Accountancy Laws, Ethics, Taxes and Financial Reporting .../media/event...

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Accountancy Laws, Ethics, Taxes and Financial Reporting Review — Ethics

Ken Garrett, CPA

Learning today. Leading tomorrow.

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Notice to Readers

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If you have any problems or questions using your online course, please e-mail [email protected]. If you move before completing this course, please contact Member Services at (800) 922-5272 with your new address. Materials Terms and Conditions—CalCPA Education Foundation program materials, both hardcopy and electronic, are protected by U.S. copyright law. Materials are provided only for use by the participant registered for the program. You agree that you will not sell, distribute, transmit, or otherwise transfer all or any portions of the content of program materials without written permission from the author(s). Please contact the CalCPA Education Foundation course materials coordinator at [email protected] or (650) 522-3208 to obtain permission. eBook FAQs—Visit www.calcpa.org/ebooks to view frequently asked questions. Be sure to save your annotations made throughout the course. 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Copyright © 2016 Ken Garrett, CPA

No copyright claimed in U.S. Government materials.

ALET4 _________________________________________________________________________________________________________www.calcpa.org (800) 922-5272 rev 03/2015

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Table of Contents

Course Objectives and Overview 5

Course Objectives and Learning Outcomes 5

Course Overview 5

Prerequisites 5

Chapter 1 – Ethics Standards 6

Overview 6

AICPA Code of Professional Conduct – Principles 7

AICPA Code of Professional Conduct – Specific Rules 9

Check Your Knowledge – Ethics Principles 13

Check Your Knowledge – Specific Ethics Rules 13

Case Problem 16

Recent Accounting Scandals in the News 19

Questions Related to Recent Accounting Scandals 23

Transparencies 24

Chapter 2 – Fairness in Tax Practice 36

Overview 36

Standards of Fairness for Positions Taken in Tax Returns 36

Check Your Knowledge – Positions Taken in Tax Returns 39

Case Problems – Positions Taken in Tax Returns 40

Other Standards of Fairness for Tax Preparers 42

Check Your Knowledge - Other Standards of Fairness for Tax Preparers 45

Case Study - Fairness in Tax Returns 46

Accountancy Laws, Ethics, Taxes and Financial Reporting Review – Ethics

CalCPA Education Foundation 3

Copyright 2012, 2013, 2014, 2015, 2016. These materials are copyrighted and may not be reproduced or distributed in whole or in part without permission from the author.

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Transparencies 47

Chapter 3 - Fair Financial Reporting 57

Overview 57

References 57

Fairness in Financial Statements 58

Check Your Knowledge – Fairness in Financial Statements 60

Integrity, Fairness and Materiality 61

Check Your Knowledge – Integrity, Fairness and Materiality 61

Case Problem 1 – Fairness in Financial Reporting 62

Case Problem 2 – Fairness in Financial Reporting 65

Case Study 1 – Fairness in Reporting Related Party Transactions and Balances 66

Case Study 2 – Reporting Unusual or Infrequent Items 69

Case Study 3 - Reporting Pro Forma Income 73

Case Study 4 – Communication with Investors 76

Case Study 5 – Accounting Changes and Error Corrections 77

Transparencies 81

Suggested Solutions 102

Suggested Solutions for Chapter 1 102



Glossary of Terms and Abbreviations 134




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Course Objectives and OverviewCourse Objectives and Learning Outcomes

The goal of this course is to ensure that you have a current knowledge and understanding of the professional ethics standards of the AICPA and are able to apply them. Upon completion of this course you will be able to:

• Identify the AICPA’s professional ethics standards that apply to situations in practice and industry.

• Identify potential problem areas concerning compliance with ethics standards.

• Identify the criteria for evaluating the fairness of financial statements. • Identify the criteria for evaluating fairness related to tax returns and tax practice.

Course OverviewThis course guide summarizes and provides a review of the AICPA Code of Professional Conduct and Ethics Rules and the standards that apply to fairness in tax returns and financial reporting. The course guide includes questions that you can use to assess the state of your knowledge of the rules. It also offers multiple case problems and studies concerning the application of ethics standards to situations similar to ones accountants encounter in practice or employment in business.

PrerequisitesGeneral knowledge of financial reporting and taxes acquired through experience or prior education are important to understanding the content this course.




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Chapter 1 – Ethics StandardsOverview

This chapter summarizes and provides a review of the AICPA Code of Professional Conduct. It includes questions that you can use to assess your knowledge related to the rules and a case problem concerning the application of ethics standards to a situation similar to one accountants encounter in public practice or employment in business.

The AICPA Code of Professional Conduct and Ethics Rules are available at the AICPA’s web site, http://www.aicpa.org.

Objectives and Learning Outcomes

Upon completion of this chapter you will be able to:• Identify the AICPA’s professional ethics standards that apply to situations in practice and

industry.• Identify potential problem areas concerning compliance with ethics standards.•




http://www.aicpa.org


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AICPA Code of Professional Conduct – PrinciplesThe AICPA Code of Professional Conduct requires honesty, objectivity, independence, competence, carefulness, and acceptance of responsibility. It contains principles and rules. The principles are arranged in six topical areas:

• Responsibilities• Public Interest• Integrity• Objectivity and Independence• Due Care• Scope and Nature of Services

In January 2014, the AICPA approved a new codification of the Code of Professional Conduct that will be effective December 15, 2014, except that conceptual framework sections are effective December 15, 2015. The new codification does not change the principles. It does make extensive use of a new term in the context of ethics: threat. The term “threat” refers to anything that might impair independence or keep a CPA from conforming to ethics standards. For example, if an accountant has too close of a relationship with a client, that represents a “threat.” Accountants are expected to manage threats with “safeguards” to keep the threats at an “acceptably low level.”

Responsibilities

CPAs have responsibilities to society, clients and employers and each other. Those responsibilities include, above all, the responsibility to make sensitive moral and professional judgments. They also include:

• Improving the art of accounting• Maintaining public confidence in the profession• Self-governance

The Public Interest

The Code of Professional Conduct affirms the expectations placed on CPAs by the public to:

• Serve the public interest• Honor the public trust• Demonstrate commitment to professionalism

The code requires CPAs to accept their responsibility to the public, including:

• Clients and employers• Credit grantors and investors




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• Governments

The code acknowledges that CPAs often face conflicting pressures from the public groups they serve. It requires CPAs to resolve those conflicts with integrity and to not place client or employer interests ahead of other interests.

The code also acknowledges that the public rightfully expects quality services, fee arrangements and a range of services that are appropriate to the public’s trust in the professionalism of CPAs.

Integrity

Integrity is fundamental to deserving public trust and crucial to maintaining it. Integrity requires:

• Honesty and candor• Subordination of personal gain or advantage to service and public trust• Observation of the form and spirit of technical and ethical standards

The code acknowledges that integrity allows accidental mistakes and honest differences of opinion, but it does not allow deceit or sacrifice of principles.

Objectivity and Independence

Integrity requires CPAs to be:

• Impartial and intellectually honest• Free of conflicts of interest

When engaged in public practice, integrity requires independence in fact and appearance.

When employed in industry, government or other entities, integrity requires:

• Objectivity• Scrupulousness in the application of GAAP• Candor with those in public practice




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Due Care

Although integrity allows room for mistakes and honest differences of opinion, it does require the exercise of due care, and due care requires:

• Competence• Consulting with others when needs exceed competence• Diligence

Diligence requires CPAs to be prompt, careful, and thorough in the performance of their work.

Scope and Nature of Services

Integrity places some restrictions on the scope and nature of services that a CPA can provide. It is important for CPAs to:

• Work in firms (and other organizations) that have quality-control procedures and are concerned with integrity, objectivity and due care

• Consider potential conflicts of interest before performing other services for audit clients.• Not perform other services that are not compatible with public accounting

AICPA Code of Professional Conduct – Specific RulesIn addition to the principles summarized above, the AICPA Code of Professional Conduct contains specific rules pertaining to a variety of topics. The discussion that follows provides examples of these topics and rules.

Independence

Independence may be impaired by any direct or indirect financial interest in a client, by joint investments with a client, by litigation involving the client or CPA, and by many other circumstances.

Under AICPA ethics rules, independence is required for:

• A person on the attest engagement team for a client.• A person who can influence the attest engagement.• A partner or manager who provides ten hours of nonattest services to the client.• A partner in the office where the lead attest engagement partner practices.• The firm providing attest services.• Any entity controlled by the firm or any of the above persons.




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Integrity and Objectivity

CPAs must be free of conflicts of interest when they provide professional services and are not allowed to misrepresent facts to clients or others. When in dispute with clients or others, a CPA is not allowed to subordinate his or her judgment to anyone else.

Competence, Due Care, Planning and Supervision, and Sufficient Relevant Data

CPAs are not allowed to perform services for which they are not competent, must exercise due care when performing their work and must adequately plan and supervise their work.

CPAs are not permitted to make conclusions or recommendations unless they have sufficient relevant data as support.

Compliance with Professional Standards

CPAs are required to perform all professional services in accordance with the appropriate standards (e.g. auditing, management consulting, and tax.)

Compliance with GAAP

Whenever CPAs are associated with financial statements as an auditor, reviewer, compiler or preparer, the financial statements must conform to GAAP or to an other comprehensive basis of accounting.

This rule applies to employees in industry as well as to those in public practice.

Confidentiality

Disclosure of confidential client information requires client permission.

Contingent fees

The AICPA does not allow CPAs in public practice to perform the following services for a contingent fee:

• audits, reviews, compilations (generally) or examinations of prospective financial statements

• original or amended tax returns or claims for tax refunds

Fees that are fixed by courts or governmental entities acting in a judicial regulatory capacity are not regarded as contingent fees.

Before performing any services for a contingent fee, a CPA should consider state laws that may contain additional restrictions. In California, an accountancy regulation prohibits a CPA from receiving contingent fees from a client if the CPA provides any professional services to that




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client that require independence. For example, a CPA who performs an audit for a client may not perform any services under a contingent fee arrangement for that client.

Discreditable Actions

Discreditable actions are prohibited. Examples of discreditable actions include retaining client records after a client has demanded their return, discriminatory employment practices and negligence.

Advertising and Other Solicitations

Advertising is permitted as long as it is not false, misleading or deceptive.

Commissions and Referral Fees

The AICPA does not allow CPAs in public practice to accept commissions for recommending or referring a to a client any product or service, or to receive a commission from a client for products or services supplied by the client when the CPA performs the following services for the client:

• audits, reviews, compilations (generally) or examinations of prospective financial statements• original or amended tax returns or claims for tax refunds

Otherwise, commissions or referral fees are allowed, provided they are disclosed to the person or entity to whom the recommendation or referral is made.

Before accepting or receiving any commissions, a CPA should consider state laws that may contain additional restrictions. For example, in California, accountancy laws and regulations prohibit commissions when the CPA’s referral of a client to a third party is not made in conjunction with performing professional services for the client. The laws also contain specific rules for disclosure.

Form of Organization and Name

CPAs must practice under names that are approved by state laws. In addition, the AICPA rule prohibits practicing under a misleading name (which is also likely to be illegal in any state).

Providing Nonattest Services to Attest Clients

SEC rules and the Sarbanes-Oxley Act prohibit performing bookkeeping services as well as certain other consulting and nonattest services for public companies that are audit or review clients. Otherwise, as long as other laws and government regulations do not prohibit performing bookkeeping, consulting or other nonattest services for audit or other attest clients, AICPA ethics rules generally allow such services if they do not place the CPA in a management role and if:




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1. Related to the bookkeeping, consulting or other nonattest services, the client agrees to perform the management role and oversee, evaluate, accept responsibility for and maintain internal controls over the services provided, and the CPA is satisfied that the client can do those things.

2. Before performing such nonattest services, the CPA establishes in writing his or her understanding with the client of the engagement objectives, the services the CPA will perform, the client’s acceptance of the responsibilities described above, the CPA’s responsibilities and any engagement limitations.

Under the AICPA rule, preparing tax returns and transmitting the return and taxes due to the IRS or other taxing authority do not impair a CPA’s independence, as long as the client reviews and approves the return and related payment and signs the return, if applicable, before transmitting the return to the government. The rule also allows a CPA to sign and file returns in special circumstances elaborated in the rule.




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Check Your Knowledge – Ethics Principles

Choose the best answer from the alternatives.

1. When making judgments about the fairness of financial statements, what weight should a CPA give to the interests of a client relative to the interests of investors and creditors?A) Client interests should be treated as subordinate to the interests of investors and

creditors.B) Client interests should be treated as superior to the interests of investors and creditors.C) Client interests should not be placed ahead of the interests of investors and creditors.D) Client interests should not be given any weight.

2. Accountants employed in industry must be:A) free of conflicts of interestB) objectiveC) independentD) all of the above

Check Your Knowledge – Specific Ethics Rules


Independence

1. Performing any bookkeeping services always impairs the independence of:A) A CPA who audits the financial statements of a publicly held company.B) A CPA who audits the financial statements of a company that is not publicly held.C) Neither A nor B.D) Both A and B.

2. Performing which of the following bookkeeping services impairs the independence of a CPA who audits, reviews or compiles the financial statements of a company that is not publicly held?A) Recording journal entries approved by management.B) Proposing journal entries.C) Preparing source documents.D) None of the above.




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3. Performing which of the following payroll services impairs the independence of a CPA who audits, reviews or compiles the financial statements of a company that is not publicly held?A) Preparing payroll checks based on time reports and other information provided and

approved by management.B) Submitting employees’ wage rates, time worked, and other information needed to

create payroll disbursements to a financial institution and authorizing the financial institution to make direct deposits to the employees’ accountants.

C) Preparing payroll tax returns that are signed by management.

4. Performing which of the following consulting services impairs the independence of a CPA who audits, reviews or compiles the financial statements of a company that is not publicly held?A) Helping a client assess the client’s business and control risks.B) Designing and recommending improvements to control procedures. C) Presenting business risk information on behalf of management to investors.D) Helping management develop business strategies.

5. T/F: An auditor’s independence is impaired when a client threatens to sue an auditor alleging deficiency in audit work.

6. T/F: Independence is impaired when a client employs the CPA’s nondependent brother as controller.

7. When do unpaid audit fees from the prior year impair a CPA’s independence with respect to the audit for the current year?A) The fees remain unpaid at the beginning of fieldwork for the current year.B) The fees remain unpaid when the engagement letter is signed for the current year.C) The fees remain unpaid upon completion of fieldwork.D) The fees remain unpaid when the current year financial statements are issued if the

prior year fees are for services performed more than one year before the date of the current year report.

8. T/F: Seeking employment with a client impairs a CPA’s independence.

9. T/F: Acceptance of free lodging, meals and entertainment at a client-owned resort may impair a CPA’s independence.




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Confidentiality

10. T/F: AICPA confidentiality rules prohibit disclosing the name of a client without the client’s permission.




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Case Problem Background Information

AICPA ethics rules require CPAs to maintain objectivity and integrity and freedom from conflicts of interest. It also prohibits:

• knowingly misrepresenting facts• subordination of judgment to others.

A CPA knowingly misrepresents facts when the CPA knowingly:

• Makes, or permits or directs another person to present materially false or misleading information in financial statements or records.

• Does not correct materially false or misleading information in financial statements or records when the CPA has authority to correct it.

• Signs, or permits or directs another person to sign, a document that contains materially false or misleading information.

Interpretations of integrity and objectivity rules (ET 2.100.005) clarify that a CPA must be candid with the CPA’s employer’s external accountant and cannot knowingly misrepresent facts or withhold disclosure of material facts. The interpretation does not clarify whether this imposes an obligation on an accountant to voluntarily disclose information to external accountants or only to respond candidly to specific questions asked by the external accountant. The interpretation makes it clear only that this responsibility applies to “specific inquiries” that require “written representation.” Presumably the responsibility extends to specific inquiries that require only oral representation. What is unclear is whether it also requires providing information to the external CPA that is not specifically requested.

Interpretations of integrity and objectivity rules also clarify what a CPA must do to avoid subordination of judgment to others. Subordination concerns apply to judgments about accounting standards, professional standards and laws and to representation of facts. When the CPA differs with a position taken by a superior or other person, the CPAs responsibility to avoid subordination of judgment depends on the materiality of the matter of concern. If the CPA believes the matter is immaterial, the CPA is required only to discuss the concern with the person who has taken the position. The difference between the CPA and the other person need not be resolved. If the CPA believes the matter is material, then the difference must be resolved or the CPA is required to take additional steps that to ensure that appropriate action is taken by the CPAs organization. Those additional steps include discussing the concerns with higher levels of management and governing bodies. If these additional steps do not result in resolution of the




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concern or corrective action by the organization, then the CPA is required to consider several other steps:

• Evaluation of whether the employer’s internal policies require the CPA to take other steps.• Evaluating whether the CPA has a responsibility to to report the concerns to third parties, such

as regulatory agencies or external accountants.• Consulting legal counsel about the CPA’s responsibilities.• Documenting the CPA’s concerns and considerations and the discussions the CPA has had with

others.• Resigning from the organization.

Resignation alone does not prevent a CPA from subordinating judgment and the responsibilities and considerations described above apply whether or not the CPA resigns.

Case Description

An accounting supervisor who is a CPA discovered a material error in the company’s financial statements caused by a mistake made within the supervisor’s area of responsibility. Although the supervisor was worried that the mistake might cost him his job, the supervisor brought the mistake to the attention of his boss, the controller. I t was not a pleasant meeting. The controller was visibly upset and after a lengthy discussion told the supervisor to say nothing about the mistake and said that they would quietly fix it next year.

Although the independent audit was not complete for the year, the controller believed that it was unlikely that the auditors would detect the error because the auditors had already completed their work related to that area of the financial statements. The controller also remarked that changing the financial statements at such a late date would be embarrassing not only to the controller, but also to the CFO and president. They would all lose credibility with the company’s bank and prospective investors who already had copies of the unaudited financial statements. The controller said that this error was not so great as to justify such awful consequences. In addition, the controller said that had we known about this mistake earlier, we may not have been as conservative on certain reserves and thus, overall, the financial statements are not materially misstated if we don’t correct this error.

The auditor did detect the misstatement and brought it to the attention of the controller, the CFO and the president. They persuaded the auditor that the financial statements were not materially misstated overall and that it was proper to issue an unqualified opinion.




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Question

What are the ethical issues in this case and what are the ethical responsibilities of the corporate officers, the supervisor and the independent auditor? Summarize the issues in this case and your conclusions. Identify the relevant AICPA ethics principles and rules.




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Recent Accounting Scandals in the NewsFour recent accounting scandals are described below, along with the allegations made against executives of the companies involved. The information comes from news publishers and, in some cases, from SEC press releases. It is important to keep in mind that allegations are often untrue. They are presented here to show the kinds of allegations that are made against accountants and other executives of companies, fairly or not, and the perspectives on these matters found in news stories and in the press releases of the SEC.

In addition to the accounting scandals, a case of alleged embezzlement reported in Backpacker.com is described for the sake of comparison with the accounting scandals.

Toshiba

In July 2015, the Toshiba’s former president and seven other former executives and directors resigned over revelations that Toshiba had overstated its profits about $1.2 billion over six years. The New York Times reported that the former president apologized to shareholders and admitted the misstatements while saying that they were not intentional and that he had not directed subordinates to overstate profits. Toshiba executives had allegedly overstated profits by about $1.2 billion over six years though a variety of improper accounting techniques used throughout this huge company. According to an investigate report commissioned by Toshiba, top management set high and unrealistic profit objectives and pressured their subordinates to report high profits and that in Toshiba’s culture subordinates would not challenge their bosses. The New York Times quoted the investigative committee as saying that Toshiba had “a corporate culture where it is impossible to go against one’s bosses’ wishes.” The Guardian’s news story implied that Toshiba reported profits before they were earned and deferred reporting losses that had already occurred. The New York Times said “under pressure many [managers and executives] resorted to accounting gimmicks and shortcuts” according to the investigative committee.

Sources:

http://www.nytimes.com/2015/07/21/business/international/internal-panel-says-toshiba-inflated-earnings-by-1-2-billion.html

http://www.nytimes.com/2015/07/22/business/international/toshiba-chief-and-7-others-resign-in-accounting-scandal.html

http://www.theguardian.com/world/2015/jul/21/toshiba-boss-quits-hisao-tanaka-accounting-scandal
















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Computer Sciences Corporation

In June 2015, the SEC reported that it had charged Computer Sciences Corporation (CSC) with “manipulating financial results and concealing significant problems” about the company’s biggest contract. It charged certain former finance executives with ignoring accounting rules and overstating profits. The company agreed to pay a $190 million fine and five executives agreed to settlements including penalties and returning compensation. The SEC filed complaints against three other executives in federal court.

The SEC alleged that the company’s former financial executives used “cookie jar” reserve manipulations, unrecorded liabilities, illegitimate prepaid assets and other methods to overstate earnings. CSC and the five executives who settled charges against them neither admitted or denied the SEC’s findings.

Source:

https://www.sec.gov/news/pressrelease/2015-111.html

OCZ Technology Group Inc.

In October 2015, the SEC alleged that the former CEO and CFO of OCZ Technology Group, Inc. overstated OCZ’s revenues and gross margins over a three year period. The CFO reached a settlement with the SEC without admitting or denying the allegations. SEC prosecution of the former CEO was ongoing at the time of this report.

The SEC alleged an executive scheme to misclassify sales discounts as marketing expenses and that executives directed employees to create false documents to conceal the scheme. The SEC also alleged an executive scheme involving channel-stuffing and concealing large product returns from internal accountants and auditors. Other allegations included excluding labor and overhead costs from inventory and recognizing revenues upon shipment that should not have been recognized until delivery.

Source:









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Diamond Foods

In January 2014 the SEC alleged that Diamond Foods and its former CEO and CFO overstated company profits by understating the costs of walnuts it bought from producers and sold to retailers. The SEC alleged that certain costs that Diamond reported as advances for future purchases were actually costs of past purchases. The SEC also alleged that this occurred as part of a scheme developed by Diamond’s former CFO to “boost earnings and meet estimates by stock analysts.” To settle the SEC’s complaint, the company and its former CEO agreed paid fines. The former CEO also repaid bonuses he had received during the years in which earnings were overstated. The SEC believed that the CEO should have known that the profits were overstated. Neither the company nor the CEO admitted or denied the SEC allegations. The SEC has said that the penalties collected from the company and the former CEO “may be distributed to harmed investors if SEC staff determines that a distribution is feasible.”

As of the time the settlement with the company was announced in January 2014, Reuter’s reported Diamond’s former CFO denied wrongdoing and planned to fight the SEC’s charges against him. In a quote in the Reuter’s story, the former CFO’s lawyer said that his client had followed company policies and that the accounting method was approved by the company’s auditors. The lawyer accused the SEC of trying to “turn a disagreement about accounting into a hunt for a villain.”

The Reuter’s story also noted that these charges reflected the SEC’s effort to increase its focus on fraud again.

The SEC’s press release, January 2014, contained these quotes from the director of the SEC’s San Francisco Regional Office: “Diamond Foods misled investors on Main Street to believe that the company was consistently beating earnings estimates on Wall Street. Corporate officers cannot manipulate fiscal numbers to create a false impression of consistent earnings growth.”

Sources:

https://www.sec.gov/News/PressRelease/Detail/PressRelease/1370540598296

http://www.reuters.com/article/us-diamond-sec-accountingfraud-idUSBREA0813020140109








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Accountant Arrested on the Appalachian Trail

Backpacker.com and other news publishers reported the May 2015 arrest of an accountant who was alleged to have embezzled $8.7 from his employer and then hid for six years on the Appalachian Trail. According to backpacker.com, the FBI alleged that the accountant used a fake vendor account to conceal checks he had written to himself. Other news publishers reported that another hiker recognized the accountant from a photo that was included in a television show.

An associated press article and an article at an Appalchian Trail website reported additional interesting details about the accountant and his life on the trail. Other news sources reported the result of a settlement with prosectors. Examples are included among the sources shown below.

Sources:

http://www.backpacker.com/news-and-events/news/trail-news/police-8-7m-embezzlement-suspect-hid-on-appalachian-trail/

http://bigstory.ap.org/article/9b03dda40e7242a2adee5ee7ad954e4e/man-facing-87m-embezzlement-case-hid-appalachian-trail

http://appalachiantrail.com/20150921/fbi-arrests-fugitive-james-hammes-aka-bizmark-at-trail-days/

http://www.pressherald.com/2015/10/23/fugitive-who-spent-6-years-on-appalachian-trail-pleads-guilty-to-wire-fraud/

http://www.wcpo.com/news/state/state-kentucky/appalachian-trail-hiking-embezzlement-suspect-to-change-plea
























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Questions Related to Recent Accounting Scandals1. In each of the cases described above, if the executives and others who allegedly

manipulated earnings had been CPAs, which ethical standards would apply?

2. What differentiates the alleged embezzlement (Appalachian Trail) from the ethics involved in the other allegations (Toshiba, Computer Sciences Corporation, etc.) from an ethical perspective?




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Transparencies

The following pages are copies of transparencies.




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TR 1-1

AICPA Code of ProfessionalConduct Principles

Specific Rules and Interpretations




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TR 1-2

AICPA Code of ProfessionalConductCovers:

· Honesty

· Objectivity

· Independence

· Competence

· Carefulness

· Acceptance of responsibility




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TR 1-3

Code of Professional Conduct –Principles

ResponsibilitiesThe Public InterestIntegrityObjectivity and IndependenceDue CareScope and Nature of Services




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TR1-4

Responsibilities· To society, clients and employers and each other

· Improve art of accounting

· Maintain public confidence in the profession

· Self-governance

· Make sensitive professional and moral judgments




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TR 1-5

The Public Interest· Accept responsibility to public, including:

·· Clients and employers·· Credit grantors and investors·· Governments

· Do not place client or employer interests ahead of other interests




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TR 1-6

Integrity· Honest and candid

· Personal gain or advantage must be subordinate to service and public trust

· Observe form and spirit of technical and ethical standards




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TR 1-7

Objectivity and Independence· Impartial and intellectually honest

· Free of conflicts of interest

· If in public practice, be independent in fact and appearance

· If employed (e.g., in industry):·· be objective·· be scrupulous in application of GAAP·· be candid with those in public practice




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TR 1-8

Due Care· Competence

· Consult with others when needs exceed competence

· Diligence – prompt, careful, thorough




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TR 1-9

Scope and Nature of Services· Work in firms (and other organizations) that have

quality control procedures and are concerned with integrity, objectivity and due care

· Consider potential conflicts of interest before performing other services for audit clients

· Do not perform other services that are not compatible with public accounting




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TR 1-10

New Codification Effective December 15, 2014•Substance of rules does not change

•New organization

•Extensive use of “threat” language




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TR 1-11

Providing Nonattest Services to Attest Clients•Bookkeeping and consulting are permitted, if otherwise legal

•CPA must not assume management role

•Written understanding with client required




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Chapter 2 – Fairness in Tax Practice

OverviewThis chapter summarizes the AICPA standards for fairness in tax returns and includes review questions that you can use to assess the state of your knowledge concerning the rules and case problems and a case study in which you can apply your knowledge of the rules to a situation similar to ones accountants encounter in practice or in employment in business.

The AICPA Statements on Standards for Tax Services (SSTS) are available at the AICPA’s web site, http://www.aicpa.org and should be read in connection with this guide.

Objectives and Learning Outcomes

Upon completion of this chapter you will be able to: • Identify the ethical threshold for positions taken in tax returns. • Identify the criteria for evaluating fairness related to tax returns and tax practice.

Standards of Fairness for Positions Taken in Tax Returns

AICPA Standard

The “realistic possibility standard” is the minimum AICPA fairness standard for tax positions that are not disclosed in tax returns, unless a tax jurisdiction requires a higher standard. The realistic possibility standard allows a CPA to recommend an undisclosed position, or sign a tax return containing an undisclosed position, if the CPA has a good faith belief that the position would have a realistic possibility of being sustained on its merits if it were challenged by the IRS in a tax audit.

The AICPA has a lower minimum standard for tax positions that are disclosed in tax returns. Under that standard a CPA can recommend a position if the position is merely reasonable.

A CPA cannot recommend a tax position, or sign a tax return containing a tax position, without conforming to the higher of the AICPA standard or the standard of the tax jurisdiction in the circumstances.






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A higher standard applies to undisclosed positions in U.S. federal tax returns, as is described below. Therefore, the realistic possibility standard does not apply to U.S. federal tax returns. It applies only to other jurisdictions that do not themselves have higher standards.

The AICPA standard is contained in Statements on Standards for Tax Services (SSTS) No. 1.

Minimum Standard for Tax Positions in U.S. Federal Tax Returns

U.S. federal tax laws for positions taken in tax returns are stricter than the AICPA minimum standard described above and prescribe penalties for non-compliance. Under U.S. federal tax law:

• Undisclosed positions must have substantial authority.

• Disclosed positions must have a reasonable basis.

• Exception: If the position involves a tax shelter or reportable transaction, there must be a reasonable belief that the position would more likely than not be sustained on its merits if challenged.

For U.S. federal tax returns, a CPA cannot ethically recommend positions or sign tax returns that do not comply with these federal requirements.

Comparison of Tax Position Standards

Statements on Standards for Tax Services, Interpretation 1-1, associates the various standards for tax positions with the following probabilities that a position will be sustained on its merits if challenged:

• More likely than not: More than 50%

• Substantial authority: 40% or more

• Realistic possibility: 33% or more

• Reasonable basis: 20% or more

While it is, of course, not possible in practice to quantify such probabilities, the AICPA interpretation uses these percentages to facilitate comparison of the various standards.




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Note about Financial Accounting Standards

GAAP requires recognizing tax expense based on tax positions that are more likely than not to be sustained on their technical merits if challenged by the IRS (FASB ASC 740-10-25-6.) In addition, in a rule based on the FASB’s Interpretation No. 48 (FIN 48), GAAP requires separately classifying and disclosing the effects of tax positions taken in tax returns that are less likely than not to be sustained on their technical merits (FASB ASC 740-10-50-15.) The rules do not make taking aggressive positions less ethical or unethical. They do not change or in any way affect the ethical standards for tax return preparation. Nevertheless these rules increase the chance that taxing authorities will identify aggressive positions and that increased risk may discourage management from taking aggressive positions even though it is legal and ethical to take them. These rules normally only affect C corporations because S corporations and other pass-through entities normally do not report significant amounts of income taxes in their financial statements.

The tax effects of positions taken in tax returns that do not meet the FASB more-likely-than-not standard can be recognized in financial statements when the positions are settled with the tax authorities or when the statute of limitations expire.




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Check Your Knowledge – Positions Taken in Tax Returns


1. What is the current rule under U.S. federal tax law for undisclosed positions taken in tax returns? A) A position must have a realistic possibility of being sustained on its merits if

challenged.B) The position must have substantial authority. C) It must be more likely than not that the position will be sustained on its merits if

challenged. D) The position must be unlikely to be detected in an audit.

2. T/F: A CPA preparing a U.S. federal tax return for a client can recommend a position that lacks substantial authority as long as the position has a reasonable basis and is properly disclosed.

3. When does the realistic possibility standard apply to positions taken in a state tax return?A) It applies to positions that are not disclosed when the state does not apply a stricter

standard.B) It applies when tax positions are disclosed in state tax returns.C) It applies whenever a CPA prepares a state tax return.

4. On what basis should tax expense in financial statements be determined?A) On the basis of the tax positions actually taken in tax returns in the current year.B) On the basis of tax positions that satisfy the realistic possibility standard.C) On the basis of tax positions that have substantial authority.D) On the basis of tax positions that are more likely than not to be sustained on their

merits if challenged.

5. T/F: GAAP rules that pertain to financial statements may discourage management from taking aggressive positions even though it is legal and ethical to take them.




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Case Problems – Positions Taken in Tax Returns Case 1

DescriptionA client wants to take a position in a tax return that the CPA believes is at least reasonable. The client does not want to disclose the position because the client believes that the IRS is more likely to audit the tax return if the position is disclosed and that the IRS is more likely to challenge a disclosed position if the tax return is audited.

Questions

1. In which of the following circumstances is disclosure not required in a U.S. federal tax return?A) The chance that the IRS will audit the return is small.B) The chance that the IRS will challenge the position, if audited, is small.C) The position has a realistic possibility of being sustained on its merits if the IRS

challenges it.D) The position has substantial authority.

2. What should the CPA tell the client if the position lacks substantial authority and the tax return is a U.S. Federal tax return?A) I will sign your return if you agree to pay any penalties that the IRS imposes on me.B) I cannot sign your return unless you disclose this position.C) Disclosure of the position is not likely to result in an IRS audit.




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Case 2

Description

A CPA advised a client that a new U.S. federal tax law generally does not allow deducting certain costs that older laws had allowed as deductions as they were incurred. Instead, the new law allows capitalizing and amortizing the costs. The client determined that to comply with the new law, the cost of software and labor to calculate the annual deductible amount would be so high that it would actually decrease the tax liability! (The client thinks that surely neither Congress nor the IRS would want that to happen.) The client wants to take a position that tax laws allow deducting the costs as incurred in the circumstances.

Question

1. T/F: The CPA can recommend deducting the costs as incurred rather than following the new law because the cost of complying with the new law is so high that it actually reduces the taxes owed.

2. If the position the client wants to take has no reasonable basis, which of the following actions could the CPA ethically recommend?A) Estimate the amounts to capitalize and deduct rather than calculating them accurately.B) Take the position and be prepared to pay the penalties if the IRS disallows the position

in an audit.C) Take the position and disclose it.




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Other Standards of Fairness for Tax PreparersAnswers to Questions on Returns (SSTS 2)

For CPAs who sign tax returns as preparers, SSTS 2 requires them to have made a “reasonable effort to obtain from the taxpayer the information necessary to provide appropriate answers to all questions” on the tax returns.”

It is true that some questions are not applicable to every taxpayer, and some questions may be more important than others. Before leaving any question blank, however, a CPA should consider the applicability and importance of the question to determining taxable income and the tax liability. Additionally, the CPA should consider whether leaving the answer blank might result in penalties and remember the usual obligation of the preparer to sign a statement saying that the return is true, correct and complete.

Although a CPA cannot justify leaving an answer blank merely because the answer may place the taxpayer at a disadvantage, some circumstances do justify leaving an answer blank. For example, if the answer is not important for determining taxable income or the tax liability, an answer can be omitted if the information is not readily available. In addition, it may be appropriate to omit an answer when there is genuine uncertainty about whether the question applies to the taxpayer.

When the answer to a question requires a long explanation, it may be sufficient to omit the detailed answer to the question and state on the return that the information can be supplied upon examination.

Whenever it is reasonable to omit an answer, a taxpayer does not have an obligation to explain the reason for the omission in the return.

Verifying Taxpayer Supporting Data (SSTS 3)

Although a CPA is generally not required to verify the information provided by a tax client, SSTS 3 does say that a CPA “should make reasonable inquiries” about the supporting data in the following two circumstances.

• When the information provided by a taxpayer appears incomplete, incorrect, or inconsistent.

• When tax laws “impose a condition with respect to deductibility or other tax treatment” such as only permitting deductions supported by books and records or other substantiating documentation.




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Unless a CPA has reason to doubt the integrity of the information provided by a taxpayer in response to such inquiries, the CPA can rely in good faith on the taxpayer’s information. Nevertheless, a CPA should encourage taxpayers to provide supporting information when that would help the CPA to fully consider the appropriate tax treatment of income and deductions. This might be particularly important when considering transactions that have complexity, as may be the case when securities transactions or pass-through entities are involved.

A CPA is expected to consider all information available, including information obtained from the tax returns of other taxpayers.

Using Estimates in Tax Returns (SSTS 4)

SSTS 4 permits CPAs to use taxpayer estimates to prepare tax returns as long as the following two conditions are met.

• It is impractical to obtain more accurate data.

• The CPA “determines that the estimates are reasonable” considering the information that the CPA has about the facts and circumstances.

SSTS 4 also cautions that the estimates should not be presented in a way that implies that the information is more accurate than an estimate. Although disclosure generally is not required when estimates are used, disclosure might be necessary when nondisclosure might be misleading.

Departing from a Position Concluded by Administrative Proceeding or Court Decision (SSTS 5)

Conclusions in a court decision or administrative proceeding (such as an examination by a tax authority or an appeals conference) about the treatment of items in a tax return may in some circumstances bind a taxpayer to follow the same treatment in later returns. When such conclusions do not bind a taxpayer in that way, then a CPA can recommend a different position in the later returns as long as the conditions of SSTS 1 (Tax Return Positions) are met.

Having Knowledge of an Error Involving a Tax Return (SSTS 6)

When a CPA is aware that a tax return contains an error or that a required tax return has not been filed, the CPA should take three actions:

• Inform the taxpayer about the error or omission.

• Advise taxpayer about the potential consequences.




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• Recommend corrective measures.

When a client does not take corrective measures, the CPA should consider whether it is appropriate to continue providing services to the client.

When a CPA represents a taxpayer in an administrative proceeding and is aware of an error in the return subject to the proceeding, the CPA should ask the taxpayer for authority to disclose the error to the taxing authority. If the client refuses, the CPA should consider whether it appropriate to continue representing the client in the administrative proceeding or to provide any other services to the client.

When the CPA who has knowledge of an error is an employee, rather than an independent CPA, the CPA should consider whether it is appropriate to resign if the employer does not agree to take proper corrective measures.

Communication of Tax Advice (SSTS 7)

When providing written tax advice, a CPA should conform to any relevant standards of tax authorities concerning written tax advice. When providing oral tax advice, a CPA should assess whether it is necessary to make a record of such advice. Whether the advice is written or oral, a CPA should consider relevant reporting and disclosure standards for the related tax position and the potential penalties associated with the tax position.

If a CPA provides tax advice, and tax laws later change or other subsequent developments would have changed the original advice, a CPA has no obligation to communicate these matters to the taxpayer. However, the CPA should communicate these matters if they arise in the course of helping the taxpayer implement the tax advice or, of course, if the CPA has such an obligation by agreement with the taxpayer.




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Check Your Knowledge - Other Standards of Fairness for Tax Preparers


1. When might it be fair to leave the answer to a question on a tax return blank?A) The information is not readily available. B) The meaning of the question related to the particular tax return is uncertain.C) The answer to the question would place the taxpayer at a disadvantage.

2. When tax laws only permit deductions supported by books and records or other substantiating documentation, what should a CPA preparer do?

A) Inspect the supporting books, records or other substantiating documentation. B) Make reasonable inquiries about the supporting books, records or other substantiating

documentation. C) Inform the taxpayer that the law requires the taxpayer to have supporting books,

records or other substantiating documentation. Inspection and inquiries are not required.

3. T/F: CPAs are not allowed to use taxpayer estimates to prepare tax returns.

4. T/F: If an administrative proceeding has required a specific tax treatment of an item in a prior year’s return, a CPA is not bound to recommend the same treatment in subsequent years.

5. T/F: Confidentiality rules permit a CPA to conceal knowledge of an error in a tax return from taxing authorities.

6. When providing oral tax advice, what should a CPA do?A) Assess whether it is necessary to make a record of such advice. B) Make a record of such advice.C) Follow up with a written communication containing the advice.




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Case Study - Fairness in Tax ReturnsA CPA is a controller for a privately owned company that is an S corporation. For ten years the company has engaged a small CPA firm to review the company’s financial statements. The CPA firm also has prepared the corporate tax returns and the individual tax returns for the company’s owner. The company has expanded its operations and its need for external financing has grown over the years to the point that the company now needs an audit rather than a review. The company’s owner asked the controller to obtain audit bids from several firms and then arrange a meeting with partners from the two firms with the lowest bids. During a meeting with one of the firms, a tax partner who accompanied the audit partner said, “Our firm works with a lot of high net-worth individuals and I would like give you a proposal to do the corporation’s and your personal tax work as well.” The owner said, “Fine, the controller can give you my prior tax returns and explain my situation to you, and I will consider your proposal.”

Later when the firm made the proposal the tax partner said that his firm would be able to substantially reduce the owner’s taxes. When the owner asked what would be involved, the tax partner said, “Your tax returns have been prepared conservatively and we know how to be more aggressive. If you hire us I can explain in detail what we would do differently.” The owner said she would like to think about it.

After the meeting and at the owner’s request, the controller phoned the CPA who previously had prepared the owner’s tax return. The controller explained what was said during the meeting and asked the CPA if he had any idea what the other firm was thinking about doing. The CPA said that he did not know specifically what the other firm had in mind, but that he has heard that the other CPA firm is very aggressive – so aggressive, in fact, that the IRS probably would not approve of many of the techniques. The CPA said that he believes that the company is now paying taxes as low as can be supported under the law and that becoming more aggressive would expose the company and the owner to expensive, stressful IRS audits and penalties.

When the controller relayed the information back to the owner, she said, “What do you think I ought to do?” Later the owner asked the independent CPA who had been preparing her tax returns the same question.

What would you say if you were the controller?

What would you say if you were the independent CPA?




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Transparencies





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TR 2-1

Standard for Tax Positions

U.S. Federal Standard

Must have substantial authority.

AICPA Standard

Must have a realistic possibility of being sustained on its merits if challenged by the taxing authority.




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TR 2-2

Exception to Tax Position Standards

U.S. Federal

· Reasonable basis and

· Disclosed

AICPA

· Reasonable basis and

· Disclosed




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TR 2-3

Where is the ethical line?AICPA:

FrivolousReasonable basis, undisclosed

Reasonable basis, disclosedRealistic possibilitySubstantial authorityMore likely than not

U.S. Federal:

FrivolousReasonable basis, undisclosedRealistic possibility, undisclosed

Reasonable basis, disclosedRealistic possibility, disclosedSubstantial authorityMore likely than not




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TR 2-4

Questions on Tax Returns (SSTS 2)

Fairness requires reasonable effort to obtain from the taxpayer the information necessary to provide appropriate answers.




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TR 2-5

Verifying Supporting Data (SSTS 3)Verification generally not required.

Make reasonable inquiries in when:

1. Data appears incomplete, incorrect, or inconsistent; or

2. When tax laws require supporting documents




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TR 2-6

Estimates (SSTS 4)Allowed when two conditions are met:

1. Greater accuracy is impractical.

2. Estimates are reasonable




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TR 2-7

Departure from Taxing Authority or Court Decisions (SSTS 5)Where decisions do not bind a taxpayer, tax positions in later returns subject only to normal federal or AICPA fairness standard (see SSTS 1).




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TR 2-8

Knowledge of Error (SSTS 6)Three actions are required:

1. Inform taxpayer.

2. Advise taxpayer of consequences.

3. Recommend corrections.




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TR 2-9

Communication of Advice (SSTS 7)Written advice: Conform to tax authority rules.

Oral advice: Consider documenting advice.




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Chapter 3 - Fair Financial Reporting

OverviewThis chapter summarizes the standards for fairness in financial statements. It includes questions that you can use to assess the state of your knowledge concerning the rules. It also includes case problems and a case study so you can apply your knowledge to situations similar to ones accountants encounter in public practice or employment in industry.

Objectives and Learning Outcomes Upon completion of this chapter you will be able to identify the criteria for evaluating the fairness of financial statements.

ReferencesThe AICPA Code of Professional Conduct and Ethics Rules is available at the AICPA’s web site, http://www.aicpa.org. The FASB Accounting Standards Codification is available at the FASB website, http://www.fasb.org.






http://www.fasb.org

http://www.fasb.org

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Fairness in Financial Statements• GAAP in the United States of America is defined as those standards that are included in the

FASB Accounting Standards Codification. (GAAP also includes International Financial Reporting Standards.)

• Disclosure of a GAAP departure generally does not make a departure proper in the way that disclosure of a tax position makes it proper to take an aggressive tax position.

• Fairness requires complying with GAAP or an other comprehensive basis of accounting (OCBOA), choosing appropriate accounting methods where options exist, presenting financial statements and notes informatively, classifying and summarizing information in a reasonable manner, and presenting amounts, descriptions and other information that is materially correct. Although conservatism is a factor that the FASB and its predecessors have historically considered when establishing accounting standards, it is not in itself the determining factor, and many established accounting standards are not the most conservative methods. Similarly, conservatism may be a factor to consider when choosing among alternative methods in accounting practice, especially as a response to uncertainty about future events. Nevertheless, the most conservative alternative may not be the most appropriate method. Today, the FASB emphasizes neutrality over conservatism when it establishes accounting standards. The ultimate goal of the choice is fairness.

• Information is material if its omission or misstatement would change or influence the judgment of a reasonable person relying on it.

• Quantitative considerations (usually dollar amount), qualitative considerations (usually the nature of the item) and surrounding circumstances (e.g., potential effects of the information) affect judgments about materiality.

• Whether or not window dressing techniques are ethical depends on the action involved and the surrounding circumstances. Actions that may be ethical include:

1) Changing operations2) Changing contracts3) Reassessing the facts and circumstances4) Reconsidering an interpretation of accounting principles5) Revising an estimate6) Changing an accounting method7) Correcting an error




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• Arbitrary adjustments, intentional misstatements or omissions and sham transactions are not ethical.




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Check Your Knowledge – Fairness in Financial Statements


1. T/F: Disclosure of a GAAP departure in a note to financial statements generally does not make the departure proper in the way that disclosure of a tax position makes it proper to take an aggressive tax position.

2. Which of the following actions would always be considered unethical? A. Revising the financial statements for a change in an estimate after the books have been

closed. B. Not disclosing an immaterial change in an accounting method. C. Intentionally misstating the financial statements by an immaterial amount. D. All of the above would always be considered unethical.




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Integrity, Fairness and MaterialityMateriality is an inherently ethical idea because it represents an attempt to judge how financial information affects people who use that information. In addition, making judgments about materiality tests a CPA’s integrity in all its aspects: objectivity, independence, due care, and competence. It tests a CPA’s ability to act in a way that serves the public interest and honors the public trust. It tests a CPA’s ability to resolve conflicting pressures between client management and the other parties who have interests in the affairs of the reporting entity.

Information is material if its omission or misstatement would change or influence the judgment of a reasonable person relying on it. Assessing materiality ultimately involves making judgments about how investors and lenders would perceive the importance of information in financial statements. Quantitative considerations (usually dollar amount), qualitative considerations (usually the nature of the item) and surrounding circumstances (e.g., potential effects of the information) affect judgments about materiality.

Although CPA’s may refer to guidelines for assessing materiality that are issued by their firm, professional associations or professional publishers, the CPA is responsible for judging in the circumstances what is material by considering how the pertinent information would influence a reasonable person who relied on it.

Check Your Knowledge – Integrity, Fairness and Materiality


1. T/F: Arbitrary adjustments and intentional misstatements are ethical if they are immaterial.

2. T/F: Ethics do not require CPAs employed by a private entity to make adjustments to financial statements for known, but immaterial, misstatements.

3. T/F: A CPA’s assessment of materiality is properly influenced by the CPA’s own perception of the needs of a reasonable person who will rely on the financial statements.

4. If management of a company believes an item is material to the financial statements, but the company’s independent CPA believes it is not, whose judgment should prevail?A) Management may defer to the judgment of the independent CPA.B) The CPA may defer to the judgment of management.C) Neither management nor the CPA should defer to the other’s judgment.




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Case Problem 1 – Fairness in Financial ReportingPart A

A company is not having a good year. Two months before year-end, management expects profits to be down 10 percent from the prior year because bad weather reduced sales and a series of unfortunate events increased various expenses. This year’s lower profits will break a five-year upward trend. Management hopes to sell an interest in the company to an investor in the near future and is afraid the income slump will reduce stock prices and that the board will award smaller bonuses.

The president asked the CFO to think of ways to increase profits and the CFO proposed the following actions:

a. Use a sales promotion that will give rebates to customers who make purchases before year-end. The marketing director estimated that such a program would boost profits by 2 percent primarily by encouraging customers to buy goods that they would otherwise not buy until next year. As a result, sales will be lower during the next year potentially reducing profits that year by 4 percent. (Essentially, the rebate lowers profitability over the two-year period by 2 percent.)

b. Accelerate product shipments. Normally it takes 10 days to fill a customer order. That could be reduced to six days near year-end. This would increase profits by 2 percent. The shipping supervisor said the acceleration is feasible, but will require several people to work overtime and cancel vacations during the year-end holiday period, adversely affecting morale.

c. Postpone scheduled plant maintenance until next year, increasing profits by 2 percent. The plant manager opposes this action because she is concerned that delaying maintenance will increase safety risks and may cause higher maintenance costs during the next year, but she is not able to quantify these effects. She says it is not right to quantify safety risks.

d. Reduce the allowance for uncollectible accounts. This will increase net income by 2 percent. The accounting supervisor does not believe it is right to reduce the allowance. He said he calculated the allowance the same way he has always calculated it. The controller said the allowance is just an estimate and it is possible to support a smaller allowance. Although accounts receivable aging statistics are comparable to prior years, recent write-offs have been somewhat lower than average.

e. Record certain costs as prepaids. These costs have been charged to expense in prior years. This would increase net income by 2 percent. The controller said that the costs have been




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expensed in prior years because he considered them immaterial, but he noted that the costs do benefit future periods. He said that it would not be necessary to disclose this change in accounting method because the effect is immaterial.

f. Reduce depreciation expense by lengthening the estimated useful lives of certain equipment. This would increase net income by 2 percent in the current year. The controller said the useful lives are not precise estimates and immaterial changes like this do not require disclosure. The plant manager said it is possible to use the equipment longer only by incurring additional maintenance expenses in future years. The plant manager is not able to quantify this effect.

Question

In your opinion, what issues bear on the ethics of management’s decision? Explain how each of the strategies might be justified ethically and how each might be considered unethical. Weigh the issues and choose which, if any, of the strategies you find acceptable. Explain your conclusions.




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Part B

An accountant who believes earning management is a good thing said:

It is arguable that earning management legitimately enhances the value of a business. Companies with smooth, ever increasing earnings trends tend to be worth more than other companies. They are perceived as less risky than companies that report ups and down in earnings, even if the overall trend is upward. The lower risk motivates investors to pay more for the stock and lenders to make more loans at lower interest rates.

Accounting standards do not result in precise, unarguable measurements of income. Accounting standards represent conventions, not ultimate truths of any kind. They also allow some flexibility in their application and interpretation. In addition, business transactions and events are often subject to more than one interpretation or assessment. All of these factors reduce the precision of income measurement and require management to make judgments with unavoidable effects on financial statements.

In the context of the two conditions described above, it is fair for management and its accountants to take all legal steps to create a smooth upward trend in earnings. Legal steps include making judgments that support that earnings trend, as long as they conform to accounting standards.

Question

Do you agree?




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Case Problem 2 – Fairness in Financial ReportingFour days after year-end, the controller and the assistant controller of a company met with the CFO to review the financial results for the year. Profits were down 3 percent from a forecast that had been presented to the board and that the CFO had relayed to investors and lenders in December. The CFO asked the controller to fix this problem. The controller told the CFO that she did not think there was anything that could be done, but that she would double check and let the CFO know. The CFO said, “I don’t want to hear that. Just say you’ll fix it. You have my authorization and I will take responsibility for this decision.” The controller then said nothing, left the meeting, made adjustments to loss contingency accruals sufficient to make income approximately equal to the forecast, and prepared a memorandum to support the lower accruals. The assistant controller said nothing during the meeting with the CFO, but after leaving the meeting he told the controller that she was on her own, and that he would not sign the journal entries because he believed the entries to be dishonest.

In your opinion, what are the ethical issues in this case? What are the responsibilities of the CFO, controller and assistant controller? Discuss the behavior of the CFO, the controller and the assistant controller from an ethical perspective. Also describe how each person might have handled this situation more ethically.




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Case Study 1 – Fairness in Reporting Related Party Transactions and BalancesBackground Information – Standards for Related Party Transactions and Balances

Generally, related party transactions should be recorded according to the same rules that apply to other transactions. The problem is that related party transactions are often not like other transactions.

The economic substances of related party transactions do not always correspond to their legal forms. In addition, the economic substance is often not readily discernible, and the legal form is often not established in writing nor is it readily discernible. These ambiguities require accountants to make significant judgments in applying accounting principles to the transactions because the ambiguities suggest that more than one accounting method might be appropriate. Making those judgments tests an accountant’s scrupulousness, objectivity and impartiality. The ambiguities make it hard, sometimes even impossible, to prepare fair financial statements.

Examples of related parties include:

• people who own and manage the company (and their immediate families and other entities that they own or control)

• parent or subsidiary companies and their affiliates• subsidiaries of a common parent• employee benefit trusts

All material related party transactions and balances should be disclosed (i.e., nature, terms, amount, relationship, etc.) For material related party transactions, the following information should be disclosed:

• nature of the relationship with the related party• transaction terms and amounts• effects of changing transaction terms from prior years• balances and settlement terms for receivable and payable balances

Generally, related party balances should be classified separately from other amounts in balance sheets.

Even when there are no transactions with an affiliate, disclosure of common control is required when that control could affect results of operations or financial position.




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Related party transactions are not presumed to be arms length. However, if disclosures represent or imply that a transaction is equivalent to arms length, management must have evidence to substantiate that representation.

Unethical actions include:

• Ignoring the substance of a transaction.• Deliberately misclassifying or misstating a transaction or balance.• Deliberately omitting or misstating a required disclosure.

The AICPA has published a “toolkit” titled “Accounting and Auditing for Related Parties and Related Party Transactions.” It summarizes the relevant accounting standards, professional standards and securities laws and provides practical guidance for implementing them. At the AICPA website, use the search feature to find: Accounting and Auditing for Related Parties and Related Party Transactions Toolkit.

Case Description

A stockholder, who is also president, of a small company borrowed $200,000 from the company on December 1, repaid the loan on December 31, and then borrowed the money again on January 3 (the first business day after the end of the fiscal year that ended on December 31). The stockholder subsequently repaid the loan on January 20. The stockholder paid $1,500 interest, which represented the same rate at which the company could borrow money under its bank credit line. The stockholder does not want the balance sheet to show the stockholder loan as of the end of the year and has asked the controller and independent CPA if it is acceptable to omit disclosure of this transaction based on immateriality. The company’s net worth is $4 million and its income for the year was $1 million.

Questions

Choose the answer you believe is best from the alternatives given.

1. What has happened here in substance?

A. The stockholder borrowed $200,000 on December 1 and repaid it on December 31, and then borrowed $200,000 again on January 3 and repaid it on January 20. These were two separate loans.

B. The stockholder borrowed $200,000 on December 1 and repaid it on January 20. In substance, there was really only one loan.




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C. Whether there was one loan or two loans is ambiguous.

2. Why do related party transactions pose ethical challenges for CPAs?

A. The accounting principles that apply to related party transactions are not the same as the principles that apply to other transactions.

B. Such related party transactions are designed to deceive the users of financial statements.

C. The ambiguities suggest that more than one accounting method might be appropriate and that situation tests an accountant’s scrupulousness, objectivity and impartiality.

3. Would it be fair to omit disclosure of this transaction based on immateriality, as the client has requested?

A. Yes, because the loan amount is small compared to the net worth of the company, the interest is small compared to the net income of the company, and the loan was only outstanding for a short period of time.

B. Yes, because the transaction occurred at arms-length terms.

C. No, because the loan is a substantial sum compared to net worth and may also be material merely because it is a related party transaction, which may be the reason the client prefers nondisclosure.

4. T/F: As long as the transactions and balances are disclosed in notes to the financial statements, it would be fair to include the balance (if any) of the stockholder’s note payable in a line item for notes payable that includes notes payable to unrelated parties.

5. T/F: It would be fair to disclose that this transaction occurred at arms-length terms.

Case Assessment

Draft an appropriate disclosure.




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Case Study 2 – Reporting Unusual or Infrequent ItemsBackground – Standards for Extraordinary, Infrequent and Unusual Items

FASB Accounting Standard Update No. 2015-01 eliminates the requirement and possibility to report extraordinary items. The whole concept of extraordinary items will vanish in accounting standards. That new standard is effective for fiscal years beginning after December 15, 2015. Companies can adopt the new standard early.

The standards that are being eliminated required: • Reporitng extraordinary items separately from income from continuing operations.

• Classifying an event or transaction as extraordinary if it is both unusual and infrequent.

• Allocating taxes to extraordinary items.

The revised standard, after the elimination of extraordinary items, will continue to require separate reporting of unusual and infrequent items as components of income from continuing operations. After extraordinary items are eliminated from the FASB standards, here is a summary of the remaining rules:

• Unusual means not related to the ordinary and typical activities of the business.

• Infrequent means not reasonably expected to happen again in the foreseeable future.

• Items that are either unusual or infrequent, or both, should be reported as part of continuing operations. They should be reported as a separate line item within continuing operations, or disclosed in notes, if they are material.

• Taxes should not be allocated to items that are unusual or infrequent.

Unethical actions include deliberate misclassification or deliberate improper presentation and disclosure.

Definitions

Term Meaning

Unusual Not ordinary or typicalInfrequent NonrecurringExtraordinary Both unusual and infrequent




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Summary of Presentation Rules

Type PresentationUnusual Continuing operationsInfrequent Continuing operationsExtraordinary Below continuing operations

Summary of Classification Rule

The only items reportable below income from continuing operations are:• discontinued operations• extraordinary items• cumulative effect of a change in accounting principle

Example – Extraordinary Items

Revenues $5,000,000Selling expenses 2,000,000Administrative expenses 1,700,000Income before extraordinary loss 1,300,000Extraordinary loss 1,000,000Net income $ 300,000

Example – Unusual or Infrequent Items (in this case, a litigation settlement)

Revenues $5,000,000Selling expenses 2,000,000Administrative expenses 1,700,000Litigation settlement 1,000,000Net income $ 300,000

Check Your Knowledge

Chose the best answer from the alternatives.

1. T/F: Extraordinary items have been stricken from accounting standards as of December 15, 2015.

2. Extraordinary items are events or transactions that:A) Occur infrequently.B) Are not related to ordinary operating activities of a business.




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C) Have either characteristic A or B.D) Have both characteristics A and B.

3. T/F: Extraordinary items should be reported net of taxes after income from continuing operations in an income statement.

4. T/F: Unusual or infrequent items should be included in income from continuing operations, but disclosed or shown separately in income statements.

Case Description

During the current year, a company (S corporation) settled litigation for $1,000,000, which is material to its financial statements. Although the company is seldom the defendant in litigation, the litigation pertained to the ordinary operating activities of the business and was not extraordinary. Management wants to present the loss separately from other results of operations so that the users of its financial statements can easily see that the company had an especially profitable year except for the litigation loss. In addition, management wants to report depreciation separately from other expenses because it is not a cash expense.

Case Assessment

Consider the following examples as well as other options for reporting these items. What is your opinion about the ethical propriety of the examples? Explain your conclusions concerning those examples and the presentation you believe is most ethical.

Example – Acceptable?

Revenues $5,000,000Selling expenses 2,000,000Administrative expenses 1,300,000Income before litigationsettlement and depreciation 1,700,000

Litigation settlement 1,000,000Depreciation 400,000Net income $ 300,000




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Example – Acceptable?

Revenues $5,000,000

Selling expenses 2,000,000Administrative expenses 1,300,000 Total operating expenses 3,300,000

Litigation settlement 1,000,000Depreciation 400,000 Total other expenses 1,400,000

Net income $ 300,000




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Case Study 3 - Reporting Pro Forma IncomeBackground – Standards for Pro Forma Information

• Pro forma financial information has gained in popularity among companies and their investors, while GAAP financial statements have declined in popularity (even though GAAP financial statements are still expected and required by laws and contracts).

• Many investors believe pro forma information helps them assess the future prospects of a business.

• Critics believe pro forma information is less reliable than the information in GAAP financial statements because pro forma information is not regulated by GAAP and because it tends to be less conservative. They believe it is frequently used unethically to mislead investors.

• The pro forma financial information that investors most often seek is net income or earnings per share before items such as:

- Restructuring charges- Unusual expenses- Infrequent expenses- Discontinued operations - Asset impairments- Other one-time charges- Research and development costs- Stock compensation- Interest expense

• In addition, for privately owned companies pro forma income might exclude depreciation and officers’ compensation.

• Pro forma income disclosures seek to differentiate recurring and non-recurring items and cash and non-cash items.

• Pro forma income disclosures often amount to cash profits before non-recurring items.




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• Pro forma income disclosures are usually made outside of GAAP financial statements, but GAAP financial statements sometimes include subtotals or line items that facilitate the pro forma disclosures.

• Pro forma income disclosures often emphasize favorable results and obscure unfavorable results.

• Existing accounting standards generally do not provide guidance for the fair presentation of pro forma financial results, except in connection with disclosures of particular events and transactions, such as discontinued operations, extraordinary items and accounting changes, and in connection with formal financial forecasts and projections.

• It is not unethical to report pro forma information, but it is unethical to distort financial results or to mislead investors in either GAAP financial statements or pro forma information.

Questions

Chose the best answer from the alternatives.

1. Why has reporting pro forma income become popular with companies and their investors? A) Many investors believe it helps them assess the future prospects of a business.B) Management can use it to mislead investors.C) It is required by the FASB.

2. Which of the following items are often added to net income when reporting pro forma income for a privately held business?A) DepreciationB) Nonrecurring expensesC) InterestD) All of the above

Case Description

During the current year, a company (S-corporation) terminated a group of employees, relocated to less-expensive facilities and wrote-off unproductive assets. The company did not discontinue a segment of its business. It simply restructured its organization and cleaned up the balance sheet. The cost of this restructuring and other one-time charges were $1,000,000, which is material to its financial statements. The company’s accountants do not consider these costs extraordinary. Management wants to show these expenses as a separate line item and show a subtotal before that item so that it can emphasize to creditors and investors that the company




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would have had much higher income without these expenses. Management wants to emphasize that the subtotal rather than the net income is indicative of the company’s future financial performance.

Proposed PresentationRevenues $5,000,000Selling expenses 2,000,000Administrative expenses 1,300,000 Depreciation 400,000Income before restructuring and other one-time charges 1,300,000 Restructuring and other one-time charges 1,000,000Net income $ 300,000

Case Assessment

What is your opinion about the ethical propriety of this treatment?




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Case Study 4 – Communication with InvestorsAt the beginning of the current year, a company began to outsource much of its accounting activities. This enabled the company to reduce the number of employees, to lower its office lease costs and to eliminate certain data processing costs. It now pays a monthly fee for accounting services which is about 20 percent lower than the cost it incurred in the prior year for these accounting activities (including salaries, benefits, office rent, data processing and other related costs). In addition, the company recognized a gain on the sale of the computer equipment and furniture to the accounting services firm. (The firm agreed to buy these items to facilitate obtaining the contract for accounting services.) That gain has been recorded as an offset to the expense for the monthly fees.

The company’s income statement includes a line item titled “moving expenses” which represents the cost of moving the whole company to smaller offices at the beginning of the year. The rent per square foot is lower than the rent in the previous space, and rent expense decreased about 30 percent from the prior year. About one-third of that decrease resulted from outsourcing accounting and the other two-thirds from the lower rental rate per square foot.

Overall income increased 11 percent over the prior year for the following reasons:

Higher revenues 3%Lower accounting expenses 10%Lower rent per square foot 1%Gain on sale of equipment and furniture 2%Moving expenses (5%) Net increase 11%

In a letter to a potential investor, the president stated that net income from the company’s core business had increased 16 percent over the prior year after adjusting for non-recurring moving expenses. He attributed the increase to higher sales and lower costs, but did not provide the detailed analysis shown above.

Case Assessment

Is the president’s letter ethical?

If the controller, who is a CPA, attends a meeting with the prospective investor at which the letter is presented to the investor, what obligation, if any, does the controller have to provide additional information about the increase in income?

If the company’s independent CPA is at that meeting, what obligation does he or she have to provide additional information about the increase in income?




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Case Study 5 – Accounting Changes and Error CorrectionsReadings/References

• FASB Accounting Standards Codification, 250, Accounting Changes and Error Corrections

Background Information

• Changes in accounting principle, changes in estimates and error corrections engage an accountant’s ethics because they have different effects on the financial statements and because they can be more difficult to distinguish from each other in practice than in theory. In addition, given the opportunity, management will tend to favor reporting a transaction as a change in estimate if it increases income and favor reporting it as a change in accounting principle or error correction if it decreases income. A scrupulous accountant, however, must try to objectively, impartially judge which treatment is the most fair in the circumstances.

• Accounting standards permit changing an accounting method as long as the new method is preferable to the old method. A new method is preferable if it represents a more authoritative accounting principle or if it more fairly presents financial position and results of operations.

• For many decades, GAAP generally required financial statements to show the cumulative effect of a change in an accounting principle on the income statement, net of taxes, after income from continuing operations. That rule changed beginning with 2006 financial statements. The current rule generally requires financial statements to show the effect of a change in an accounting principle retrospectively by essentially restating prior financial statements.

• Financial statements should show the effects of changes in estimates as part of current (or future) operations in the income statement.

• Sometimes changes in estimates result in changes in accounting principles. For example, a change in expected future benefits associated with certain costs could result in capitalizing costs that were previously expensed. When that happens, the change should be reported as a change in estimate.

• Financial statements should show the effects of material error corrections by restating prior period financial statements or by showing the effect on beginning retained earnings if prior period financial statements are not presented.




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• Changing from an unacceptable accounting principle to an acceptable one is an error correction.

• It is often possible to support a voluntary change in an accounting principle on the basis of revised estimates. This allows disclosing most voluntary changes (rather than those required by new FASB standards) as changes in estimates rather than as changes in accounting principles. When the change increases net income, the change often sounds like better news if it is called a change in estimate rather than a change in accounting principle. That is why management tends to prefer reporting items that increase income as changes in estimates.

Effects of Accounting Changes and Error Corrections Principle Estimate ErrorIncome fromoperations Usually Yes No

Net income Usually Yes No

Prior yearfinancial statements Usually No Yes

Ranking of Desirability from Management’s Perspective

If positive If negative effect effect Change in estimate 1 3Change in principle 2 2Error correction 3 1

Unethical Actions

• Deliberate misclassification

• Improper presentation and disclosure

• Changing to a less preferable accounting method

• Making arbitrary estimates




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Check Your Knowledge


1. T/F: Changing from an unacceptable accounting method to an acceptable method is an error correction.

2. A change from MACRS to straight-line depreciation over the estimated useful life may be considered:A) a change in estimate effected by a change in accounting principleB) a change in accounting principleC) an error correctionD) A or C

3. T/F: If the settlement of litigation results in lower costs than have been accrued in prior years, the difference should be reported by restating prior financial statements.

4. T/F: A write-off of previously capitalized costs should be reported as a change in an accounting principle.




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Case Description

To increase profits, the new president of a company asked the controller to change from an accelerated to straight-line depreciation method and to depreciate assets over longer lives. The president wants to make the changes, but does not want to report them as a change in accounting principle nor to otherwise “make a big deal about the changes in the footnotes.” The controller studied the estimated useful lives of the company’s plant and equipment and concluded that using longer lives can be supported by past experience. However, the shorter lives are also supportable. The useful lives appear to depend on the level of maintenance applied to the plant and equipment and on subjective decisions concerning when it is efficient to buy new equipment. The controller also evaluated whether switching to the straight-line method can be justified and concluded that it can be argued that the straight-line method does result in a more rational allocation of costs, but that the accelerated method also has merit. When management originally started using the accelerated method, management believed that greater benefits would be derived from using the equipment in early years than in later years. Although that has been true to some extent, the decline in benefits over time is much more gradual than the decline in depreciation expense that results from the use of the accelerated method. The straight-line appears to be a better, but less than perfect, match with the pattern of benefits.

Case Assessment

In your opinion, do the changes appear appropriate?

If the changes are made, how should they be reported in financial statements and notes?

What ethical issues should the controller consider?




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Transparencies





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TR 3-1

Fairness Standard for Financial StatementsFairness requires:· Compliance with GAAP (or OCBOA)· Use of appropriate accounting methods where

options exist· Presenting financial statements and notes

informatively· Classifying and summarizing information

reasonably· Presenting amounts, descriptions and other

information that is materially correct.




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TR 3-2

Window Dressing TechniquesActions that may be ethical:

1) Changing operations2) Changing contracts3) Reassessing the facts and circumstances4) Reconsidering an interpretation of accounting

principles5) Revising an estimate6) Changing an accounting method7) Correcting an error

Actions that are not ethical:· Arbitrary adjustments· Intentional misstatements or omissions· Sham transactions




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TR 3-3

What is material?Information is material if its omission or misstatement would change or influence the judgment of a reasonable person relying on it.




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TR 3-4

Factors Affecting Materiality· Dollar amount (quantitative)

· Nature of the item (qualitative)

· Surrounding circumstances




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TR 3-5

Related Parties – Examples

· people who own and manage the company (and their immediate families and other entities that they own or control)

· parent or subsidiary companies and their affiliates

· subsidiaries of a common parent

· employee benefit trusts




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TR 3-6

Related Party Disclosures

For material related party transactions, disclose:

· nature of the relationship with the related party

· transaction terms and amounts

· effects of changing transaction terms from prior years

· balances and settlement terms for receivable and payable balances




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TR 3-7

Unethical Actions· Ignore the substance of a transaction

· Deliberately misclassify or misstate a transaction or balance

· Deliberately omit or misstate a required disclosure




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TR 3-8

DefinitionsTerm Meaning

Unusual Not ordinary or typical

Infrequent Nonrecurring

Extraordinary Both unusual and infrequent




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TR 3-9

PresentationType Presentation

Unusual Continuing operations

Infrequent Continuing operations

Extraordinary Below continuing operations




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TR 3-10

Example – Extraordinary ItemRevenues $5,000,000Expenses 4,000,000Income before extraordinary loss 1,000,000Extraordinary loss 600,000Net income $ 400,000




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TR 3-11

Example – Unusual or Infrequent ItemsRevenues $5,000,000Selling expenses 2,000,000Administrative expenses 1,500,000Litigation settlement 1,000,000Net income $ 500,000




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TR 3-12

Desirability Ranking If positive If negative effect effect

Unusual orinfrequent 1 2

Extraordinary 2 1




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TR 3-13

Unethical Actions · Deliberate misclassification

· Improper presentation and disclosure




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TR 3-14

Classification Rule The only items reportable below income from continuing operations are:

· Discontinued operations

· Extraordinary items

· Cumulative effect of a change in accounting principle




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TR 3-15

Example – Acceptable? Revenues $5,000,000Selling expenses 2,000,000Administrative expenses 1,300,000Income before litigationsettlement and depreciation 1,700,000 Litigation settlement 1,000,000Depreciation 400,000Net income $ 300,000




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TR 3-16

Example – Acceptable? Revenues $5,000,000

Selling expenses 2,000,000Administrative expenses 1,300,000 Total operating expenses 3,300,000

Litigation settlement 1,000,000Depreciation 400,000 Total other expenses 1,400,000

Net income $ 300,000




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TR 3-17

Accounting Changes and ErrorsChanges in:

· Principle· Estimate· Reporting entity

Error Corrections




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TR 3-18

Effects of Accounting Changes and Error Corrections Prin- Esti- ciple mate ErrorIncome fromoperations Usually Yes No

Net income Usually Yes No

Prior yearfinancial statements Usually No Yes




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TR 3-19

Ranking of Desirability fromManagement’s Perspective If positive If negative effect effect Change in estimate 1 3Change in principle 2 2Error corrections 3 1




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TR 3-20

Unethical Actions · Deliberate misclassification

· Improper presentation and disclosure

· Changing to a less preferable accounting method

· Making arbitrary estimates




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Suggested SolutionsSuggested Solutions for Chapter 1Check Your Knowledge - Ethics Principles

1. Correct response: C

According to the AICPA Code of Professional Conduct, client interests should not be placed ahead of the interests of investors and creditors. The rules do not require client interests to be treated as subordinate to other interests or ignored.

Incorrect responses: A, B and D Reasons those responses are incorrect:

A. The rules do not require client interests to be treated as subordinate to other interests.B. The rules explicitly prohibit treating client interests as superior to the interests of

investors and creditors.D. Client interests should be considered, but not placed ahead of other interests.

2. Correct response: B According to the AICPA Code of Professional Conduct, accountants employed in industry

should be objective, scrupulous in the application of GAAP and candid with those in public practice.

Incorrect responses: A, C and D Reasons those responses are incorrect:

A. The rules do not require accountants in industry to be free of conflicts of interest. CPAs in public accounting are required to be free of conflicts of interests.

C. The rules do not require accountants in industry to be independent. CPAs in public accounting are required to be independent.

D. Objectivity is required but not independence or freedom from conflicts of interest.




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Check Your Knowledge - Ethics Rules

Independence

1. Correct response: A

SEC rules and the Sarbanes-Oxley Act prohibit performing these services as well as certain other consulting services for public companies.

Incorrect responses: B, C and D Reasons those responses are incorrect:

B. Performance of bookkeeping services for a nonpublic company does not necessarily impair a CPA’s independence. However, to be independent, the client must take responsibility for the financial statements, the CPA must ascertain that the client understands the entity’s business activity, financial condition and accounting issues, the CPA must not play a management role, and the CPA must apply attest procedures to his or her own work.

C. It does impair the independence of a CPA who audits a publicly held company.D. It does not necessarily impair the independence of a CPA who audits a nonpublic

company.


According to AICPA ethics rules (101-3, Performance of Other Services, ET101.05), preparing source documents, such as purchase orders, employee time reports, and sales orders, impairs independence.

Incorrect responses: A, B and D Reasons those responses are incorrect:

A. Recording journal entries does not impair independence as long as management has approved them.

B. Proposing journal entries for management’s approval does not impair independence because the CPA is acting in an advisory role rather than in a management role,




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provided that the client reviews the entries and understands their nature and how they will affect the financial statements.

D. Preparing source documents (response C) does impair independence.

3. Correct response: B

Authorizing the financial institution to make direct deposits impairs independence because such authorization is equivalent to signing a check – it consummates a transaction and effectively gives the signer custody of the company’s assets. It would not impair independence for the CPA to submit the information if management, rather than the CPA, authorized the financial institution to make the direct deposits. This makes it impractical in most cases for the CPA to submit the information because submitting and authorizing normally occur simultaneously.

Incorrect responses: A and C

Reasons those responses are incorrect:A. Preparing payroll checks does not impair independence as long as management has

approved the employee time reports and other information used to prepare the checks. Merely preparing the payroll tax return does not consummate the transaction or give the CPA custody of the company’s assets.

C. Independence is not impaired as long as management, not the independent CPA, signs the payroll tax returns. Merely preparing the payroll tax return does not consummate the transaction or give the CPA custody of the company’s assets.

4. Correct response: C Presenting information on behalf of management places the CPA in a management role that impairs independence.

Incorrect responses: A, B and D

Reasons those responses are incorrect:A. Helping a client assess risks does not impair independence because that places the

CPA in an advisory role rather than in a management role.B. Designing and recommending improvements does not impair independence because

that places the CPA in an advisory role rather than in a management role.D. Helping management develop business strategies does not impair independence

because that places the CPA in an advisory role rather than in a management role.




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5. True, if the auditor believes it is probable that the client will sue.

6. True. Siblings are considered close relatives and when they are employed by a client in a key position such as controller, they impair independence.

7. Correct response: D

According to AICPA ethics standards, independence is impaired if fees for any professional services remain unpaid when the current year financial statements are issued if the fees are for services performed more than one year before the date of the current year report.

Incorrect responses: A, B and C

Reasons those responses are incorrect:A. Fees unpaid at the beginning of fieldwork do not impair independence unless they

remain unpaid when the financial statements are issued. Generally, however, is not prudent to begin fieldwork until the fees have been paid to avoid a situation in which the current year audit has been completed and the old fees have still not been collected.

B. Signing an engagement letter does not require prior collection of fees. Generally, however, it is prudent to address the unpaid fees in the engagement letter because the auditor would not be able to complete the engagement if the old fees are not paid.

C. Although it would be imprudent to go so far as to complete the fieldwork for another year’s audit when the prior year’s fees have not been collected, this is not prohibited by AICPA Ethics standards.

8. True. As long as the CPA is seeking employment with a client or as long as an employment offer is outstanding, independence is impaired. California law imposes an additional restriction when a public company is involved. That law is covered in a later section of this chapter.

9. True. Gifts impair independence unless they are clearly insignificant to the recipient. Entertainment impairs independence unless the entertainment is reasonable in the circumstances.




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Confidentiality

10. False. AICPA rules permit such disclosure unless the name is confidential. For example, if a CPA specializes in bankruptcy work, the mere disclosure of a client name may constitute disclosure of confidential information. However, any disclosure of a client’s name may be illegal under California law. That law is covered in a later section of this chapter.




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Case Problem

The following principles of the AICPA Code of Professional Conduct apply to this case:

• the responsibility to make sensitive professional and moral judgments• the responsibility to not place client or employer interests ahead of other interests• the responsibility to make personal gain subordinate to service and public trust and the

responsibility to be honest and candid• the responsibility to be impartial, intellectually honest, scrupulous in the application of GAAP

and candid with those in public practice

Issues to consider in evaluating the ethical course of action include:

• The supervisor believes the error is material.

• The auditors did not detect the error and probably will not know about it unless informed by the client.

• Certain reserves may be overstated and the controller’s suggestion that this may have been intentional may indicate that objectivity is lacking.

• The financial statements may not be materially overstated overall.

It may be appropriate to consider the following issue:

• The controller, CFO and president may lose credibility. Although that is not good, ethical standards do not allow putting employer interests ahead of other interest. AICPA principles appear to permit considering employer interests as long as they are not put ahead of other interests. However, employer interests may be difficult to separate from the personal gain that AICPA principles requires to be subordinate to service and public trust.

Although the financial statements may not be materially misstated overall, the controller’s position does not appear to conform to ethical standards related especially to integrity and objectivity. The statement that “they would quietly fix it next year” suggests an intentional deception, and the observation that auditors would probably not find the error suggests that the controller is less candid with the auditors than required by AICPA principles. It appears that the ethical course of action for the controller would be to discuss the error with the CFO, assess the potential overstatement of reserves, make an honest assessment of the need to make adjustments and disclose the matter to the auditors.




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The accounting supervisor should not subordinate his judgment to that of the controller and should recommend the course of action described above. If the controller refused, the accounting supervisor should inform the controller that he has an obligation to inform the CFO and the auditors if the controller does not. If the controller refuses, then the accounting supervisor should take such actions.

The auditor’s responsibility is to independently assess whether the financial statements are materially misstated and to issue a qualified or adverse opinion if they are. The auditor’s judgment cannot be subordinate to the client’s judgment. The auditor’s responsibility includes assessing whether the misstatements are intentional or not. In this case, the misstatement of certain reserves appears to have been intentional and leaving the other misstatement uncorrected appears to have been intentional. If the auditor makes such conclusions, the auditor has a responsibility to report that conclusion to the audit committee or owner.

If the supervisor did go over the head of the controller and then the CFO also refused to address the concerns, the supervisor has rather unpleasant remaining responsibilities. The supervisor may need to discuss the concerns with the organization’s governing body. If that did not resolve the concerns, then the supervisor is required to consider several other steps:

• Evaluating whether the organization’s internal policies require other steps.• Evaluating whether the supervisor has a responsibility to report the concerns to third parties,

such as regulatory agencies or external accountants.• Consulting legal counsel about the supervisor’s responsibilities.• Documenting the supervisor’s concerns and considerations and the discussions the CPA has

had with others.• Resigning from the organization.

Resignation alone does not prevent subordinating judgment and the responsibilities and considerations described above apply whether or not the CPA resigns.

While it may seem wholly appropriate for the supervisor to speak candidly with the auditors about this matter early in the process, the AICPA rule (ET 2.130.030) leaves some uncertainty about the necessity of this course of action. A CPA must be candid with the CPA’s employer’s external accountant and cannot knowingly misrepresent facts or withhold disclosure of material facts. The rule does not clarify whether this imposes an obligation on an accountant to voluntarily disclose information to external accountants or only to respond candidly to specific questions asked by the external accountant. The interpretation makes it clear only that this responsibility applies to “specific inquiries” that require “written representation.” Presumably




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the responsibility extends to specific inquiries that require only oral representation. What is unclear is whether it also requires providing information to the external CPA that is not specifically requested.

It is probably reasonable to say that most of these matters are resolved between the controller and the controller’s subordinates and certainly at the next higher level in any event. Still, one does hear of friends who have resigned from jobs over ethical concerns. Often those resignations may have occurred without the employee having fulfilled all of the responsibilities described in AICPA rules. The rules are a heavy burden. In addition, sometimes, at least, the resignations may result from ego conflict rather than substantive ethical disputes. Once a subordinate has begun the process of challenging superiors, conceding that a superior has been right and the subordinate has been wrong, can feel so embarrassing as to be intolerable.




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Questions Related to Recent Accounting Scandals

1. The Toshiba, Computer Sciences Corporation, OCZ Technology Group Inc. and Diamond Foods cases involve allegations of manipulating financial statements to make companies appear to be more profitable than a fairer presentation of financial statements under GAAP would have shown.

The cases that involved allegations of financial statement manipulation may have involved intentional deceptions, which amounts to fraud, but none of the executives involved admitted to fraudulent financial reporting, nor has fraud been proved in court. Intent is hard to discern and prove.

In the Toshiba case many executives were alleged to be involved in the effort to enhance the apparent profitability of the company. Based on the allegations, the corporate culture appears to have made subordination of judgment to superiors into a virtue, which the code of ethics for CPAs does not allow. In that corporate culture, it would be legitimate to set aside objectivity and to place a perceived employer’s interest and personal gain above all others, or perhaps to mistake interests of executives for the employer’s interest itself. It also appears likely that company executives and accountants were not candid with independent auditors.

The Computer Sciences Corporation, OCA Technology Group Inc. and Diamond Foods cases involved similar allegations related to distorting financial results, but the corporate culture is not mentioned and apparently fewer people were involved. In those cases, the allegations imply a lack of objectivity, seeking unfair personal gain at the expense of others, and lack of candor with independent auditors, if not outright deception.

The ethics standards are intended to set boundaries for CPAs. Presumably, if one stays within those boundaries, fairness to all parties is achieved and a CPA can believe that professional responsibilities have been fulfilled. In these cases, violations of laws, not ethics standards, have been alleged. Under pressure of aggressive prosecution settlements were reached. One can identify the ethics rules that applied in the cases, but one cannot really know to what extent they may have been breached or met. If the allegations are true, then surely the ethics standards were breached.

2. If the allegations are true, then the ethics principles involved are virtually the same.

The Toshiba, Computer Sciences Corporation, OCZ Technology Group Inc. and Diamond Foods cases involve allegations of manipulating financial statements to make companies appear to be more profitable than a fairer presentation of financial statements under GAAP would have shown. The accountant arrested on the Appalachian Trail was charged with embezzling money. The accountant took money from the company and made the payments he




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made to himself appear to be payments to a vendor, thus distorting the financial statements. Deception has been alleged in all of these cases and in all cases the companies and their shareholders were harmed. While the deceptive acts themselves are different, they essentially violate the same provisions of the code of ethics.

The accountant who allegedly embezzled $8 million dollars, placed personal gain ahead of the interests of others and deceived the company and its shareholders by misrepresenting the nature of unauthorized payments made to himself. The accountant presented them as if they were authorized payments to a vendor. Lack of candor with auditors is implicitly involved.




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Suggested Solutions for Chapter 2

Check Your Knowledge – Positions Taken in Tax Returns


Undisclosed positions must have substantial authority. If the undisclosed position involves a tax shelter or reportable transaction there must be a reasonable belief that the tax treatment of the of the position would more likely than not be sustained on its merits if challenged.

Incorrect responses: A, C and D

Reasons those responses are incorrect: A. U.S. tax laws now impose a higher standard for undisclosed positions. C. U.S. tax laws impose a lower standard for undisclosed positions, unless the

undisclosed position involves a tax shelter or reportable transaction D. The probability that a position will be discovered in an audit, or that the taxpayer will

be audited, is not a valid consideration in determining whether a position is ethical or legal.

2. True. For disclosed positions, only a reasonable basis for the position is needed.


The realistic possibility standard applies to undisclosed positions taken in a state tax return when the state does not require a higher standard. A CPA should apply the higher of the AICPA standard or the tax jurisdiction standard.

Incorrect responses: B and C

Reasons those responses are incorrect:B. When positions are disclosed, they must be reasonable but they need not meet the

realistic possibility standard.C. A CPA should apply the realistic possibility standard only when the tax jurisdiction

does not require a higher standard.




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Tax expense in financial statements should be determined on the basis of tax positions that are more likely than not to be sustained on their merits if challenged.


Reasons those responses are incorrect:A. Tax positions actually taken in tax returns may not be more likely than not to be

sustained on their merits if challenged.B. Positions that satisfy the realistic possibility standard may not be more likely than not

to be sustained on their merits if challenged.C. Positions that have substantial authority may not be more likely than not to be

sustained on their merits if challenged.

5. True. GAAP rules for determining tax expense and disclosure requirements related to the tax effects of positions not recognized in tax expense increase the chance that taxing authorities will identify aggressive positions and that increased risk may discourage management from taking aggressive positions even though it is legal and ethical to take them

Case Problem 1 – Positions Taken in Tax Returns


Taxpayers make take a position that is not disclosed as long as that position has substantial authority.


Reasons those responses are incorrect:A. A taxpayer can consider the risk that a return may be audited when deciding among

alternative positions to take in a tax return, but a small risk of being audited does not justify omitting disclosure when disclosure is required.

B. A taxpayer can consider the risk that the IRS will challenge a position, if audited, when deciding among alternative positions to take in a tax return, but a small risk of challenge does not justify omitting disclosure when disclosure is required.




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C. The realistic possibility standard is no longer the standard that applies to positions taken in U.S. federal tax returns.


If the position lacks substantial authority and the tax return is a U.S. federal tax return, disclosure is required and the CPA is not allowed to sign the return.


Reasons those responses are incorrect:A. A client’s promise to pay any penalties imposed on the CPA by the IRS does not justify

signing a return that a CPA believes does not conform to the tax laws.

C. Disclosure of the position may result in an IRS audit. Even if it did not, the chance that a return may be audited does not affect the obligation to disclose a position when disclosure is required.

Case Problem 2 – Positions Taken in Tax Returns

1. Correct response: False

The CPA cannot recommend deducting the costs as incurred rather than following the new law on the basis that the cost of complying with the new law is so high that it actually reduces the taxes owed. The CPA can only recommend positions that have substantial authority or a reasonable basis with disclosure. High compliance costs do not in themselves provide such grounds.


If the position the client wants to take has no reasonable basis, the CPA may be able to ethically recommend estimating the amounts to capitalize and deduct rather than calculating them accurately.


Reasons those responses are incorrect:




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B. It is unlikely in the circumstances that the client’s position has substantial authority or even a reasonable basis. The CPA cannot recommend positions in U.S. federal tax returns that lack a reasonable basis.

C. It is unlikely in the circumstances that the client’s position has a reasonable basis. The CPA cannot recommend positions in U.S. federal tax returns that lack a reasonable basis, even if they are disclosed.

Check Your Knowledge – Other Standards of Fairness in Tax Returns


It is appropriate to leave the answer to a question blank when the meaning of the question related to the particular tax return is genuinely uncertain.


Reasons those responses are incorrect:A. This answer is incorrect because it is incomplete. It is appropriate to leave the answer

to a question blank when the information is not readily available if the answer is not significant to taxable income or the tax liability. If the answer is significant, then it is important to determine the answer to the question.

B. Although this is a great motivation, it does not legitimate leaving an answer blank under SSTS 2.


When tax laws only permit deductions supported by books and records or other substantiating documentation, a CPA preparer should make reasonable inquiries about the supporting books, records or other substantiating documentation.


Reasons those responses are incorrect:A. Inspection is generally not required. Unless a CPA has a reason to doubt the integrity

of the information provided by a taxpayer in response to such inquiries, the CPA can rely in good faith on the tax payer’s information.

C. Merely informing the taxpayer is not sufficient.




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3. Correct response: False.

CPAs are allowed to use taxpayer estimates to prepare tax returns as long as two conditions are met. They are:• It is impractical to obtain more accurate data.• The CPA “determines that the estimates are reasonable” considering the information that

the CPA has about the facts and circumstances.

4. Correct response: True.

Although a CPA might generally recommend the same treatment, this is not a binding requirement unless the taxpayer is legally bound to follow the same treatment as might happen, for example, in connection with a formal closing agreement.

5. Correct response: False.

Confidentiality rules generally prohibit a CPA from disclosing errors to taxing authorities without a client’s permission. Nevertheless, a CPA has a responsibility to inform a client or employer when the CPA is aware of an error, to provide information about the potential consequences and to recommend corrective actions. If a client or employer refuses to take corrective actions, the CPA should consider whether it is appropriate to continue providing services to the client or employer.


When providing oral tax advice, a CPA should use professional judgment to assess whether it is necessary to make a record of such advice. When providing routine advice in well-defined areas, neither a record nor a written communication is usually warranted. On the other hand, when the advice involves complex or unusual areas or involves a large sum of money, written communication is often warranted.


Reasons those responses are incorrect:B. A CPA is not required to make a record of oral advice.C. A CPA is not required to follow up with a written communication confirming the oral

advice.




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Case Study – Fairness in Tax Returns

The firm that proposed the tax reduction technique has not provided information that enables the controller or the current CPA who prepares the owner’s tax returns to evaluate the propriety of the techniques the new CPA would apply. Accordingly, neither the controller nor the CPA has sufficient relevant data to support a conclusion or recommendation about the propriety of the techniques. What they can do, however, is explain how a CPA is required to assess positions taken in tax returns, explain what it means to be legally aggressive, and explain the risks associated with being aggressive. Tax laws allow tax preparers to recommend positions in tax returns that are not likely to be sustained on their merits if challenged as long as the positions have a reasonable basis and are properly disclosed. As long as a position meets those criteria (reasonable basis and disclosed), it is legal and ethical even if it is aggressive. To be aggressive means to take positions that may not, or even probably will not, be sustained in an IRS audit. Taking aggressive positions is accompanied by the risks of being audited and of being assessed penalties in addition to the taxes owed. Taking aggressive positions is also accompanied by the prospect of winning disputes with the IRS over contentious issues and saving substantial amounts of taxes.

Assuming that the new CPA is only considering positions that have a reasonable basis, whether the owner should take the additional risk associated with aggressive positions depends on whether the owner considers the risk worth taking. The CPA has an ethical obligation to explain the risk and to make sure the position either has substantial authority or has a reasonable basis and is disclosed.

The company in this case is an S corporation. If it were a C corporation, the obligation imposed by the FASB in FIN 48 (FASB ASC 740-10-50-15) to separately classify and disclose taxes that might be owed related to aggressive tax positions might also affect the client’s decision. Although the chance that an aggressive position would be detected in an IRS audit is not relevant to determining whether the ethical standard for tax positions has been met, that chance is relevant to deciding whether or not to take an aggressive position. FIN 48 may increase that risk.




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Suggested Solutions for Chapter 3

Check Your Knowledge – Fairness in Financial Statements

1. True. Fairness requires compliance with GAAP.


Intentional misstatements are considered fraud.

Incorrect responses: A, B and D

Reasons those responses are incorrect: A. If estimates change materially after year-end and before the financial statements are

issued, the financial statements should be revised. B. Only material changes in accounting methods require disclosure. However, fairness

requires that appropriate accounting methods must be chosen where options exist. D. Only item C would always be considered unethical.

Check Your Knowledge – Integrity, Fairness and Materiality

1. False. It is generally not possible to defend these actions as ethical. If they are not material, why would anyone make them?

2. False. It is more ethical to make adjustments for known immaterial misstatements than to ignore them, unless they are trivial. Although one may be able to defend not making immaterial adjustments, not making an adjustment for a known misstatement is similar in result to making an arbitrary adjustment – financial statements contain known misstatements that could have been corrected.

3. True. Professional standards have left assessments of materiality to a CPA’s professional judgment about the needs of a reasonable person who will rely on the financial statements.

4. Correct response: C Both management and independent CPAs have responsibilities for making judgments about materiality. Management’s responsibility for materiality arises from management’s primary responsibility for the fairness of financial statements. The




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CPA’s responsibility arises from the CPA’s responsibility to issue an appropriate report on those financial statements.

Incorrect responses: A and B

Reasons those responses are incorrect:A. Management, not the independent CPA, has primary responsibility for the fairness of

financial statements. Materiality judgments are not the sole responsibility of independent CPA’s.

B. Even though management has primary responsibility for the fairness of financial statements, the independent CPA also has a responsibility to evaluate materiality which cannot be deferred to management.




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Case Problem 1, Part A

The primary ethical issue from an accounting perspective is fairness of the financial statements in accordance with GAAP. Other ethical issues from a business or human perspective may also apply.

a. The sales promotion is an example of changing operations to affect financial statement results. Sales promotions are not normally considered unethical. From a business perspective, however, the sales promotion might be unethical if, for example, this strategy results in an unfair gain to management through a bonus system or if it affects the business adversely by increasing costs, which it does in this case. In addition, it may be unfair to fail to mention the effect of the special promotion in analyses provided to the board or other interested parties discussing the results of operations and comparing them with prior periods.

b. Accelerating product shipments is another example of changing operations to affect financial statement results. Like sales promotions, accelerating product shipments is not normally considered unethical. However, this action may be unethical for the similar reasons to those described above. In this case, accelerating product shipments adversely affects the lives of the employees and indirectly adversely affects the productivity of the company through lower morale. These effects are difficult to quantify. Besides, the adverse effects on the employees are not quantitative.

c. This item is also an example of changing operations to affect financial statements results and is not normally considered unethical. However, it could be unethical if the additional safety risk is not acceptable and if the higher maintenance costs in future years decrease the profitability of the company.

d. This is an example of revising an estimate in to affect financial statement results. It would be ethical to reduce the allowance for uncollectible accounts if it can be demonstrated objectively to be overstated. It would not be ethical to arbitrarily reduce the allowance for uncollectible accounts merely to meet a profit target. Unfortunately, objectivity is often difficult to achieve in the case of an estimate, such as an allowance for uncollectible accounts, because estimating the allowance involves predicting the future. The estimate for the allowance for uncollectible accounts may be a range rather than a single amount. When that is the case, it is appropriate to accrue the low end of the range unless some other amount within the range represents a better estimate. Determining whether an other amount represents a better estimate often involves subjectivity. Accounting methods should be applied consistently, but “calculations” of estimates are not the same as accounting methods. The important concern is the fairness of the estimate, not consistency of the estimation




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method. The reduction in recent write-offs may indicate that a smaller allowance is appropriate, as long as the controller expects the lower write-offs to represent a new trend.

e. This item represents an example of changing an accounting method or correcting an error to affect the financial statement results. Ordinarily, this technique is ethical as long as the change in accounting principle or error correction conforms to generally accepted accounting principles. However, it would not be ethical to make these adjustments for one year only without an intention to make similar adjustments in future years. The controller in this problem is correct in saying that immaterial changes in accounting methods and error corrections do not require disclosure.

f. This technique represents a change in an estimate. Ordinarily, lengthening the estimated useful life of fixed assets is ethical as long as the new lives represent management’s best estimates. Arbitrarily lengthening estimated useful lives would not be ethical. In this problem, if the company uses the equipment longer, it will incur higher maintenance costs in future years, which may reduce future profitability. As the controller said, immaterial changes of this sort do not require disclosure.

Achieving a 10 percent increase in net income will require adopting at least five of these strategies. Each is immaterial taken alone. Together they are material, or else management would be ignoring the 10 percent decline in net income. No existing accounting standards or ethics rules provide explicit guidance. If management implements these strategies, it appears that fairness would require candid discussion of the techniques used to boost income in certain circumstances (for example, at board meetings and in written and oral comparisons of the current year with prior years provided to users of the financial statements.)

Case Problem 1, Part B

Here are two possible answers:

1. Yes. In my experience, accounting has always ultimately involved making some arbitrary decisions. In addition, I have found that even the sharpest minds often disagree on the meanings of accounting standards and business events and transactions. In these circumstances, one is fooling oneself to believe that income is precisely measurable, and is being a foolish prig to oppose earnings management. Fraud is not the same as earnings management. Fraud is performed to deceive. Earnings management is not performed to deceive. It is performed to show a prudent exercise of judgment in measuring income in the face of uncertainty and in a competitive world in which those who make these necessary judgments do better than those who do not.




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It is foolish to believe that one is upholding a high standard of morality by refusing to manage earnings. Whatever one does is subject to criticism because the standards and the transactions and events to which they apply are subject to multiple interpretations.

2. No. It is always possible to determine the right thing to do in accounting. The rules of the FASB are mostly clear, and it is possible to arrive at a consensus on their meaning with other accountants if one persists. Similarly, objective decisions are always achievable related to business transactions and events.

Earnings management involves an intentional distortion of income. It is fraud. An accountant’s job is to measure earnings, and not to make earnings conform to management preferences for the sake of personal benefit.




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Case Problem 2

The ethical issues in this case include.

• CPAs should not place client or employer’s interests ahead of other interests.

• CPAs are expected to be honest and candid and make personal gain or advantage subordinate to public service and trust.

• CPAs must be impartial, intellectually honest and scrupulous in the application of GAAP.

On the surface, the CFO’s instruction to the controller to fix the problem sounds unethical, especially since the CFO told the controller that he did not want to hear any objections. By telling the controller that the CFO would take responsibility for the decision, the CFO is attempting to persuade the controller to consent to his decision. However, it would not be appropriate for the controller to subordinate her judgment to the CFO merely because the CFO is her boss.

The case problem implies that the controller did in fact subordinate her judgment to that of the CFO and make adjustments that she did not believe were appropriate. If that is the case, then preparing the memorandum to support the lower accrual amounts to a deception.

It is ethical for the assistant controller to refuse to sign journal entries that he believes are dishonest. However, the assistant controller was less than honest and candid during the meeting with the CFO. The assistant controller’s silence may amount to tacit approval and his refusal to sign the journal entries may represent cowardice as much as honesty.

Rather than the CFO demanding that the controller fix the problem, it would have been more ethical for the CFO to discuss the problem with the controller and to ask the controller to identify any options that they legitimately might have for adjusting the financial statements. Neither the controller nor the assistant controller should have subordinated their judgment to that of the CFO. In addition, the assistant controller should have stated his objection during the meeting because that might have persuaded the CFO to choose a more ethical course of action and would have been a more honest and candid approach for the assistant controller. If the controller and assistant controller were not able to support adjustments to the financial statements, they should have refused to make such entries. If the CFO remained insistent, the controller should have discussed the issue with the president of the company. Instead, it appears that the CFO, the controller and the assistant controller each placed their own personal gain ahead of the interests of others, each in a different way.




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Case Study 1 - Fairness in Reporting Related Party Transactions and Balances

Questions

1. Suggested best response: B

It appears that in substance this loan was not actually repaid until January 20. Although $200,000 may have been deposited in the corporate account on December 31, it was never available for the company’s use because it was loaned back to the stockholder on the first business day of the next year. That fact appears to lead to a conclusion that in substance the loan was not repaid until January 20. Nevertheless, the repayment on December 31 and the re-borrowing on January 3 means that the legal form may be different from the substance or that the substance of what happened is at least somewhat ambiguous. In cases of such ambiguity more than one way of interpreting the facts can be supported.

Alternative responses: A and C

Analysis of alternative responses:

A. The legal form does appear to be that these are two separate loans. The first loan was repaid on December 31 and a new loan was made on January 3. That appears to have been the intention of the stockholder, even if that intention was driven by concerns about the appearance of the loan in the balance sheet at year-end rather than by business concerns. Nevertheless, the fact that the funds were only available to the business over a holiday suggests that the company never really had use of the funds between the loans, and that may raise questions about legal form as well as the substance of the transactions.

C. Whether these transactions represent one or two loans is at least somewhat ambiguous. Reasonable observers could reach different conclusions about the legal form and the substance of these transactions. Perhaps, however, it is the fairest interpretation of the facts to conclude that in substance the loan was not repaid until January 20 and that the brief repayment over a holiday had no substance because the company had no real use of the funds over that holiday.


Ambiguities in legal terms and economic substances suggest that more than one accounting method might be appropriate. Conflicting interests between management and the users of the financial statements or among the users themselves require an accountant




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to make fair judgments. These judgments test an accountant’s scrupulousness, objectivity and impartiality.

Incorrect responses: A and BReasons those responses are incorrect:A. Generally, related party transactions should be recorded according to the same rules

that apply to other transactions. The problem is that related party transactions are often not like other transactions either in their legal form or in their economic substance.

B. The ambiguities usually arise because the transactions are not conducted between parties that have competitive interests. Flexibility is often more important than clarity to related parties, whereas clarity is more important to parties who have competitive interests. Nevertheless, accountants must always be alert to the possibility that the ambiguities disguise intentional deception.

3. Suggested best response: C

It would not be fair to omit disclosure of this transaction. The loan amount is 5 percent of net worth. That small amount might be judged immaterial if this were not a related party transaction, but the fact that a transaction involves a related party is itself a qualitative factor that should affect the judgments about materiality. In addition, the stockholders desire to not show this loan on the year-end balance sheet suggests that it would be material to at least some users of the financial statements.

Alternative and incorrect responses: A and BAnalysis of alternative and incorrect responses:A. It is true that this loan might be considered immaterial on several grounds, including:

the loan amount is small compared to the net worth of the company, the interest is small compared to the net income of the company, and the loan was only outstanding for a short period of time. Nevertheless, the transaction and balance are likely to be considered material in spite of these grounds because they involve a related party. The stockholder’s desire to keep this loan off the balance sheet at year end probably signifies the potential materiality of the loan from the perspective of at least some users of the financial statements.

B. Even when the terms of related party transactions match those of similar transactions with unrelated parties, disclosure is required.




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4. False. They must be reported separately.

5. Suggested best response: False.

The fact that the transaction reflected an interest rate at which the company could borrow funds under its credit line may indicate that this loan reflected arms-length terms. Other factors might also warrant consideration in making that assessment, particularly, perhaps, whether or not the company would have made this loan to an unrelated party under those terms, if at all.

Related party transactions are not presumed to be arms-length, and accounting standards do not require assessing whether the transactions are equivalent to arms-length transactions and do not require disclosure that they are or are not arms-length. However, if disclosures represent or imply that a transaction is equivalent to an arms-length transaction, management must have evidence to substantiate that representation. In the circumstances described in this case, the existence of such evidence seems unlikely. The interest rate at which the company can borrow under its credit line may or may not be equivalent to the rate at which the company would loan money to an unrelated party. In addition, the stockholder’s desire to not show the loan on the year-end balance sheet suggests that perhaps this loan lacked a business purpose, which would rarely be the case in an arms-length transaction.

Case Assessment

Here is an example footnote disclosure:

The company loaned $200,000 to an officer who is also a stockholder of the company on December 1. The loan was repaid on January 20 of the following year, with interest computed at a 9.5 percent annual rate.




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Case Study 2 – Reporting Unusual or Infrequent Items

Check Your Knowledge Questions

1. True. Effective for financial statement periods beginning after December 15, 2015, reporting extraordinary items separately from continuing operations will no longer be allowed or required by FASB standards. Until then, it remains optional, but not required, because the new standard can be adopted early.

2. Correct response: D To be classified extraordinary, an event or transaction must be both unusual (which means:

not related to ordinary operating activities of a business) and infrequent.

Incorrect responses: A, B and C Reasons those responses are incorrect:

A. Material events or transactions that are infrequent, but not unusual as well, are not considered extraordinary, but should be reported as a separate item above income from continuing operations.

B. Material events or transactions that are unusual, but not infrequent as well, are not considered extraordinary, but should be reported as a separate item above income from continuing operations.

C. To be classified extraordinary, an event or transaction must be both unusual (which means, not related to ordinary operating activities of a business) and infrequent.

3. True in 2015. False in 2016. For years beginning before December 15, 2015, extraordinary items may be reported separately from income from continuing operations. Taxes should be allocated to extraordinary items, but not to items that are merely unusual or infrequent. For years beginning after December 15, 2015, it is not appropriate to report extraordinary items separately from continuing operations. That new standard can be applied retroactively.

4. True. Unusual or infrequent items should be included in income from continuing operations, and either shown separately in income statements as a part of continuing operations or, alternatively, disclosed in notes..




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Case Assessment

The $1,000,000 litigation settlement appears to represent an item that is infrequent but not unusual. Therefore, it is proper to report this loss on a separate line in the income statement. The appropriateness of reporting the loss as shown in the examples, however, is questionable. They are not proper if they imply that the litigation settlement is extraordinary or not part of continuing operations. The question is whether or not the examples make such inappropriate implications. In the first example, the subtitle “Income before litigation settlement and depreciation,” may imply that the expenses shown below the subtotal are not part of continuing operations. On the other hand, the subtotal is descriptive in a literal sense and may relay information that is relevant and important to the user of the financial statements. This presentation is probably appropriate as long as notes to financial statements or information accompanying the financial statements do not imply that the litigation settlement is extraordinary or otherwise not part of continuing operations.

In the second example, the subtotal titled “Total operating expense,” may imply that the expenses below that line are not part of continuing operations. On the other hand, there may be a valid distinction between operating expenses and expenses from continuing operations. In addition, there is no subtotal for income that implies that the other expenses are extraordinary and grouping the litigation settlement with the litigation expense perhaps implies that the litigation settlement is part of continuing operations because depreciation is part of continuing operations. Like the other example above it, this example is probably appropriate as long as footnote disclosures or other information accompanying the financial statements do not imply that the litigation settlement is an extraordinary item or otherwise not part of continuing operations. The possible implication that the litigation settlement is not part of continuing operations caused by the subtotal “Total operating expenses” could be reduced by changing that caption to one such as “Selling and administration expenses.”




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Case Study 3 - Reporting Pro Forma Information

Review Questions

1. Correct response: A Many investors believe pro forma information helps them assess the future prospects of a

business.

Incorrect responses: B and C Reasons those responses are incorrect:

B. Overall, the motivation to report pro forma earnings has more to do with providing information that helps investors assess the future prospects of a business than with attempts to mislead investors. Nevertheless, it is true that some managers have used pro forma information to mislead investors and many managers try to increase pro forma income by adding back all nonrecurring expenses, but not subtracting nonrecurring revenues or gains.

C. The FASB generally does not require pro forma information except in connection with disclosing discontinued operations, extraordinary items and accounting changes.


Interest, depreciation, and nonrecurring expenses are often added to net income when reporting pro forma income for a privately held business. Pro forma income is typically earnings before interest, taxes, depreciation and nonrecurring charges.

Incorrect responses: A, B and C Reasons those responses are incorrect:

A. Depreciation is often added to net income along with interest and nonrecurring expenses.

B. Nonrecurring expenses are often added to net income along with interest and depreciation.

C. Interest is often added to net income along with depreciation and nonrecurring expenses.




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Case Assessment

This presentation is similar to one used by many publicly held corporations. Although publicly held corporations do not show a subtotal before the restructuring and one-time charges (because this item precedes income taxes), they do use that amount to compute pro forma net income and earnings per share and then give the pro forma amounts emphasis in communications with investors and lenders. The SEC has criticized companies for overstating restructuring and one-time charges while understating other expenses to unfairly make the company look better.

In this problem, the use of the subtotal is questionable for the reasons covered in the previous case. It technically conforms to accounting standards, but it may not conform to the the spirit. Nevertheless, many investors and managers consider this presentation valuable (as long as the restructuring and one-time charges are fairly stated) because it facilitates projecting future potential profits.




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Case Study 4 - Communication with Investors

Although the president’s letter is factual, some accountants and investors may believe that the president’s letter is misleading, or less than honest and candid. The president’s letter accentuates the positive results by reporting pro forma net income. The 16 percent increase the president cites includes the gain from the sale of equipment and furniture, which is non-recurring, like the moving expenses. Neither the controller nor the independent CPA can criticize the president’s statement on the basis of existing accounting standards because there are no rules that govern what a company can say about its income outside of its GAAP financial statements and SEC filings. Nevertheless, AICPA ethics standards pertaining to integrity compel the controller and the independent accountant to be honest and candid. Are they allowed within that standard to accentuate the positive as the president has done in his letter? Probably not, because they are expected to be objective. In a meeting with the investor, the controller and independent accountant each have a professional obligation to answer the investor’s questions honestly and candidly. If the investor does not ask for a detailed explanation of the increase over the prior year, they must assess whether other statements made in the meeting and in the president’s letter would be misleading. If so, then they appear to have a professional obligation to make clarifying statements. This may create conflict with the president, if the president believes that it is fair to accentuate the positive and let the investor carry the responsibility to be diligent in investigating the company.




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Case Study 5 - Accounting Changes and Error Corrections

Check Your Knowledge Questions

1. True. Accounting standards permit changing an accounting method as long as the new method is preferable to the old method because the new method represents a more authoritative accounting principle or because it more fairly presents financial position and results of operations. Changing from an unacceptable accounting principle to an acceptable one is an error correction.


It depends largely whether MACRS approximated GAAP when management decided to use it. The change could be considered a change in estimate if estimated salvage value was originally zero, but has now changed, or if the estimated useful life was originally equal to MACRS life, but now has changed. It could be considered a change in accounting principle if estimated salvage value was originally and remains equal to zero and if the estimated useful life was originally equal to the MACRS life. But in that case, the change in estimate would be driving the change in accounting method and should be reported as a change in estimate anyway. Finally, it could be considered an error correction if the estimated salvage value was originally more than zero, or if the estimated useful life was originally different from the MACRS life.


Reasons those responses are incorrect:A. It could also be a change in change in estimate effected by a change in accounting

principle or an error correction.B. This is a change in estimate effected by a change in accounting principle, which means

that it is essentially a change in estimate.C. It could also be a change in estimate effected by a change in accounting principle.

3. False. This is a change in estimate and should be reported as part of income in the year the litigation was settled.

4. True or false, depending on the circumstances. If the write-off is the result of revised estimates, then it is a change in estimate. If the write-off is made in conjunction with a change in an accounting principle that is not the result of a change in estimate, then the




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write-off is a change in accounting principle. Most of the time, write-offs represent changes in estimate.

Case Assessment

The new company president has asked the controller to make a change in estimate and a change in accounting method. The president’s objective, to increase profits, is not a sufficient reason to make either change, but the changes may be warranted by other appropriate reasons. Lengthening the depreciable lives of the assets requires an objective assessment of the estimated useful lives. If longer lives represent a better estimate than the shorter lives, then the longer lives should be used. In this problem, it appears that the estimate of the useful lives is a range. In that case, one might argue that the shorter lives should be used because they are more conservative or one might argue that the longer lives should be used because better estimates within the range do not exist. That is the rule for loss contingencies discussed in Chapter 9. In addition, to some extent the estimated useful lives of fixed assets depend on management’s decision about how much to spend on maintenance of equipment.

When a change in an estimate is effected by a change in an accounting method, as is the case when changing to the straight-line method, then it is necessary to demonstrate that the straight-line method results in greater fairness than the accelerated method. In this problem, for example, management previously estimated that greater benefit would be derived from using the assets during the early part of their lives than during the later part, but now management believes that the benefit is approximately equal over time. It is that change in estimate that makes the change to the straight-line method a change in estimate.

If the longer lives appear to be the best estimate and if the straight-line method does result in a more rational allocation of costs, then it appears proper to make these changes in the financial statements reporting both as changes in estimates. It would not be ethical to make these changes merely to increase profits.

Material changes in estimates require disclosure. Immaterial changes do not. One might argue that fairness in this case requires disclosure of the change even if the dollar amount of the effect on the current year is not large. It must be material to some extent, or why would the president want to make the change? On the other hand, the problem appears to indicate that a change should be made, at least in the depreciation method. To not make it might be considered less than fair. And if the change is not so large as to be considered material to the current year or to future years, disclosure is not required. Disclosing immaterial matters tends to make financial statements more tedious to read and thus less informative.




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Glossary of Terms and AbbreviationsTerm or Abbreviation Meaning

ASC This acronym refers to the “Accounting Standards Codification” published by the FASB.

Material Information is said to be material if its omission or misstatement would change or influence the judgment of a reasonable person relying on it.

OCBOA This acronym stands for “other comprehensive basis of accounting.” OCBOA’s include the cash basis and the tax basis, as well as the AICPA’s Financial Reporting Framework for Small- and Medium-Sized Businesses.

Pro forma financial information

Pro forma information included in financial statements is intended to help financial statement users interpret the results of operations, financial condition, or cash flows reported in financial statements by showing information that would have been reported if a particular event had not occurred, such as an extraordinary item.

Realistic possibility standard The realistic possibility standard is the AICPA’s minimum fairness standard for tax positions that are not disclosed in tax returns, unless a tax jurisdiction requires a higher standard.

SFAC This acronym refers to the Statement of Financial Accounting Concepts published by the FASB.

Tax position This expression refers to an interpretation of tax laws or business transactions that affects information reported in tax returns.

Window Dressing This metaphorical expression refers to actions that management or accountants may take to influence amounts reported in financial statements. Such actions may be considered ethical or unethical depending on the action and the circumstances. They are unethical if they result in the misstatement of financial statements.




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Learn more and join at calcpa.org/fss

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