disclosuresneeded are a function of whether man-agement’s plans to mitigate the condi-tions or events that raise substantialdoubt will alleviate substantial doubt.Management must ask two questionsconcerning their plans: n Is it probable that plans will be effec-tively implemented within the assessmentperiod? n Is it probable that plans will mitigatethe relevant conditions or events thatraise substantial doubt within the assess-ment period?

An affirmative answer to both of thesequestions with an overall assessment thatsubstantial doubt is alleviated would requiremanagement to provide note disclosure ofthe challenges the entity faced before con-sideration of management’s plans, theirevaluation of the significance of said chal-lenges, and their plans that alleviate sub-stantial doubt. The lack of an affirmativeresponse to one or both of these questionswill necessitate disclosures concerning chal-lenges the entity faces, the significance ofsaid challenges, and management’s plans

intended to mitigate the challenges. Moreimportantly, an explicit disclosure that thereis substantial doubt about the entity’s abil-ity to continue as a going concern within

one year after the date the financial state-ments are issued will be required.

The Initial ‘Substantial Doubt’ Determination

ASU 2014-15 adds the term and def-inition of “Substantial Doubt about anEntity’s Ability to Continue as a GoingConcern” to the ASC. The definitionreads as follows:

Substantial doubt about an entity’s abil-ity to continue as a going concernexists when conditions and events, con-sidered in the aggregate, indicate that itis probable that the entity will beunable to meet its obligations as theybecome due within one year after thedate that the financial statements areissued (or within one year after the datethat the financial statements are avail-able to be issued when applicable). Theterm probable is used consistently withits use in Topic 450 on contingencies.It is important to note the following

regarding the initial assessment: n The substantial doubt determinationconcerns the entity’s likely inability tomeet its obligations. n “Probable” is used in the definitionto indicate “likely to occur.”

43FEBRUARY 2016 / THE CPA JOURNAL

This new standard specifically requires management to evaluate going concern and make

disclosures in the notes to the financial statementswhen appropriate. The auditor will, in turn,

audit management’s disclosures.

n Because management is alreadyresponsible for disclosing importantevents and circumstances occurring afterthe balance sheet date, but before finan-cial statements are issued (the subsequentevents period), FASB decided to makethe assessment period one year after thedate the financial statements are issued.As discussed further below, this providesa going concern assessment thatextends farther into the future—that is,the subsequent events period plus theone-year look-forward period—than iscurrently provided by auditing standards. n The definition includes “available tobe issued” to cover nonpublic entitiesthat may not officially issue financialstatements but are covered by the stan-dard. As indicated earlier, the going con-cern assessment applies to each annualand interim reporting period.

In the basis for conclusions of ASU2014-15, FASB acknowledged that thesubstantial doubt determination involvesa significant degree of judgment—qual-itative and quantitative informationshould be considered regarding condi-tions and events “known and reasonably

knowable.” Amendments to the ASCcontain several examples of items to con-sider in determining whether substantialdoubt exists. Examples include the enti-ty’s current financial conditions, obliga-tions due or anticipated, funds necessaryto maintain the entity’s operations, reg-ulatory issues, legal issues, natural dis-asters, and workforce issues.

Equally important, in its backgroundinformation and basis for conclusions,FASB indicates that an extensive anal-ysis concerning going concern may notbe necessary at the end of each periodfor every entity. This may be applicable,for example, when an entity has a his-tory of profitable operations and cashflow from operations, existing resourcesthat are more than adequate to meet obli-gations, and known access to financialresources if needed. On the other hand,an entity with a long history of operat-ing losses and negative cash flow fromoperations, a liquidity deficiency, andsigns that indicate that it would be dif-ficult to acquire additional resourceswould likely need an extensive analysisaddressing going concern. Entity-spe-

cific facts and circumstances must beconsidered in deciding the level ofanalysis necessary.

Management’s Plans and Substantial Doubt

As indicated earlier, when an initialassessment indicates that substantialdoubt exists, management plans, if any,must be considered to determine the spe-cific disclosures necessary. These plansshould be considered only after they havebeen fully implemented at the financialstatement issuance date. Arguably, man-agement has the best knowledge ofconditions and events giving rise tosubstantial doubt and whether their plansalleviate substantial doubt or only miti-gate substantial doubt. Our earlieroverview lists the disclosures necessaryin each case.

The implementation guidelines andillustrations of ASU 2014-15 provideexamples of plans that management mayhave implemented to address substantialdoubt. Examples include plans to disposeof assets, borrow money or restructuredebt, reduce or delay expenditures, and


ACCOUNTING AND AUDITING I accountingA&A

EXHIBITASU 2014-15 versus Auditing Guidance (PCAOB AU 341 and AICPA AU-C 570)

Item ASU 2014-15 Auditing Guidance

Definition of “substantial doubt” Explicitly defined as conditions and events, Not explicitly defined and no specificconsidered in the aggregate, that indicate threshold (e.g., more likely than not, that it is probable that an entity will not be probable) provided relative to substantial able to meet its obligations that come due doubt; indicators of substantial doubt within one year from the date that the are providedfinancial statements are issued or available to be issued

Frequency of assessment Annual and interim periods Annual audit periods

Assessment (look-forward) period One year from the date that the financial A reasonable period of time not to statements are issued or available to be exceed one year from the balance issued sheet date

increase ownership equity. The standard also addresses some ofthe issues that must be raised in evaluating the feasibility ofsaid plans. For example, assume that management’s sole plan isto dispose of assets. Several questions must be addressed. Arethere restrictions on disposal of said assets? Are the assets notmarketable? Will the disposal have a negative effect on thebusiness? An affirmative answer to these questions might sug-gest that substantial doubt is not mitigated, nor is it alleviated.On the other hand, assume that the asset is an investment in asubsidiary and it is probable that the business can be sold. Furtheranalysis of the potential transaction could alleviate substantialdoubt. Again, a significant amount of judgment may be neces-sary to assess management’s plans and the implications for mit-igating or alleviating substantial doubt.

Accounting Standards versus Auditing Standards For decades, auditors have evaluated going concern and

the need for related disclosures and audit report modification,as mandated by the PCAOB’s AU 341 and the AICPA’sAU-C 570. FASB took a bold step forward with ASU 2014-15. Though the existing auditing guidance is the basis for thenew accounting guidance, there are a few key differences, sum-marized in the Exhibit.

First, ASU 2014-15 defines substantial doubt and includesa “probable” (likely) threshold in the definition. Auditing guid-ance provides sample indicators of substantial doubt but doesnot provide a definition. FASB defined substantial doubt toreduce the subjectivity in its interpretation that may be inher-ent in the auditing guidance. Second, ASU 2014-15 requiresthat management assess substantial doubt both annually andeach interim reporting period. The auditing guidance general-ly provides for an annual assessment. Thus, ASU 2014-15mandates a rolling assessment to provide more relevantinformation for those entities that issue interim financialstatements or have them available to be issued. Third, whileboth the accounting and auditing standards provide for one-year look-forward periods, they use different anchors. ASU2014-15 uses one year from the date that the financial state-ments are issued or available to be issued as its anchor.Auditing standards use one year from the balance sheet dateas the anchor. ASU 2014-15 is written to provide a more rel-evant going concern assessment.

Filling the ‘GAAP’ASU 2014-15 represents a major step in the right direction

for the accounting profession. Management—not the inde-pendent auditor—has primary responsibility for the financialstatements. Thus, management should have primary responsi-

bility for addressing going concern, and the independentauditor should audit management’s assessment. ASU 2014-15establishes the “accounting rules” for the assessment.Because the auditing standard on going concern has been inplace for decades, it is understandable that accounting andauditing standards are not totally aligned. Despite theseinconsistencies, which hopefully will be resolved before theeffective date, FASB has definitely stepped up to the plate andfilled in the “GAAP.” q

Kayla D. Booker, PhD, CPA, is an assistant professor of account-ing at Rhodes College, Memphis, Tenn. Quinton Booker, PhD,CPA, is the BankPlus Professor and chairman of the depart-ment of accounting at Jackson State University, Jackson, Miss.He has served on the AICPA Board of Directors, the MississippiSociety of CPAs Board of Governors, the AICPA Board ofExaminers, Chairman of the FAR section of the CPA Exam, andMississippi State Board of Accountancy.


Changes to Going Concern Disclosures


ACCOUNTING AND AUDITING I standards settingA&A

The Going Concern Gap in U.S. GAAPFilling a Hole in Existing Standards

Recent events, such as the fiscal crisis of 2007–2008and the economic recession that followed, haveprompted concerns about whether investors have

received sufficient notice of impending corporate bankrupt-cy. According to data available from New GenerationResearch, from 2009 to 2013, 561 public companies filed forbankruptcy, and investors had little, if any, warning in somecases (see http://www.bankruptcyrates.com). As a result, theauditing profession has been called out by some for failingto warn financial statement users of the potential for bankrupt-cy. Anne Simpson, senior portfolio manager and investment

director, global governance at the California PublicEmployees’ Retirement System (CalPERS), called out thefailures of the current system at a roundtable meeting of theIASB. She stated, “A going concern warning from an audi-tor is rarer than a hen’s teeth. You have to be dangling offa cliff, hanging on by your fingernails before the auditor blowsthe whistle.” Simpson added that “what should be an extreme-ly useful form of audit communication to capital providers,it seems to us is not being used (Emily Chasan, “GoingConcern Opinions on Life Support with Investors,” CFOJournal, Sept. 12, 2012).

By Jennifer Edmonds, Ryan Leece, and James Penner

Background

Academic research suggests that40% of public company bankruptcies arenot preceded by audit reports modifiedfor going concern uncertainties. Inaddition, research indicates that auditorshave increased the frequency of issuinggoing concern reports in the last decade(E. Carson, N. L. Fargher, M. A. Geiger,C. S. Lennox, K. Raghunandan, and M.Willekens, “Audit Reporting for Going-Concern Uncertainty: A ResearchSynthesis,” Auditing: A Journal ofPractice & Theory, vol. 32, supp. 1,2013, pp. 353–384). However, share-holders in favor of early warningsdemand more than the auditor’s report.Given that management is most famil-iar with the entity’s condition, many havecalled for management to assess the enti-ty’s future viability.

The idea of shifting responsibility tomanagement had been considered byFASB for many years and was recentlyfinalized in Accounting StandardsUpdate (ASU) 2014-15, Presentation ofFinancial Statements—Going Concern(Subtopic 205-40). The new standardrequires management to assess and pro-vide related disclosures about an entity’sability to continue as a going concern.It is effective for financial statementsending after December 15, 2016, withearly application permitted, and it isapplicable to all companies and not-for-profit entities.

While the update brings to fruition aconcept that FASB has been working onsince it was added to the agenda in2007, discussions regarding manage-ment’s role have been fraught with con-troversy. In fact, FASB originallyvoted on whether to require managementto assess going concern in January 2012,which culminated in a 4–3 vote againstexpanding management’s responsibili-ties. The dissenters cited concerns suchas management not being able to pro-

vide an objective assessment and anassessment becoming a self-fulfillingprophecy. After reconsidering therequirement, FASB issued a revisedexposure draft in June 2013 for com-ment. Although most comment letterswere in favor of requiring management’sassessment, opinions differed regardingthe time frame and threshold, resultingin further revisions. In August 2014,FASB ultimately issued the final versionof the ASU in a 5–2 vote. FASB’s intentwas to improve the timeliness andquality of disclosures about going con-cern uncertainties and provide a gaugeagainst which the adequacy of suchdisclosures could be assessed.

A Reporting Gap

ASU 2014-15 resolves a gap in thefinancial reporting framework. Financialreports rest on the assumption that theentity will persist into the foreseeablefuture. This concept has long been under-stood by accounting professionals as thegoing concern assumption—dating backto 1953, when it was formally incorpo-rated into the U.S. accounting literatureas Accounting Research Bulletin (ARB)43, Restatement and Revision ofAccounting Research Bulletins. Despitethe concept’s long tenure in authoritativeliterature, U.S. GAAP has contained a gapin guidance related to the going concernassumption for many years. While U.S.GAAP directs management to preparefinancial reports under the going concernassumption unless liquidation is imminent,official guidance regarding management’sresponsibility for assessing the entity’sability to continue as a going concernhas been lacking [FASB AccountingStandards Codification (ASC) 205-30].Furthermore, no guidance existed toclarify the nature and extent of relatedgoing concern disclosures or to dictate theappropriate circumstances for disclosinggoing concern issues.

The SEC addressed the going concernassumption by requiring independentauditors of issuing entities to evaluategoing concern. [See section 10A(a)(3) ofthe Securities Exchange Act of 1934.]In addition, the ASB and the PCAOBrequire auditors to evaluate going con-

cern for a reasonable period of time.Accordingly, until this year, independentauditors were entrusted with the soleresponsibility for evaluating going con-cern. Under the auditing standards, ifsubstantial doubt exists, auditors mustevaluate management’s plans to allevi-ate it. If the auditor continues to believethat there is substantial doubt, in spiteof management’s plans, the auditor mustassess the adequacy of disclosure andadd an explanatory paragraph.

Even though auditors have beenrequired by the operative standard toassess the adequacy of note disclosuresregarding going concern uncertainties, thelack of an explicit financial reporting stan-dard led to variations in the timing, nature,and extent of disclosures in practice.This gap in U.S. GAAP needed to befilled to enhance the comparability offinancial statements.

Provisions and Implementation

By extending responsibility to man-agement and providing disclosure guid-ance, FASB aims to improve thereporting of going concern uncertain-ties. ASU 2014-15 requires manage-


ASU 2014-15 resolves a

gap in the financial

reporting framework.

ment to make interim and annual assessments of going concern and pro-vide related footnote disclosures.Specifically, management must assessknown or reasonably knowable condi-tions that raise substantial doubt aboutthe entity’s ability to continue as a goingconcern. Substantial doubt exists if itis probable that the entity will not beable to meet its obligations as theybecome due, with the term “probable”referring to an event or events that arelikely to occur. (See ASC 450-20-55-2.) Lastly, the time period for consid-eration is one year from the issuance offinancial statements for public compa-nies and one year from when thefinancial statements are available to beissued for nonpublic companies.

When substantial doubt exists aboutan entity’s ability to continue as a goingconcern, management must consider itsplans to alleviate the concern. Note

disclosures should include the principalconditions or events that raise substan-tial doubt, management’s evaluation ofthe significance of the conditions, andmanagement’s plans to alleviate the sub-stantial doubt. If substantial doubt con-tinues to exist despite management’splans, the disclosures must also includean explicit statement that there is “sub-stantial doubt about the entity’s abilityto continue as a going concern.”

In addition to the financial reportingdisclosures, the management of publiccompanies must document and imple-ment internal controls around the goingconcern assessment, among others. Theinternal controls should cover all portionsof the decision-making framework.Management must determine appropri-ate financial and nonfinancial indicatorsfor when additional testing and docu-mentation would need to be completed.For entities that are fiscally sound, the

documentation and controls would beless complex, and no additional disclo-sures would be necessary. For publicentities that did not meet those indica-tors, management must document, eval-uate, and test the effectiveness of theinternal controls around the plans toeffectively mitigate the substantial doubt.A decision flowchart in ASU 2014-15provides a useful example of the deci-sion process an entity may use whenapplying the standard.

Implementation of ASU 2014-15 willprovide benefits to the users of finan-cial statements through a reduction in thevariety of information presented. First,the standard will be required for all pri-vate, public, and not-for-profit entitiesand will reduce the diversity seen ingoing concern disclosures across thesegroups. Second, the standard willenhance the consistency of the disclo-sures within the footnotes and give audi-tors a benchmark for evaluating theiradequacy. All companies will be requiredto disclose any substantial doubts abouttheir ability to continue as going con-cerns and what is being done to allevi-ate them. In addition, management willassess the plans to alleviate doubt andthe steps to be taken. The increased andconsistent disclosure from managementwill allow financial statement users toevaluate the information presented andmake their own decisions.

As noted previously, FASB alsorevised the timeline for considering goingconcern uncertainties. More importantly,the one-year forward-looking period ben-efits users by starting one year from thefinancial statement issuance date, asopposed to the previous standard of oneyear from the balance sheet date. Byrequiring the timeline to start from thefinancial statement issuance date,FASB is preventing the practice of audi-tors delaying the issuance of financialreports beyond the usual time frame in


ACCOUNTING AND AUDITING I standards settingA&A

The ASB interpretations issued in January 2015 (AU-C section 9570) carryno effective date and, therefore, may be applied now. They guide auditorsas to the use of terms in the applicable reporting framework, particularly

the definitions of “reasonable period of time” and “substantial doubt.”

Because the new FASB going concern standard (ASU 2014-15, ASC 205-40)is not effective until annual and interim periods ending after December 15, 2016,its definitions of these critical terms and the ASB interpretations thereof do notyet need to be used by auditors when reporting on financial statements preparedin accordance with U.S. GAAP, unless the reporting entity has elected early adop-tion of the provisions of ASC 205-40. Nevertheless, because there are no prede-cessor definitions of these terms in U.S. GAAP, and because the current definitionof “reasonable period of time” in AU-C section 570 can be viewed only as aminimum, FASB’s definitions can serve temporarily as nonauthoritative guidancefor the exercise of auditor judgment. Nothing precludes an auditor from reportingon U.S. GAAP financial statements as guided by these definitions prior to theadoption of ASC 205-40.

THE ASB INTERPRETATIONSBy Howard Levy

order to reduce the amount of time covered. Pushing backthe assessment timeline provides users with more current andrelevant information. Research indicates that 98.3% of bankruptfirms survive for at least one year from the issuance of a goingconcern audit report (Carson et al. 2013). This is consistentwith concerns that a shorter window for management’s assess-ment might not capture companies that file for bankruptcywithin a slightly longer time horizon.

While the guidance applies to both public and nonpublicentities, opponents argued that public entities were already dis-closing going concern issues in the MD&A (managementdiscussion and analysis) section of Form 10-K. FASB con-sidered such redundancies for SEC registrants but concludedthat the update represented an overall improvement.

Other Standards

The new standard aligns U.S. GAAP with IFRS byextending responsibility to management to assess the report-ing entity’s ability to continue operations as a going concern.However, IFRS [in International Accounting Standards (IAS)1, Presentation of Financial Statements] differs from U.S.GAAP by requiring management to consider a time period ofat least one year, whereas U.S. GAAP sets an upper limit atone year. Although the IASB considered amending the dis-closure requirements about going concern, the board recentlyvoted to remove the issue from the agenda.

In September 2014, the PCAOB issued Staff Audit PracticeAlert 13, Matters Related to the Auditor’s Consideration of aCompany’s Ability to Continue as a Going Concern, to remindauditors of the existing requirements. The update specified thatauditors are expected to apply AU section 341 when evaluatingwhether audit reports should be modified to include a going con-cern paragraph. In January 2015, the AICPA’s Auditing StandardsBoard (ASB) issued an interpretation of existing going concernguidance (AU-C section 9570, “The Auditor’s Consideration ofan Entity’s Ability to Continue as a Going Concern”). The inter-pretation clarifies four topics: substantial doubt, reasonable periodof time, interim financial information, and consideration of finan-cial statement effects. The ASB’s guidance should be used by audi-tors when planning and performing an audit of non-SEC issuers.

Filling the Gap

The authors believe that a significant gap in U.S. GAAP hasbeen filled with FASB’s issuance of ASU 2014-15. The stan-dard will require some significant changes in control policies andprocedures for management, including formal documentationthereof. For auditors, this update will provide guidance for whatmanagement needs to evaluate in regard to the going concern

assumption. Users of financial statements will likely see evenfewer going concern modifications in audit reports, but theywill have more consistent data upon which to base their deci-sions. Academic researchers will be able to examine whether theimproved consistency of disclosures and the actions to be takenby management to alleviate substantial doubt about going con-cern will outweigh the likely decrease in companies filingfinancial reports with a going concern uncertainty disclosure.Although it will be some time before companies are required toimplement the new standard, there will likely be pressure forearly adoption when applicable. q

Jennifer Edmonds, PhD, is an assistant professor in theCollat School of Business at the University of Alabama atBirmingham. Ryan Leece, PhD, CPA, is an assistant profes-sor, also at the University of Alabama at Birmingham. JamesPenner, PhD, CPA, is an assistant professor of accounting inthe Haworth College of Business at Western MichiganUniversity, Kalamazoo, Mich.


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The Going Concern Gap in U.S. GAAP


ACCOUNTING AND AUDITING I auditingA&A

Auditors’ and Management’s New Approach Regarding the Going Concern Assessment

W ith its issuance of Accounting Standards Update(ASU) 2014-15, Presentation of FinancialStatements—Going Concern (Subtopic 205-40):

Disclosure of Uncertainties about an Entity’s Ability toContinue as a Going Concern, FASB has altered thefocus of the going concern assessment from the auditor tomanagement. Previously, AICPA AU-C section 570 andPCAOB AU section 341, “The Auditor’s Considerationof an Entity’s Ability to Continue as a Going Concern,”

provided guidance for the auditor’s consideration and dis-closure of going concern in audit reports for auditors ofnonpublic and public entities, respectively. Despite someoverlap between FASB’s new standard and existing audit-ing standards, some significant differences arose, causingthe AICPA to issue AU-C section 9570, “The Auditor’sConsideration of an Entity’s Ability to Continue as a GoingConcern: Auditing Interpretations of AU-C section 570.”The AICPA’s resolution of these differences and the

By Alan Reinstein and Stefanie L. Tate

attendant implications for practicing audi-tors are summarized in the Exhibit. Theauthors also highlight the differencesbetween the U.S. and international account-ing and auditing standards.

Overview and Time FrameStandards. ASU 2014-15 requires

management to “evaluate whether thereare conditions or events … that raise sub-stantial doubt about the entity’s abilityto continue as a going concern withinone year after the date that the finan-cial statements are issued,” (p. 2, empha-sis added). AU-C section 570 and AUsection 341.02 require auditors toassess whether substantial doubt existsabout an entity’s ability to continue as agoing concern for a period not to exceedone year beyond the date of the auditedfinancial statements. The AICPAresolved this difference by requiring theauditor to opine on the fair presentationof the financial statements in “accordancewith the applicable financial reportingframework” (AU-C section 9570.04),thus extending the auditor’s time frameto match management’s. Internationalaccounting and auditing standards requireconsidering going concern for at leastone year beyond the financial statements’balance sheet date (IAS 1, Presentationof Financial Statements, para. 26, andISA 570, Going Concern, para. 13,respectively). While using the term “atleast” allows extending the internationalperiod of going concern consideration toone year beyond the issuance date as theU.S. standard now requires, the exten-sion is not required, resulting in poten-tial inconsistencies between U.S. andinternational standards.

Implications. Explicitly requiringmanagement to assess going concern,followed by the auditor’s considera-tion of the assessment, parallels othermanagement assertions (e.g., valuation).Going concern assessments, like many

other judgments relating to valuation,are forward looking, requiring first man-agement and then the auditor to evalu-ate future events. Will customers paytheir accounts receivable? Will inven-tory sell for at least cost? Going con-cern considerations add a new twist onthe already complex management judg-ments relating to valuation.

For many valuation decisions, manage-ment can delay issuing the financial state-ments and auditors can delay issuing theopinion for some period of time to reducetheir uncertainty. For example, issuance canbe delayed for weeks or months to seewhether a customer pays its balances or theinventory sells over its cost price. The audi-tors must now assess going concern evi-dence through one year after financialstatement issuance—rather than the balancesheet—date. Although delays could resolvesome going concern conditions, no amountof delay will reduce both management’sand the auditor’s responsibility for a fullone-year prediction.

Substantial Doubt Alleviated—Auditor’s Responsibilities

Standards. ASU 2014-15 requires man-agement to make specific going concerndisclosures when its own plan alleviatessubstantial doubt, such as disclosing theconditions and events that led to thesedoubts and specific plans to mitigate them.Previously, if management disclosed agoing concern issue, auditors consideredadding a going concern emphasis of mat-ter paragraph in the auditor’s report. If man-agement failed to disclose a going concernissue, auditors would issue an “except for”qualification for inadequate GAAP dis-closure. Although the reporting requirementfor auditors did not change, under AU-Csection 9570, they should obtain appro-priate audit evidence regarding the suffi-ciency of disclosures.

Implications. Extending the timeframe for going concern consideration

could increase the risk of inadequatelyreporting on going concern issues, there-by increasing the potential for lawsuitsagainst auditors; however, improvedmanagement processes and increasedmanagement disclosure requirementscould reduce auditors’ risk because man-agement now assumes greater responsi-bility for the going concern assessment.Moreover, analyzing management’sassessment should help support the audi-tor’s own assessment, especially ifmanagement performs its task compe-

tently. Prior research indicates that goingconcern emphasis of matter paragraphsreduce the likelihood of auditors facingclass action lawsuits and the severity ofsettlements (Kaplan and Williams, “Do Going Concern Audit ReportsProtect Auditors from Litigation: ASimultaneous Equation Approach,”Accounting Review, 2013, vol. 88 no. 1,pp. 199–232); increased managementdisclosure could act similarly.

Interim Financial StatementsStandards. ASU 2014-15 requires man-

agement to evaluate going concern for bothannual and interim financial statements.


Explicitly requiring management to assessgoing concern, followed

by the auditor’s consideration of the

assessment, parallelsother management

assertions.

The prior guidance regulating the review ofpublic companies’ interim financial state-ments, AU section 722 and AU-C section930, required auditors to inquire of man-agement and consider the adequacy of goingconcern disclosures if substantial doubt exist-ed in the prior period, or the auditorbecame aware of conditions during normalinterim review procedures. Under AU-C sec-tion 9570, auditors should now activelyassess going concern at each interim date.

Implications. This change will expandaudit procedures for interim financial state-ment reviews. While previously auditors’consideration of going concern was sec-ondary (if the auditor became aware ofconditions), auditors should now addexplicit procedures related to manage-ment’s going concern assessment as part

of their interim reviews, likely increasingthe cost and time required to completethese reviews, especially when the goingconcern assessment is more difficult.

Shifting ResponsibilitiesASU 2014-15 moves the primary

responsibility for the going concernassessment from the auditor to man-agement. It provides principles and def-initions that should reduce diversity inthe timing and content of commonlyprovided financial statement disclosures.Management should develop processesand controls to identify and evaluatewhether conditions or events exist thatraise substantial doubt about the enti-ty’s ability to continue as a going con-cern and consider whether its plans that

seek to mitigate those relevant condi-tions or events will alleviate the sub-stantial doubt. Given the complexityinvolved in these assessments, man-agement might need to hire outside con-sultants for assistance.

This standard, and the AICPA’s result-ing AU-C section 9570 that conformsthe auditor’s responsibility and time frameto ASU 2014-15, will change current auditpractices. Auditors should considerrequesting going concern information inmanagement’s representation letter.Moreover, extending the time frame ofgoing concern consideration requires audi-tors to expand their current predictions,and no amount of delay in issuing finan-cial statements can reduce the time frameof uncertainty. The new standards extend


A&A

EXHIBITGoing Concern: Comparison of Prior and New Guidance

Topic ASU 2014-15 AU-C 570, AU-C 930 Effect of AU-C 9570

Time frame One year after the date of issuance One year after the balance sheet Apply ASU 2014-15 and considerof the financial statements date going concern one year after financial

statements’ issue date.

If substantial Management should disclose: Auditors should consider the need Evaluate the adequacy of doubt is n Conditions or events that raise for and adequacy of management’s management’s disclosures in addition alleviated substantial doubt, disclosures and the need for an to determining the appropriateness of

n Its evaluation of the significance emphasis of matter paragraph. a going concern emphasis of matter of conditions or events in meeting paragraph in the audit report.obligations,n Its plans to alleviate substantial doubt.

Interim Management should evaluate AU-C 930: Auditors should inquire Expands going concern review whether conditions exist that raise of management and consider the procedures to the same level as substantial doubt for interim periods adequacy of disclosures at interim if: other review procedures; expands (as well as annual periods). n going concern doubt existed for procedures to assess management’s

prior annual financial statements; or going concern assessment and n the auditor becomes aware of adequacy of management’s disclosuresconditions leading to substantial doubt during interim review procedures.

ACCOUNTING AND AUDITING I auditing


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the reach of the going concern assessmentbeyond annual audits to reviews. Theadded management disclosure require-ments related to going concern, even whenmanagement plans appear to mitigate thoseissues, increase an auditor’s duties to assessmanagement’s process related to goingconcern assessment and the adequacy ofdisclosure. This enhanced managementprocess and increased disclosure couldreduce the auditor’s legal liability if a com-pany fails without the auditor havingissued a going concern emphasis of mat-ter paragraph. q

Alan Reinstein, DBA, CPA, CGMA,is the George R. Husband Professor ofAccounting at the Mike Ilitch School

of Business Administration, WayneState University, Detroit, Mich.Stefanie L. Tate, PhD, CPA, is anassociate professor of accounting atthe Manning School of Business, theUniversity of Massachusetts Lowell,Lowell, Mass.

The authors wish to thank Abe Akresh(Government Accountability Office,retired), Dave Dupree (Comerica), JohnFleming (Loscalzo Associates), GeraldHepp (Gnosis Praxis), Greg Trompeter(University of Central Florida), andLeah Woodall (Google) for their help-ful comments.

Extending the time frame of going concern

consideration requires auditors to expand their current

predictions, and no amount of delay in issuing financial

statements can reduce the time frame of uncertainty.

Auditors’ and Management’s New Approach Regarding the Going Concern Assessment


In April 2014, European Union (EU) legislation was adopt-ed to reform the European statutory audit market. In thiscontext, a statutory audit is a legally required audit of an

entity’s financial statements conducted by an external (statu-tory) auditor. The legislation, which comprises a regulationand a directive and which applies mainly to the approximate-ly 30,000 public-interest entities (PIE) within the EU, will gen-erally become effective in June 2016. PIEs comprise 1) allentities governed by the law of one of the 28 EU memberstates (and of Norway, Lichtenstein, and Iceland, all of whichare members of the European Economic Area) that are listedon a regulated market, 2) all EU credit institutions, eventhose that are not listed, 3) all EU insurance companies, evenif they are not listed, and 4) entities designated as such by amember state at its option. While the EU audit reform mea-sures do not directly apply to U.S. companies or their U.S.auditors, they can have an impact on U.S. multinationals thathave EU-based subsidiaries that qualify as PIEs.

Major Provisions The following are the main provisions of the regulation

and the directive taken together:n Increase the responsibilities of the audit committee in respectof oversight of the performance of the statutory auditn Introduce new auditor reporting requirementsn Require mandatory audit firm rotationn Add restrictions on the types of nonaudit services that canbe performed by statutory auditors for PIE clientsn Place a “cap” on the amount of fees permitted for the per-formance of permitted nonaudit services.

The following are brief summaries of the EU audit reformprovisions that could have the greatest impact on U.S. com-panies and their auditors.

Mandatory audit firm rotation. PIEs must rotate audit firmsevery 10 years, although member states have the option toextend the mandatory rotation period to 20 years provided that

a public “tender” is conducted at the conclusion of the 10-yearperiod, or 24 years if a “joint audit” is performed (i.e., twoaudit firms sharing responsibility, though not necessarily equal-ly, to produce a single joint auditor’s report). Member stateswill also have the option to set a shorter mandatory-rotationperiod; thus, for example, Italy will be allowed to retain itscurrent nine-year rotation requirement. The mandatory firmrotation rules are subject to transition provisions based on theperiod of the existing statutory auditor/client relationship asof June 16, 2014. Note that the new firm rotation rules donot replace those requiring the key audit partner to rotateafter a maximum of seven years.

Restrictions on nonaudit services. In general, services thatmay not be performed by statutory auditors on their PIEclients include 1) tax and tax compliance (including tax formpreparation) and the calculation of deferred taxes, 2) corpo-rate finance and valuation services (due diligence services,including the issuance of comfort letters, are permitted), 3)bookkeeping and financial statement preparation, and 4) thedesign and implementation of internal control or risk man-agement procedures or financial IT systems. Once again, indi-vidual member states have an option under which they mayallow certain tax services if they do not have a direct (orhave only an immaterial) effect on the audited financial state-ments; member states also have the option of adding to thelist of prohibited nonaudit services. It is noteworthy that theprohibited services are more extensive than those currentlyin effect in some member states and are also considerablymore restrictive than those prohibited by the SEC’s inde-pendence rules.

Cap on fees for permitted nonaudit services. All nonaudit ser-vices that are not explicitly prohibited are permissible, subjectto approval by the entity’s audit committee based upon an assess-ment of the potential threat to auditor independence that the services might pose. The fees for such services may not exceed70% of the average of fees paid for the latest three consecutive

European Audit ReformBy Allan B. Afterman

How It Could Affect U.S. Companies

COLUMNS I sec insightsCOL.

years for the statutory audit. Note, though, that the cap appliesonly to the firm conducting the audit; thus it does not apply tofees generated from services provided by firms in the statutoryaudit firm’s network. However, the prohibition of certainnonaudit services does apply at the network level. Individualmember states may set an upper bound on fees for allowablenonaudit services that is lower than 70%.

Patchwork Effect of the Reform MeasuresEU audit reform legislation is complicated because it is based

on both a directive and a regulation. A directive binds mem-ber states to the objectives sought to be achieved, while leav-ing national authorities with the choice of the form andmeans to implement them. A directive must be implementedin national legislation. Unlike a directive, a regulation is direct-ly binding throughout the EU and is therefore directly appli-cable in all EU member states without the need for any national implementation legislation. Nevertheless, there areseveral options available in the audit regulation pursuant towhich member states have choices.

Because of all the choices and options built into the regu-lation and the directive, a patchwork of requirements that dif-fer among the various member states is almost certain to bethe result. What those differences are will be clarified asinterpretive guidance issued by the European Commission andby regulators in individual member states, expected later thisspring. Moreover, the legislation contains ambiguous word-ing subject to differing interpretations among EU jurisdictions,thus adding a further layer of potential implementation incon-sistencies among the member states.

Potential Implications for U.S. CompaniesComplying with the new requirements may pose problems for

U.S. companies, especially if EU statutory audits are being con-ducted by the same firm (or, in some situations, by a memberof that firm’s network) performing the audit of the U.S. par-ent’s consolidated statements. The following are some addition-al potential implications for U.S. companies and their auditors: n If a U.S. parent has subsidiaries in the EU, the U.S. parentwould not be required to rotate audit firms. However, any U.S.parent company’s EU subsidiary that falls within the defini-tion of a PIE in the member state in which it resides willhave to comply with that state’s rotation requirement.n The mandatory audit firm rotation requirement does nothave extraterritorial effect; thus, if a PIE incorporated in theEU has a subsidiary incorporated in the United States, thereis no legal obligation on the PIE to rotate its auditors in theUnited States. Nevertheless, as a spillover effect, PIEs oper-ating within the EU may wish, for practical and cost-effec-tive reasons, to rotate auditors in the United States as well.

n There are no specific rotation provisions in the regulationregarding group audits with multiple PIEs; each PIE must com-ply with the rotation rules of the jurisdiction in which it resides.However, if a U.S. parent has a number of significant EU PIEsresiding in member states that have, in accordance with theiroptions, set different mandatory rotation cycles, groups maywish, for practical reasons, to rotate all audit firms for allsuch PIEs over the shortest cycle. n While neither the prohibition of nonaudit services nor thecap on fees from permissible services applies to entities out-side the EU, it is possible that U.S. companies having manysignificant PIE subsidiaries in EU member states may, for prac-tical reasons, decide to change providers of nonaudit servicesat the group level (i.e., to include U.S. subsidiaries and inter-mediate U.S. parents) at the same time as they change suchproviders for EU PIEs.n In principle, the regulation prohibits the provision of cer-tain nonaudit services only within the EU. Hence, for entitiesincorporated in the United States (or other non-EU countries)that are controlled by the audited PIE, the statutory audit firmor a member of that firm’s network may perform otherwiseprohibited nonaudit services. However, the rules require anassessment by the statutory audit firm regarding whether thefirm’s independence might be compromised; if so, both thestatutory audit firm and members of that firm’s network arerequired to take measures to mitigate the risks. Ultimately,the statutory audit firm must determine that mitigating safe-guards are in place so that its independence and judgment arenot impaired. Certain services—including bookkeeping anddesigning and implementing internal control procedures—whenperformed by a member of the statutory audit firm’s networkare, under the rules, deemed to be incapable of mitigation.Thus, such services may not be provided under any circum-stances by the PIE’s statutory audit firm or any member ofits network to any U.S. subsidiary (or U.S. parent).Accordingly, as a practical matter, affected U.S. companiesmight decide to seek providers of such services that are notmembers of the statutory audit firm’s network.

The takeaway here is that, while EU audit reform mainlycovers EU enterprises, it can have a significant effect oncompanies domiciled in the United States—or anywhere elsein the world, for that matter. q

Allan B. Afterman, PhD, CPA, is the author of numeroustreatises on financial reporting and SEC practice and has con-sulted with governments on the establishment of national secu-rities laws and financial reporting standards. He is a formeradjunct professor in the Booth School of Business at theUniversity of Chicago, and was assistant to the national direc-tor of SEC practice at a major public accounting firm.



There are several points in a business’s life cycle thatrepresent increased risk. One prime example is the buy-ing or selling of all or part of a business. Aside from the

operational risks in such an undertaking, there are tax risks thatcan be complex but can also present opportunities to both thebuyer and seller. State and local tax risks vary, based upon thetype of transaction (i.e., stock or asset sale), type of entity beingpurchased or sold (i.e., partnership or corporation), and the typeand history of the business being acquired. Understanding thetax profile of the buying and selling entities, the jurisdictions in

which each business has operations, and the long-term goals ofthe parties is key to providing prudent advice. This articlefocuses on certain state and local risks that should be consid-ered in any purchase/sale transaction.

Type of Transaction Different levels of successor liability can exist depending upon

the type of transaction that is ultimately undertaken in an acqui-sition. In an asset acquisition, successor liability is generallylimited to trust fund taxes. Generally, trust fund taxes includethose taxes that a business is collecting and remitting on behalfof other parties or that are directly related to the property beingacquired in the transaction. Trust fund taxes include, but are notlimited to, sales, payroll, and property taxes. In some states(e.g., Illinois, Pennsylvania), however, statutory language hasbeen drafted to encompass taxes beyond trust fund taxes,including income taxes, for purposes of successor liability (ILCSsection 5/902; PA Stat. Ann. section 1403). While the potentialsuccessor liability for asset acquisitions can be somewhat limit-ed, successor liability for a stock acquisition includes all entity-level taxes (e.g., income tax, business registrations), in additionto trust fund taxes. Parties to acquisitions or divestitures shouldconsider the legal and tax implications of a particular type oftransaction, because these elements can vastly change the levelof due diligence required or potential tax exposure relating to thespecific acquisition.

Type of Entity Being AcquiredThe type of entity that is the target in a transaction can affect

the entity level taxes that are potential tax risk areas for thebuyer. For example, when pass-through entities are acquired,

State and Local Tax Considerations for BusinessAcquisitions and Divestitures

By Patrick Duffany, Milo W. Peck, and Corey Rosenthal

COLUMNS I state & local taxationCOL.

entity level taxes based on income are generally not a signif-icant concern because the majority of income taxes for pass-through entities are imposed at the owner level, not the enti-ty level. As discussed below, however, one must still addresswhether there are any withholding taxes that a flow-throughentity should have remitted and whether those risks would beassumed by the buyer. In addition, there are some jurisdictionsthat do not conform to the federal income tax entity classifi-cation of certain flow-through entities and impose entity-levelincome taxes regardless of entity type; for example, NewHampshire imposes a state income tax on entities regardlessof the entity’s federal income tax classification. Similarly, several cities and localities, including New York City andWashington, D.C., impose income taxes at the entity level onnondisregarded pass-through entities.

Similarly, some states do not recognize or can require sep-arate state elections to receive conforming federal treatmentfor S corporations. Several states do not differentiate betweenC corporations and S corporations and impose tax at the enti-ty level regardless of the federal classification (e.g., Louisiana,Tennessee, Texas). In comparison, both New Jersey andNew York require distinct state S corporation elections toreceive pass-through treatment. If these elections were notmade, the buyer might be liable for unpaid taxes that were his-torically due, regardless of whether the previous owner paidtax on the flow-through income.

In addition, some jurisdictions impose an entity-level taxin addition to subjecting the pass-through income to tax atthe shareholder/member level. California (1.5% on income),Illinois (1.5% on income) and Massachusetts (1.83% or 2.75%on income, based on the level of gross receipts) have dual-layered tax regimes for S corporations, imposing an incometax on the entity and at the shareholder level. In addition toimposing an income tax on the flow-through of income to anLLC’s owners, California imposes an “LLC fee”, which is agraduated “tax” ranging up to $11,790 and is based on theCalifornia gross receipts of LLCs doing business in the state.The authors have seen many situations where lower-tier LLCshave been required to pay the LLC fee, but have not beenaware of how the nexus rules work with respect to upper-tierLLCs in a multitier LLC structure.

Despite taxes for pass-through entities generally notbeing required to be paid at the entity level, several statesdo impose nonresident withholding taxes on the ownersof multistate businesses that are required to file (i.e., havenexus) in a state. Therefore, a buyer might have succes-sor liability for nonresident withholding taxes in any stateswhere a business is not appropriately withholding or wherethe business has nexus and has not historically filed. Whilenonwithholding exposure can be mitigated by nonresidents


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appropriately filing personal income returns in such states,any potential nonfiling exposure in states where the sell-er has not filed will likely remain open until a return isfiled. Note that the filing of a composite return by a busi-ness generally eliminates the need for nonresident with-holding on behalf of included partners or members.However, states like California could require both quar-terly nonresident withholding and estimated tax paymentsfor the composite filings, based upon the different ratesimposed for each filing.

Professionals representing a buyer in any transaction shouldreview the multistate activities of the target entity to ensure thatthe buyer is aware of all potential tax nonfiling and relatedrisks. Likewise, sellers should ensure that they understand thetrue tax risk related to potential non-filing (as well as other taxrisks), because many jurisdictions offer “voluntary disclosure pro-grams” that might mitigate tax risks identified by the buyer.

Type and History of BusinessThe type of business being bought or sold can greatly impact

the potential state and local tax exposure. For example, ser-vice businesses typically have a very broad nexus footprint,and an increasing number of states are subjecting services tosales tax. The authors have found that sales and use (S&U)taxes are some of the most complex areas and can present asignificant risk in any transaction.

Typically, S&U tax risks can be classified into three gen-eral categories: n Nexus—did the selling entity have a filing obligation, eitherdue to its own activities or the activities of its “representatives”? n Taxability—i.e., if the selling entity had nexus, were anyof its products or services taxable? n Compliance—were the required returns properly filed andtaxes paid (including use tax), and did the seller have suffi-cient documentation relating to any exempt sales?

Even if the target is fully compliant with the sales tax rulesas applied to its products or services, it is important toinquire about the target’s history of business acquisitions. Asdiscussed above, many states impose successor liability fortaxes on buyers—even when only assets are acquired. In orderto avoid successor liability, a buyer generally must complywith notification and withholding requirements. Suchrequirements are often overlooked, creating an additional S&Utax risk in business acquisitions.

Transactional Tax Considerations In addition to reviewing the acquisition history of a tar-

get, the purchaser of a business should be aware of poten-tial exposures created by the current transaction. For exam-ple, while many states provide bulk sale exemption rules forthe sale of the majority of business assets in a single trans-action, some states (e.g., New York) provide an extremelysmall exemption amount (e.g., $600), which creates currentS&U liabilities for the acquirer if the transaction is not prop-erly structured. Similarly, a few states now impose transfertaxes on the value of qualifying assets sold as part of anacquisition. Such transfer taxes can be the responsibility ofthe buyer, seller, or both, and can often specifically beassigned to a particular party in the purchase and sale agree-ment. Transfer taxes can refer to documentary stamp taxes,including real estate conveyance taxes, controlling interesttransfer taxes, or other taxes that are attributable to the acqui-sition. The authors have seen several states over recent yearsexpand real estate transfer taxes or controlling interest trans-fer taxes to encompass a greater amount of qualifying assetsor larger number of transactions.

Other Tax Exposure ConsiderationsIn an effort to increase tax revenues, a few states have

expanded their taxing regimes to include nontraditional tax


COLUMNS I state & local taxationCOL.

The CPA Journal welcomes letters from readers in response to articles published in the magazine as well

as those concerning issues of general interest to the accounting profession. Although we receive more

letters than we are able to publish, all letters receive consideration.

The editors reserve the right to edit letters for clarity and length. Writers should include their

contact information, including a daytime telephone number and an e-mail address, if possible.

Letters may be addressed to Letters to the Editor, The CPA Journal, 14 Wall Street, 19th Floor,

New York, N.Y., 10005, or to [email protected].

Let Us Hear From YouLet Us Hear From You


types or taxing authority measures.Currently, a handful of jurisdictionsimpose statewide non–income taxregimes. Both Ohio’s CommercialActivity Tax (CAT) and Washington’sBusiness and Occupation (B&O) tax arebased on gross receipts rather thanincome and are imposed based on“economic nexus” rules, rather thanphysical presence.

Similarly, some net income taxing statesare making an effort to expand their poten-tial taxpayer base by enacting economicnexus statutes. These statutes generallyprovide for the taxation of particularbusinesses based on sales or other factorpresence within the particular state (i.e.,$500,000 of sales or $50,000 of payroll orproperty in the state). The use of factorpresence standards for income tax nexuscan create tax risks for any business andshould be reviewed in any due diligenceengagement.

Planning OpportunitiesDespite presenting a host of state and

local tax risks and obstacles, businessacquisitions present significant opportu-nities and benefits when properly struc-tured. Businesses looking to offset oreliminate tax on transactional gainsshould review the proposed acquisitionstructure to determine if any tax attributes(such as net operating losses or statetax credits) could reduce any potentialtax due. Similarly, taxpayers shouldreview the possibility of electing assetsale treatment pursuant to IRC section338(h)(10) to increase the potential post-transaction depreciation base on theacquired assets. The increased tax coston the seller of any such election todayshould be compared with the potentialtax benefits to the buyer over the livesof the assets to determine whether sucha planning opportunity is prudent underthe specific circumstances.

Professionals advising buyers or sell-ers in any due diligence engagementmust be aware of a multitude of tax

risks—including international, federal,state, and local. This article endeavors tobriefly discuss a few of the many statetax risks, but it does not address allpotential risks. Professionals represent-ing a party in a purchase/sale transactionshould make sure that someone familiar

with multistate tax rules is part of theengagement team. q

Patrick Duffany, CPA, is a partner,Milo W. Peck, JD, is a manager, andCorey Rosenthal, JD, is a principal, allat CohnReznick LLP, New York, N.Y.

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Instead of looking at Social Security as a governmententitlement that one should start receiving as soon as eli-gible, one should consider it an investment that will pro-

vide a far greater return on investment (ROI) by waiting thanany other investment they have.

From a financial planning and personal wealth point of view,Social Security benefits should be looked at as an asset classthat needs investment management coordinated with the restof an individual’s portfolio and financial plan. SocialSecurity is an opportunity for CPA financial planners to advisetheir clients on an important source of permanent cash flow.

Cash Flow

Social Security benefits have no residual value other than aspouse being able to receive the spouse’s benefits upon one’s death,with all benefits ceasing upon the second spouse’s death. Retirementand financial planning is partly about asset preservation and growth

and partly about cash flow, so both need to be considered. Inmost instances, as individuals age, cash flow assumes a greaterimportance than asset values. Of course, asset values drive cashflow, but not in every situation. For example, investments in growthcompany stocks pay relatively low dividends with the expecta-tion of increasing asset value. Likewise, investments in short-termbank certificates of deposit also provide low cash flow while pro-viding safety of principal and liquidity.

When advising individuals who are set to start receiving SocialSecurity benefits, CPAs should look at their overall asset allo-cation and cash flow. The advice the authors provide usually cen-ters on their spending goals and cash flow. If their cash flow fallsshort, then either more aggressive investing needs to be done,spending requirements have to be reduced, or retiring later orworking part time should be considered. Either way, cash flowdrives the decision, not asset values.

When Benefits Start

Regular Social Security benefits canbegin at age 62; however, the longer thebenefits are delayed, the greater they willbe up until reaching age 70. Payments onbehalf of dependents are paid if a parentdies or attains age 65. A married personcan receive benefits based upon theirspouse’s record if it will be greater thanif based on their own account. Benefitsare reduced if one starts receiving thembefore the full retirement age (age 66 anda few months) and are increased if onewaits until one’s 70th birthday.

A spouse can take benefits at age 62(based on one’s own record) and increasethese to half of a spouse’s when fullretirement age is attained; this is the max-imum, even if a spouse decides to waituntil age 70 to claim increased benefits.

Benefits stop at death, but a survivingspouse can then receive a deceasedspouse’s benefits if those benefits are

Treating Social Security as an Asset ClassBy Sidney Kess and Edward Mendlowitz

COLUMNS I personal financial planningCOL.

greater than one’s own. Divorced spouses may also get bene-fits based upon their ex-spouse’s record. Disabled personsmay also receive benefits.

Social Security entails some confusing rules, and most indi-viduals would benefit from consulting with a CPA financialplanner familiar with Social Security’s intricacies to determinethe best course of action.

Asset Value of Social Security

Social Security may have no asset value, but its cash flow willgreatly increase if benefits begin as late as possible, up until one’s70th birthday. The return for waiting is an approximate 32%greater annual payout for the rest of one’s lifetime—that is a32% ROI for waiting a little less than four years. Right now,85% of the benefits will be taxed for most recipients, whichstill compares favorably with any other form of investment return.In addition, Social Security payouts increase annually based onan inflation factor, and all payments are guaranteed. As a cashflow source, this should be compared to other investments;very few will provide this great of a return.

Capitalization of Benefits

Another way to look at the asset value of Social Securityis to capitalize the cash flow. While this article is concernedwith the permanent guaranteed nature of Social Security ben-efits, many individuals seem interested in their pseudo–“assetvalue.” To determine this, a current rate of return is dividedinto the expected annual benefits. For instance, if projectedbenefits were $40,000 and the rate of return was 4%, the assetvalue would be $1 million. Likewise, a 2% rate of return wouldresult in a $2 million pseudo–asset value.

Waiting Strategy

For those who do not need the money early, waiting untilage 70 to receive Social Security benefits is a no-brainer. Forthose who do, withdrawing needed funds from other asset cat-egories they already have is a viable strategy, even if they haveto take early taxable withdrawals from retirement accounts andannuities or sell stocks. That strategy would entail spending downcash and some fixed income investments where the tax bitewould be minimal. CPA financial planners can assist individu-als by working out the numbers and measuring the results againstthe ROI of waiting for Social Security benefits to start.

Government Entitlement

A common concern with many individuals is that theywill die before receiving sufficient Social Security benefitsor “breaking even.” However, waiting will protect their cashflow for as long as they live, and therefore Social Securityis guaranteed to be there as long as they live and with


On November 2, 2015, President Obama signed intolaw H.R. 1314, the Bipartisan Budget Act of 2015,

which made significant changes to Social Security opti-mization strategies. Two in particular are known as“file and suspend” and “restricted application.”

“File and suspend” provides the higher earningspouse the ability to file for Social Security benefitsat full retirement age (currently age 66) and to sus-pend collecting benefits until age 70. This allows thehigher earning spouse to increase his or her individ-ual yearly benefits by about 32% once collectionbegins. By filing and suspending, the lower earner ornonearner spouse can begin collecting a spousalbenefit (as much as 50%) based upon the otherspouse’s record.

“Restricted application” allows a spouse with herown earnings record to begin collecting spousal ben-efits at or after full retirement age while suspendingthe collection or her own Social Security benefits. Atage 70, this person would switch to her own bene-fits, thereby achieving the 32% yearly increase.

The budget act effectively eliminated these twostrategies, with exceptions grandfathered in underthe law. A spouse who desires to “file and suspend”must have been born no later than May 1, 1950. Aspouse who desires to take a spousal benefit whileallowing her own benefit to increase (restricted appli-cation) must have been born no later than January 1,1954. A divorcee who was married for at least 10years and turned 62 by January 1, 2016, can stillfile for a spousal benefit and then let his own bene-fits increase until age 70. In couples whose ages dif-fer by more than four years and whose youngerspouse will turn 62 by December 31, 2015, theyounger spouse is still allowed to file for the fullspousal benefit at full retirement age and then lether own benefit increase until age 70.

The act also affected other aspects of Social Securityrelating to divorced and widowed individuals, as wellas those collecting disability benefits. q

Peter A. Weitsen, CPA, is a partner at WithumSmith+Brown, PC.

CHANGES TO SOCIAL SECURITYOPTIMIZATION STRATEGIES

By Peter A. Weitsen

some built-in increases. Their cash flow will be protectedshould they live many years thereafter—they can never out-live this cash flow or this asset class. Rather than be con-cerned with “losing” money to Social Security, the authorssuggest individuals think of Social Security as a secure cashflow “forever.”

Another common argument against delaying SocialSecurity is that a better ROI is possible by receiving thebenefits early and reinvesting them. While technically true,it is also highly unlikely unless the investments are madevery aggressively. In today’s low-interest environment, itis not reasonable to expect a four-year 32% return just tobreak even; because early Social Security benefits will bereduced by income taxes on 85% of the payments, theamount to be invested will be that much lower. Furthermore,the 32%-increased benefits will continue to be paid annu-ally and are guaranteed for the rest of the participant’s life,and will even experience cost-of-living increases. Of course,if payments begin early and the participant dies, the accu-mulated funds can be left to heirs. This raises a question:Is that accumulated amount sufficient to forgo the guaran-teed-for-life benefits if the participant lives a long life?Again, if the goal is secure cash flow in the overall finan-cial plan, then delaying is the right strategy.

Additional information

Further information about Social Security benefits, as wellas access to individual earnings records and benefit estimates,can be found at http://www.socialsecurity.gov. The authorsrecommend that individuals periodically check their record andaccount information.

The purpose of financial planning services is to assist indi-viduals in making decisions to secure their goals and finan-cial future. Social Security benefits can be a source of per-manent guaranteed cash flow and a key part of an individu-al’s overall financial plan. And while Social Security planningis complicated, effective strategizing can increase lifetime ben-efits by many thousands of dollars. It is incumbent uponadvisors to understand the rules and to recommend solutionstailored to an individual’s personal situation. q

Sidney Kess, JD, LLM, CPA, is of counsel to Kostelanetz& Fink. He is a member of the NYSSCPA Hall of Fame andwas awarded the Society’s Outstanding CPA in EducationAward in May 2015. He is also a member of The CPAJournal Editorial Board. Edward Mendlowitz, CPA/PFS,ABV, is partner at WithumSmith+Brown, PC. He is alsothe author of a twice-weekly blog posted at http://www.part-ners-network.com.


COLUMNS I personal financial planningCOL.

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Audit Analytics is an independent research firm that provides customized databases for audit, regula-tory, and disclosure applications. Its website

(http://www.auditanalytics.com) allows access to data on audi-tor engagements, audit firm quality, audit opinions, financialrestatements, and PCAOB inspection reports, all of whichCPAs can use for best practices and business development. Itsdatabases include over 150,000 audited companies and 10,000CPA firms.

Through its extensive research, Audit Analytics periodicallymakes research reports available to the general public at pricesranging from $50 to $200. Summaries of the results of AuditAnalytics’ research projects are available for free through indus-

try news articles, which are easily accessed through its website.The website also contains a collection of audit-related news, aca-demic research articles, and a blog focused on current events.

News

An easy way for the general public keep up with audit-relat-ed news and short summaries of Audit Analytics’ studies isthrough the news archive (http://www.auditanalytics.com/0000/news.php). Publication sources include Accounting Today,Compliance Week, CPA Practice Advisor, MarketWatch, theWall Street Journal, and many others, some of which requireseparate subscription access.

MarketWatch correspondent Francine McKenna (re: theAuditors blog) cited Audit Analytics in “Almost Half ofAuditor Warnings about Potential Failure Are on IPOs”(http://on.mktw.net/1nACESb). The most frequently occurringreasons for auditors to give going concern opinions are netlosses since inception or lack of significant revenues. The arti-cle provides a data table of 15 NASDAQ companies with audi-tor warnings, including details on the initial public offering(IPO) price and subsequent market price. Amazingly, in manycases, investors were willing to pay close to the IPO priceseven after auditor warnings.

An August 2015 presentation by PCAOB board memberJeanette M. Franzel, “Current Issues, Trends, and OpenQuestions in Audits of Internal Control over FinancialReporting,” relied on data from Audit Analytics to illustrateher points (e.g., that the percentage of adverse internal con-trol opinions appears to be rising). Franzel also referred tothe PCAOB’s own data analysis, which showed that increas-es in audit fees do not appear to be driven by internal controlaudits (http://pcaobus.org/News/Speech/Pages/08102015_Franzel.aspx).

Blog

The Audit Analytics blog (http://www.auditanalytics.com/blog/) is an excellent free source of information on the organi-zation’s projects, as well as a place to read its expert take on

Audit AnalyticsBy Susan B. Anders

COLUMNS I tech talkCOL.

current events. While some of the posts are short and concise,others include lengthy discussions with exhibits and links to othersources. Posts are published frequently, and they are presentedas abstracts with drill-downs to the complete article, making iteasy for readers to identify topics of specific interest.

For example, “2015 SEC Enforcement Actions ProduceDecade High Results” (http://bit.ly/1nqk9z0), postedNovember 12, 2015, summarizes the SEC’s enforcementactions from 2013 to 2015 and examines specific cases. Infact, 2015 was a record-setting period for the number of actionsand assessed penalties. The article includes links to more detailon each case discussed, along with access to the underlyingSEC Release 2015-245 and a Bloomberg Business news reporton the SEC’s proposed postrestatement clawback for execu-tives to return incentive compensation.

CPAs at local and regional firms may be interested in theSeptember 2015 post, “Audit Firm Membership inAssociations, Networks, and Alliances.” While AuditAnalytics’ data shows that the Big Four dominate the publiccompany market share, the four largest ERISA (EmployeeRetirement Income Security Act) benefit auditors are small-er firm alliances. The article also discusses academicresearch which indicates that smaller firms benefit from join-ing alliances through being able to win larger audit engage-ments and reducing the likelihood of restatements and PCAOBinspection deficiencies (http://bit.ly/1TDALzR).

Academic Research

Audit Analytics also provides links to academic research pub-lications that make use of its data at http://www.auditanalytics.com/0000/papers.php. Although reading throughacademic articles is probably not high on most readers’ to-do lists,some of them are actually targeted to practitioners. For example,“Current Issues in Auditing” provides practitioner summaries withpractical applications. A July 2015 article (“Are Lengthy AuditReport Lags a Warning Signal?” by Alan I. Blankley, David N.Hurtt, and Jason E. MacGregor, http://bit.ly/1nqkMsl) uses AuditAnalytics’ data to confirm that the longer an audit takes beyonda normal time frame, the more likely it will be that the compa-ny will eventually have to restate its financial statements. Theauthors suggest that while greater effort spent on the audit isnormally associated with a higher quality audit, there is a pointof diminishing returns. They also provide guidance for CPA firmsin using their own internal audit engagement data to developprediction models specific to their client experiences. q

Susan B. Anders, PhD, CPA/CGMA, is the Louis J. andRamona Rodriguez Distinguished Professor of Accounting atMidwestern State University, Wichita Falls, Tex. She is a mem-ber of The CPA Journal Editorial Board.


Attestation Update—A&A for CPAs (http://attestation

update.com) is one of the blogs maintained by Califor-

nia CPA James Ulvog, and is billed as “technical stuff for CPAs

providing attestation services.” His practice focuses on pro-

viding attestation and peer review services, and his blog

focuses on news, events, and tools in accounting and audit-

ing areas, especially for small firms.

A topic of several recent posts has been SSARS 21,

Statements on Standards for Accounting and Review Ser-vices: Clarification and Recodification. The blog offers sam-

ple compilation report wording, sample review report lan-

guage, and a link to purchase a primer on compilation and

preparation engagements. There is also a collection of posts

on SSARS 19, Compilation and Review Engagements, doc-

umentation requirements, and the blogger’s advice for

addressing the CPA’s obligations (http://attestationupdate.

com/ssars-19-documentation-requirements/).

ATTESTATION UPDATE BLOG

Blogger Francine McKenna transitioned to a full-time posi-tion as a reporter with MarketWatch in 2015 and pours

much of her energy into covering financial regulation and leg-islation for that online news source. But she still maintainsher long-standing re: The Auditors blog at http://retheaudi-tors.com, which serves as an outlet for more focused com-mentary on the auditing community. For example, recentposts covered the speculation over whether PCAOB James R. Doty would be reappointed (http://bit.ly/1Stj8nB),recounted recent SEC sanctions against Grant Thornton(http://bit.ly/1StjfiY), and discussed loopholes in the enforcement of the Dodd-Frank Act clawback rule(http://bit.ly/1Stj9YD).

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[email protected]

Former NYS Tax Dept.

District Manager

Metropolitan Area

• SALES TAX

• RESIDENCY

Audits, Collections, Appeals

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Selected Interest Rates 12/31/15 11/30/15

Fed Funds Rate 0.20% 0.08% 3-Month Libor 0.61% 0.42% Prime Rate 3.50% 3.25% 15-Year Mortgage 3.24% 3.18% 30-Year Mortgage 4.01% 3.95% 1-Year ARM 2.68% 2.59% 3-Month Treasury Bill 0.16% 0.22% 3-Year Treasury Note 1.31% 1.24% 30-Year Treasury Bond 3.01% 2.98% 10-Year Inflation Indexed Treas. 0.73% 0.62%

The information herein was obtained from various sources believed to be accurate; however, Forté Capital does not guarantee its accuracy or completeness. This report was prepared forgeneral information purposes only. Neither the information nor any opinion expressed constitutes an offer to buy or sell any securities, options, or futures contracts. Forté Capital’sProprietary Market Risk Barometer is a summary of 30 indicators and is copyrighted by Forté Capital LLC. For further information, visit www.fortecaptial.com, send a message [email protected], or call 866-586-8100.

Forté Capital’s Selected Statistics

U.S. Equity Indexes 12/31/15 YTD Return

S&P 500 2,044 -- 0.70%

Dow Jones Industrials 17,425 -- 2.20%

NASDAQ Composite 5,007 5.70%

NYSE Composite 10,143 -- 6.40%

Dow Jones Total Stock Market 21,101 -- 1.50%

Dow Jones Transports 7,509 -- 17.80%

Dow Jones Utilities 578 -- 6.50%

Forté Capital's Proprietary Bullish Neutral Bearish

Market Risk Barometer 10 9 8 7 6 5 4 3 2 1

Market ValuationMonetary Environment Investor PsychologyInternal Market Technicals

Overall Short-Term Outlook 4.57Overall Long-Term Outlook 5.11

45

45

Equity Market Statistics 12/31/15 11/30/15

Dow Jones Industrials

Dividend Yield 2.63% 2.52% Price-to-Earnings Ratio (12-Mth Trailing) 15.73 16.38 Price-to-Book Value 2.96 3.07

S&P 500 Index

Earnings Yield 5.01% 5.01% Dividend Yield 2.14% 2.12% Price/Earnings (12-Mth Trailing as Rpt) 19.98 19.97 Price/Earnings (Estimated 2014 EPS) 19.53 19.49

Commentary on Significant Economic Data This Month

Annualized existing home sales came in at 5.46 million in December, almost erasing the drop in November, which was caused by closing delays as the industry adjusted to meet new documentation requirements. Sales increased 14.7% month-over-month and 7.7% year-over-year. Regionally, salesincreased across the board, led by the West, which saw sales increase 23.2% for the month. The single-family market tightened considerably: the month’ssupply came in at 3.9, down from 5.1 in November. This was caused by a decline in listings, as well as a jump in sales for the month. The seasonallyadjusted median sales price for existing homes was up 2.8% from November to $230,870.

Most Prior

Key Economic Statistics Recent Month

National

Producer Price Index (monthly chg) -- 0.20% 0.30%

Consumer Price Index (monthly chg) -- 0.10% 0.00%

Unemployment Rate 5.00% 5.00%

ISM Manufacturing Index 48.20 48.60

ISM Services Index 55.30 55.90

Change in Non-Farm Payroll Emp. 292,000 211,000

New York State

Consumer Price Index - NY, NJ, CT (monthly) -- 0.40% -- 0.20%

Unemployment Rate 4.80% 4.80%

NYS Index of Coincident indicators (annual) 2.20% 3.20%

As of 12/31/15

Chart of the MonthExisting Home Sales (in millions)

Source: Federal Reserve

5.8

5.6

5.4

5.2

5

4.8

4.6

4.4

4.2

May 15 Jun 15 Jul 15 Aug 15 Sep 15 Oct 15 Nov 15 Dec 15

ECONOMIC & MARKET DATA I monthly updateEMD


Hollywood has long stereotypedaccountants as boring numbercrunchers. In my view, that is not

the case. For the past 25 years, the account-ing profession has allowed me to developthe skills necessary to fill a variety of roles.I’ve been an audit partner, a consultant andmanaging director, a board member, anda CFO. Career-wise, becoming a CPA isthe best thing that has happened to me.

Why Accounting?Students often ask me if it is better to

go into public accounting or the privatesector after graduation. I recommend pub-lic accounting because it not only helpedme build a strong technical foundation, italso provided me with a holistic view ofthe various services that CPAs can offer—auditing, accounting, tax planning, businessvaluation, and consulting, to name a few.

For example, though I started in audit-ing, I later moved into transaction advisoryservices with a focus on financial due dili-gence and mergers and acquisitions.Admittedly, public accounting entails longworking hours and intense busy seasons, but,in return, accountants can take advantageof various learning opportunities on the job.

In public accounting, hard work gets rec-ognized and rewarded quickly. When youprove that you’re a reliable performer, youwill be given the opportunity to work oncomplex client matters where you will beable to further expand your technical andpeople skills. As an auditor, I worked withclients across different industries andgained extensive experience in financialand management accounting, SEC report-ing, business restructuring, processreengineering, internal controls, and sys-

tem review and implementation. The skillsI developed there are invaluable to this day.

My mentors not only taught me the impor-tance of networking, they also encouragedme to take an active role at the NYSSCPAby joining relevant technical committees.By getting involved, I was able to enhancemy technical skills, learn industry best prac-tices, sharpen my interpersonal skills, andexpand my business contacts.

Transition from Public to PrivateThe job market is always changing,

and it is particularly important for techni-cians like us to stay ahead of the curve.That is, you should start acquiring the skillsneeded for the position you want to holdin 10 years. Change is good when youare prepared for it.

When I was in college, I knew that anaccounting degree would get me a good job,but I had no idea how to become a CFO, con-troller, or even a vice president of finance inthe private sector. Fortunately, my career inpublic accounting prepared me by teachingme not only how to handle pressure, butalso how to interact with clients’ finance andaccounting personnel, understand their dutiesand responsibilities, and get acquainted withthe challenges of their positions.

Since joining private industry over a decadeago, I have held many titles, including VPof business acquisitions; VP and general man-ager of enterprise financial solutions; divisionalCFO; and executive VP, CFO, and directorof a public company. To succeed in these jobs,I needed to be technically solid, as well as ateam player with effective communication andpeople skills.

Integrity should be the basis of every busi-ness decision CPAs make. As a former CFO

of a public company, I needed to lead by exam-ple (i.e., set the right tone at the top). I need-ed to hold myself out as a problem solver capa-ble of delivering viable and ethical businesssolutions. I learned a lot from the mistakes oth-ers made (such as earnings management), andI credit my success in the private sector to theon-the-job technical and ethics training that Ireceived as a public accountant.

Key TakeawaysSuccess does not come easily, but

nothing is impossible for a willing heart.Here is my advice for any CPA lookingto succeed: n It is a competitive world, and job secu-rity cannot be taken for granted. Companiespromote based on merit and not tenure, andemployees must grow their skills or riskbeing left behind. n Success is 90% hard work and 10%luck. While you can’t control luck, you cancontrol how hard you work. n The journey of learning starts from lis-tening to others and making good obser-vations. Talk less and listen to what oth-ers have to say. n Join a professional society to expandyour network and learn from colleagues. n Everyone should learn to be continuouslybroadening their skill set. Professionalswith relevant technical knowledge andexperience do better in the marketplace.Knowledge is something no one can takeaway from you. q

Anthony S. Chan, CPA, is the presidentof CA Global Consulting Inc., New York,N.Y. He is also a member of The CPAJournal Editorial Board.

GUEST EDITORIAL I then & nowGE

It’s Amazing What CPAs Can DoBy Anthony S. Chan

A Career Spent Wearing Many Hats

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Documents

Jan 2006 cpaj cover · February 2016 | vol. LXXXVI, no.2 56 Departments 42 Accounting & Auditing I Accounting Changes to Going Concern Disclosures Accounting Guidance Shifts Responsibilities