More than two years after the FASB issued its exposure draft on the topic, they have completed the project [on stock compensation] with the issuance of SFAS No. 123, Accounting for Stock-Based Compensation, which was issued in October 1995.

The FASB states in SFAS No. 123 that it continues to believe that the value of stock compensation issued to employees should be recognized in income by the employer. This is, of course, the approach which was proposed in the FASB's exposure draft. However, due to the tremendous dissent which was expressed during the comment period, the FASB decided that it would not require recognition of an expense in income for fixed award plans. Rather, it decided to encourage recognition, but allow companies to continue to account for the stock options under the provisions of APB Opinion No. 25 and provide pro forma disclosure of the impact on earnings using a valuation model.

Thus, for fixed awards, companies must employ a valuation model to estimate the value of the stock options. That value can either be included in income or companies can report the effect on earnings as a pro forma disclosure without recognizing the amount in income. The FASB suggests the use of the Black-Scholes, binomial, or similar pricing model which takes into account the following information as of the grant date:

• the exercise price.
• the expected life of the option.
• the current price of the stock.
• the expected volatility of the stock.
• the expected dividends on the stock.
• the risk-free interest rate for the expected term of the option.

As can be seen, even when using a pricing model which is fairly reliable, there is a significant amount of judgment which is involved in determining the inputs to the pricing model.

To underscore its desire to have companies recognize the value in earnings, the FASB states that the method specified in SFAS No. 123 is deemed to be preferable for purposes of justifying a change in accounting principle to the intrinsic value method under APB Opinion No. 25.

For companies who choose to opt for disclosure only-and it would seem that the vast majority of companies will, indeed, take this option-the disclosure requirements become effective for periods beginning after December 15, 1995. However, companies should note that when the disclosures become effective, they will apply to all awards granted for periods beginning after December 15, 1994.

SFAS No. 123 retains the existing accounting applicable to variable award plans-particularly to those with a cash alternative, commonly referred to as stock appreciation rights. Additionally, SFAS No. 123 specifies that when options are exchanged for goods or services with a non-employee, the transaction will need to be reflected at fair value. In such a case, however, the company should remember that the value received may be more determinable than is the value of the options given.

We join Dr. Munter now for a discussion of the conditions that must be met for a plan to be noncompensatory.

AAR

You mentioned that employee stock purchase plans are also covered by the provisions of Statement No. 123. There are some conditions that must be met for the plan to be considered noncompensatory, meaning that no compensation would be recorded. Can you explain what is required here?

Dr. Munter

Yes. In that area, what the FASB does is it establishes 3 conditions. If all 3 are met, then the employee stock purchase plan is deemed to be noncompensatory. This is a very important consideration because if it's noncompensatory, you obviously don't have to record any expense and furthermore, if you are opting for the disclosure route that SFAS No. 123 calls for, you don't have to make the pro forma disclosures either. It follows from the determination of whether it's compensatory or noncompensatory.

To be deemed to be noncompensatory, the 3 conditions that have to met are: first of all, there aren't options available to the employees other than a window. They can have up to 31 days from initial time of purchase to buy those, but for example if you have an option whereby the employee can buy the stock based on either the market price now or the market price at the time of purchase, then it's compensatory. So that would fail the first condition.

The second condition deals with the level of the discount that the employees are allowed. It's a long discussion in SFAS No. 123, but what it basically says is the discount should not be greater than the savings that the company would generate from not having to go to the public marketplace to issue stock. Importantly in the second condition, SFAS No. 123 says that a discount of 5% or less is assumed to meet the condition. That's going to create a lot of problems for many companies, because it's far more common, as you know, for employee stock purchase plans to have discounts of 15%, which are driven by the tax considerations. Then, you are beyond that window and so most of those kinds of plans would become compensatory.

The third condition is that it be available to substantially all employees who meet some minimum eligibility requirements. If all 3 of those conditions are met, then it's noncompensatory and you don't have to account for it or disclose the pro forma information. If any of those three conditions fail to be met, it's compensatory and then either you have to account for it, recognizing it in earnings or alternately you have to provide pro forma disclosure of earnings.

If the plan is deemed to be compensatory, then compensation cost will need to be recognized using either the option pricing approach of SFAS No. 123, or the intrinsic value approach of APB Opinion No. 25.

Dr. Munter joins us once again to tell us about the disclosures required regardless of what approach is taken.

AAR

Let's talk about the matter of disclosures for a minute. Earlier you discussed the pro forma disclosures required when accounting under APB Opinion No. 25 is continued. I understand that there are some other disclosure requirements for all entities regardless of the accounting approach taken. What is this all about?

Dr. Munter

What they have is really a long list of disclosures about the number of options available, shares, and things like that. What they have done is specified precisely what information has to be included. Again, you would start if you are making pro forma disclosures of your stock options [with] the effect of that on earnings, again on a net-of-tax basis. Beyond that, there's a lot of other information.

First of all, you have to provide information on the number and the weighted average exercise price of the options broken out into seven different categories, which is: for the options that were outstanding at the beginning of year; those that were outstanding at the end of the year; those that were exercisable at the end of the year; those granted during the year; those that were exercised during the year; those that were forfeited during the year; and those that expired during the year.

In addition to that, we also have to disclose the weighted-average-grant-date fair value of the options that were granted during the year. Now bear in mind, only the current service piece would be included in the pro forma disclosure, but you have to provide the entire fair value-based measure in the disclosures. Thirdly, we have to disclose the number, and weighted-average-grant-date of the fair value of any other equity instruments which have been issued during the period.

In addition to that, we have to have a description of what method is being used. For example, did we use the Black-Scholes model, or did we use a binomial pricing model to come up with it, as well as the significant assumptions that are used to measure the fair value. There's a lot of assumptions going into that including, the expected term of the option, the risk-free rate of return, the anticipated dividend rate, and the stock volatility. Those are all significant assumptions that we would have to disclose information on.

We would also have to disclose the total compensation that is recognized in income, whether we are following the SFAS No. 123 approach or whether we're following the APB Opinion No. 25 approach. Then lastly, if there have been any significant modifications of outstanding awards, what the terms of the modifications are, and the effect of repricing of existing options.

Since SFAS No. 123 requires the use of a valuation model, either for recognition or for disclosure, those who deal with companies having such plans should begin carefully evaluating the information needed to apply the valuation models.

From Audio Accounting and Auditing Report, November, 1995

Issued in September 1995, these two documents will allow practitioners to participate in limited risk and limited liability agreed-upon procedures engagements. SAS No. 75, Engagements to Apply Agreed-Upon Procedures to Specified Elements, Accounts, or Items of a Financial Statement, supersedes SAS No. 35, Special Reports-Applying Agreed-Upon Procedures to Specified Elements, Accounts, or Items of a Financial Statement. SSAE No. 4, Agreed-Upon Procedures Engagements, extends the applicability of attestation standards to circumstances where the practitioner is engaged to apply agreed-upon procedures to a written assertion provided by the client, where that written assertion does not relate to a financial statement element, account, or item. Hereafter, we'll refer to this as a financial statement component.

An agreed-upon procedures engagement is one in which a practitioner is engaged by a client to issue a report of findings based on specific procedures performed related to a financial statement component or other written assertion provided by the client. In these engagements, practitioners should follow the guidance provided in SAS No. 75 or SSAE No. 4 except that those documents are not applicable to the following 4 types of engagements:

1. They do not apply in circumstances where the practitioner reports on specified compliance requirements based solely on an audit of financial statements. In these engagements, the provisions of SAS No. 62, Special Reports, should be followed.

2. They do not apply in circumstances where the practitioner reports on compliance in governmental engagements. In these engagements, the provisions of SAS No. 74, Compliance Auditing Considerations in Audits of Governmental Entities and Recipients of Governmental Financial Assistance, should be followed.

3. They do not apply in circumstances where the practitioner is requested to apply substantive procedures to user transactions or assets at a service organization and reference is made in the audit report to having carried out designated procedures. In these engagements, the provisions of SAS No. 70, Reports on the Processing of Transactions by Service Organizations, should be followed.

4. They do not apply in circumstances where the practitioner is requested to issue a letter for underwriters, commonly referred to as a comfort letter. In these engagements, the provisions of SAS No. 72, Letters for Underwriters and Certain Other Requesting Parties, as amended by SAS No. 76 should be followed. We'll discuss SAS No. 76 a little later in our program.

Further, for SSAE No. 4 engagements, the client is required to provide a written assertion that is capable of reasonably consistent estimation or measurement. In contrast, under a SAS No. 75 engagement, financial statement components implicitly or explicitly contain the assertions to be tested by the practitioner. As such, the components may be presented in a schedule or statement, or in the practitioner's report, appropriately identifying what is being presented and the point in time or the time period covered.

Practitioners should be aware that SSAE No. 4 engagements cannot be performed when no written assertion is provided by the client. However, the practitioner may be able to provide certain non-attest services involving advice or recommendations to the client. In these circumstances, the practitioner should refer to guidance provided in Statement on Standards for Consulting Services, Consulting Services: Definitions and Standards. Further, certain other professional services do not constitute attestation services under Paragraph 2 of SSAE No. 1, Attestation Standards. Examples of these non attest services include serving as an advocate for a client's tax position, preparation of tax returns and providing tax advice, and compiling of financial statements.

Dr. Munter joins us now to discuss SAS No. 75 and when it would be applicable.

AAR

Let's focus on SAS No. 75 for a few minutes. What are some of the assertions where that standard will become applicable?

Dr. Munter

SAS No. 75 would deal with situations where you are applying agreed-upon procedures to a specified element, account, or item of the financial statements. We're looking at a balance that you would find in the financial statements. You might be looking at, for example, the appropriateness of the provision for income taxes, or the royalty provision, or the receivables. So, you're talking about an item that you'd find in the financial statements and you're asked to apply agreed-upon procedures to that specific item or perhaps a group of items, but to that specific item. That's where SAS No. 75 would be applicable when we're dealing with financial statement elements. That's what distinguishes SAS No. 75 from SSAE No. 4 where you're not necessarily dealing with financial statement elements.

AAR

Before accepting an engagement to issue a report under SAS No. 75 didn't I see some conditions that must be met?

Dr. Munter

Yes, the CPA has to make sure there is an agreement in place with the other party or parties that specifies what the procedures are that are going to be done; that the other parties accept responsibility for the adequacy of the procedures to meet their needs; that the other parties understand the nature of the report that will be given, and that the report will be restricted to just the named parties to that report, and won't be made available to other parties for other needs. Unless those provisions have been agreed to ahead of time, then the accountant cannot accept the agreed-upon procedure engagement. What would happen is, you'd be doing a restricted scope engagement, and if the report were going to be distributed widely you'd be accepting much more responsibility than you really had intended. You have to make very certain that there is a clear understanding up front with all of the parties about the procedures, their responsibility for the adequacy of them, and the restricted distribution of the report.

AAR

And all of this should be in a written agreement?

Dr. Munter

It obviously, preferably should be in an engagement letter that is signed by all parties to ensure that there is an understanding of that.

AAR

The practitioner should receive an acknowledgment from each of the specified users concerning the procedures performed, or to be performed, and that the specified users take responsibility for the sufficiency of the agreed-upon procedures for their purposes. How does the practitioner go about doing this?

Dr. Munter

That's precisely why an engagement letter can be so helpful. If you have everybody agree to it, you have the engagement letter signed, that gives documentary evidence that they do accept responsibility for the adequacy of the procedures to meet their needs. Also there would, of course, be oral conversations as well, because the accountant would want to do some probing to try and find out exactly what their needs are. Ultimately yes, the users accept responsibility for the adequacy of the procedures to meet their needs, but the users don't always know what procedures will be acceptable for their needs. The CPA wants to speak with them and give suggestions about procedures that might be acceptable and might be useful for their own needs. So it's in addition to, you don't just want to have an engagement letter sent out and signed. You also want to make sure that there are face to face meetings with the other parties to the extent possible so, that you can discuss with them the appropriateness of the procedures, what information would come to light by application of certain procedures. Then you also want to make sure that there is not any misunderstanding about the procedures that will be used. So, you want to be very careful in terms of terminology that's being used in describing procedures.

If the practitioner is not able to communicate directly with all of the specified users, the practitioner may satisfy these requirements by applying any one or more of the following, or similar procedures:

1. Compare the procedures to be applied to written requirements of the specified users.
2. Discuss the procedures to be applied with appropriate representatives of the specified users involved.
3. Review relevant contracts with, or correspondence from, the specified users.

The practitioner should not report on an engagement when specified users do not agree upon the procedures performed, or to be performed, and do not take responsibility for the sufficiency of the procedures for their purposes.

The practitioner should establish a clear understanding regarding the terms of engagement, preferably in an engagement letter. Engagement letters should be addressed to the client, and in some circumstances also to all specified users. Matters that might be included in such an engagement letter are the following:

1. The nature of the engagement.
2. Identification of, or reference to, the financial statement components and the party responsible for them.
3. Identification of specified users.
4. Specified users' acknowledgment of their responsibility for the sufficiency of the procedures.
5. Responsibilities of the practitioner.
6. Basis of accounting of the financial statement components.
7. Reference to applicable AICPA standards.
8. Agreement on procedures by enumerating, or referring to, the procedures.
9. Disclaimers expected to be included in the practitioner's report.
10. Use restrictions.
11. Assistance to be provided to the accountant.
12. Involvement of a specialist.
13. Agreed-upon materiality limits.

Specified users are responsible for the sufficiency-nature, timing, and extent-of the agreed-upon procedures, because they best understand their own needs. The specified users assume the risk that such procedures might be insufficient for their purposes. Additionally, the specified users assume the risk that they might misunderstand or otherwise inappropriately use findings properly reported by the practitioner.

Dr. Munter joins us again to explain the practitioner's responsibilities.

Dr. Munter

The practitioner, of course, since this is an engagement covered by a SAS, is obviously compelled to comply with the appropriate professional standards, SAS No. 75 as well as any of the generally accepted auditing standards that would be applicable to that engagement. Independence in particular being one of the issues, due care, etc., so the practitioner is compelled to comply with the applicable professional standards. Then, the risk that the practitioner assumes is the same as would be the case in any attestation engagement, there's always some risk there. When we audit, we accept audit risk. We can never reduce that to zero. Here, there is the risk that the practitioner might inappropriately apply the procedures and, thus, reach incorrect conclusions. The practitioner may inappropriately evaluate the results of the procedures and, thus, the findings not be appropriate. Those risks are accepted by the practitioner. Again, the way the practitioner moves to reduce those risks is by adequately planning and supervising the engagement, making sure the quality control standards for the practice are complied with in terms of the staffing of it, and things like that. That serves to mitigate that risk, but the practitioner does need to be aware that he or she is still responsible for appropriately applying the procedures, appropriate evaluation and reporting.

AAR

How limited or extensive should the practitioner and the specified users agree to make these procedures, and can they be modified during the course of the engagement?

Dr. Munter

First, they can be modified during the course of the engagement, but the practitioner wants to be very careful about that. You don't want to just give carte blanche. You're in there in the midst of doing the engagement, they call up and say, Oh, let's not do that procedure. You want to consider what the reason is for the request for modification. Make sure that all the parties understand that there will be modifications, and all of them accept that modification as being appropriate to meet their circumstances, that there is a legitimate business reason for that. If you're satisfied about that, then there could be modifications. If there are questions, then you are more likely to end up perhaps withdrawing from the engagement if they request modifications [for which] there does not appear to be a substantive business reason.

Relative to the description of the procedures themselves, the descriptions want you to be very precise, and you don't want to use generic audit wording. You don't want to say things like, you're going to verify account balances, or you're going to trace certain items. You want to be very careful on the terminology that is being used. You don't want somebody to misconstrue this as an audit engagement, and thus, extend your responsibility beyond that which is intended. The description of the procedures to be applied does need to be very precise so that it will be understandable, not only by the practitioner, but by the users as well.

The procedures that the practitioner agrees to perform pursuant to an engagement to apply agreed-upon procedures may be more or less extensive than the procedures that the practitioner would determine to be necessary had he or she been engaged to perform another form of engagement. The practitioner has no responsibility to determine the differences between the agreed-upon procedures to be performed, and the procedures that the practitioner would have determined to be necessary had he or she been engaged to perform another form of engagement.

The practitioner should obtain evidential matter from applying the agreed-upon procedures to provide a reasonable basis for the finding or findings expressed in his or her report, but need not perform additional procedures outside the scope of the engagement to gather additional evidential matter.

Examples of appropriate procedures include:

1. Execution of a sampling application after agreeing on relevant parameters.
2. Inspection of specified documents evidencing certain types of transactions or detailed attributes thereof.
3. Confirmation of specific information with third parties.
4. Comparison of documents, schedules, or analyses with certain specified attributes.
5. Performance of procedures on work performed by others.
6. Performance of mathematical computations.

Examples of inappropriate procedures include:

1. Mere reading of the work performed by others solely to describe their findings.
2. Evaluating the competency or objectivity of another party.
3. Obtaining an understanding about a particular subject.
4. Interpreting documents outside the scope of the practitioner's professional expertise.

In certain circumstances, it may be appropriate or necessary for the practitioner to involve a specialist in the performance of one or more of the agreed-upon procedures. The practitioner and the specified users explicitly should agree to the involvement of the specialist and the practitioner's report should describe the nature of any assistance provided by the specialist.

The practitioner should present the results of applying agreed-upon procedures in the form of findings. The practitioner should not provide negative assurance about whether the financial statement components are fairly stated in relation to established or stated criteria, for example, generally accepted accounting principles. For example, the practitioner should not include a statement in the report that nothing came to my attention that caused me to believe that the specified element, account, or item of a financial statement is not fairly stated in accordance with generally accepted accounting principles. The practitioner should report all findings from application of the agreed-upon procedures. The concept of materiality does not apply to findings to be reported in an engagement to apply agreed-upon procedures unless the definition of materiality is agreed to by the specified users. Any agreed-upon materiality limits should be described in the practitioner's report.

The practitioner should prepare and maintain working papers in connection with an engagement to apply agreed-upon procedures under SAS No. 75; such working papers should be appropriate to the circumstances and the practitioner's needs on the engagement to which they apply. Although the quantity, type, and content of working papers vary with the circumstances, ordinarily they should indicate that:

1. The work was adequately planned and supervised.
2. Evidential matter was obtained to provide a reasonable basis for the finding, or findings, expressed in the practitioner's report.

Working papers are the property of the practitioner, and some states have statutes or regulations that designate the practitioner as the owner of the working papers. The practitioner's rights of ownership, however, are subject to ethical limitations relating to confidentiality. Certain of the practitioner's working papers sometimes may serve as a useful reference source for his or her client, but the working papers should not be regarded as part of, or a substitute for, the client's records. The practitioner should adopt reasonable procedures for safe custody of his or her working papers, and should retain them for a period of time sufficient to meet the needs of his or her practice, and satisfy any pertinent legal requirements of records retention.

The practitioner's report on applying agreed-upon procedures to a financial statement component under SAS No. 75 should be in the form of procedures and findings. The practitioner's report should contain the following elements:

1. A title that includes the word independent.
2. Reference to the financial statement components of an identified entity and the character of the engagement.
3. Identification of specified users.
4. The basis of accounting of the financial statement component, unless clearly evident.
5. A statement that the procedures performed were those agreed to by the specified users identified in the report.
6. Reference to standards established by the AICPA.
7. A statement that the sufficiency of the procedures solely is the responsibility of the specified users, and a disclaimer of responsibility for the sufficiency of those procedures.
8. A list of the procedures performed, or reference thereto, and related findings.
9. Where applicable, a description of any agreed-upon materiality limits.
10. A statement that the practitioner was not engaged to, and did not, perform an audit of the financial statement components; a disclaimer of opinion on the financial statement components and a statement that if the practitioner had performed additional procedures, other matters might have come to his or her attention that would have been reported.
11. A disclaimer of opinion on the effectiveness of the internal control structure over financial reporting or any part thereof when the practitioner has performed procedures applicable to internal controls.
12. A statement of restrictions on the use of the report because it is intended to be used solely by the specified users.
13. Where applicable, reservations or restrictions concerning procedures or findings.
14. Where applicable, a description of the nature of the assistance provided by a specialist.

The date of completion of the agreed-upon procedures should be used as the date of the practitioner's report. A practitioner may find a representation letter to be a useful and practical means of obtaining representations from the parties responsible for the specified financial statement components. The need for such a letter may depend on the nature of the engagement and the specified users. Examples of matters that might appear in a representation letter include a statement that a responsible party has disclosed to the accountant the following:

1. All known matters contradicting the basis of accounting for the financial statement components.
2. Any communication from regulatory agencies affecting the financial statement components.

The responsible party's refusal to furnish written representations determined by the practitioner to be appropriate for the engagement constitutes a limitation on the performance of the engagement. In these circumstances, the practitioner should do one of the following:

1. Disclose in the report the inability to obtain representations from the responsible party.
2. Withdraw from the engagement.
3. Change the engagement to another form of engagement.

SAS No. 75 is effective for reports on engagements to apply agreed-upon procedures dated after April 30, 1996. Earlier application is encouraged.

Now let's join Dr. Munter for a look at SSAE No. 4.

AAR

Let's move over and look at SSAE No. 4. To what types of assertions does this standard apply?

Dr. Munter

The general answer is to any assertions that are not covered by SAS No. 75. The distinction being SAS No. 75 covers assertions in the financial statements, and therefore, SSAE No. 4 would cover assertions that are not embodied in the financial statements. We may have, for example, assertions about compliance with contractual provisions. We may have assertions about the adequacy of controls. We may have-in cases where we are looking at acquisitions or dispositions there may be questions about whether or not the taxes are paid up, which would not necessarily be an element of the financial statements, but management may assert that the payroll taxes are current or something like that. That would be an assertion that the practitioner could do an agreed-upon procedure engagement under SSAE No. 4. What's happened here is, the Auditing Standards Board has issued these two documents in concert with one another, because previously there had been confusion about whether you're dealing with a SAS or an SSAE. So what they've done is issued two documents that have basically the same set of standards in them. It's not as important whether it's covered by the SAS or the SSAE. They are also making a clear distinction-if you've got a financial statement element, SAS No. 75. If you've got some other assertion, then SSAE No. 4 would be the applicable document.

AAR

Do the conditions vary between the SSAE No. 4 and SAS No. 75?

Dr. Munter

In terms of accepting the engagement and performing the engagement, no they don't. You have the same kind of requirements up front. The exact same exceptions that we enumerated earlier are in both documents. You have the responsibility to make sure that all parties understand the procedures, that they accept the responsibility for it, that they document it. Beyond that, though, there are additional responsibilities for the practitioner, that they have to assess their knowledge about the matter, their competency in it, whether or not the assertion is capable of evaluation against objective criteria that can be stated. That, we don't find in SAS No. 75 because you're talking GAAP-based financial statement elements, so that already provides the criteria and the knowledge.

When we're talking about assertions that are not financial-statement related necessarily, a key consideration for the practitioner is to determine whether the assertion can be measured against objective criteria-compliance with a contractual agreement, you know you can read the contract and that becomes the objective criteria. Whether the taxes are current to date you have, obviously, laws that would provide the basis for determining whether that assertion is met. That would be the objective criteria, so whether there are objective criteria number one, and number two, whether the practitioner is competent to make that assessment. There may be some assertions that could be evaluated against objective criteria, and the practitioner might not be competent to make that assessment. For example, a company might assert that its pension plan is fully funded, and that could be evaluated against objective criteria because you have the pension plan document that would serve as that. But if you don't have actuarial capabilities you would not necessarily be able to determine that, and you might have to rely on specialists to do that. That knowledge becomes then, a critical part of the decision by the practitioner to accept those engagements.

AAR

The examples of appropriate and inappropriate procedures that you gave earlier under SAS No. 75 would be the same as SSAE No. 4, or are there differences?

Dr. Munter

They would be basically the same. Again, the problem you run into is that terminology can be misconstrued. In SSAE No. 4 we're really looking at an emerging kind of practice development area. We have been used to for many years applying agreed-upon procedures to financial statement elements. That's relatively well-defined. There's some degree of understanding, certainly by the practitioner, and some degree of understanding by the other parties as to what is being evaluated, what procedures might be appropriate for that.

When we get into the realm of the attestation engagement you're talking, first of all, about having to define the assertion against objective criteria, and then to try to define procedures that would be appropriate for that, which may or may not be audit type procedures. You may be using a lot more of different types of procedures than you would be using if it were a financial statement element. It makes it even more imperative that the wording that describes the procedures be very precise, and not be using general audit terminology, as I mentioned before vouching, or tracing, or things like that. It has to be very specific so that all parties do have a clear understanding about not only the assertion and the objective criteria, but also the procedures, the specifics of the procedures that will be employed.

AAR

How does the practitioner report and document all the findings from application of the agreed-upon procedures?

Dr. Munter

Again, documentation-we have the work paper considerations. We would want to document the engagement, again, in an engagement letter that is signed by all parties, with the same kind of provisions that they accept responsibility for the adequacy of the procedures. They also accept responsibility for the assertions. A very important issue here is, that in order to do an SSAE No. 4 engagement, there has to be a written assertion by management to report on. That's not in SAS No. 75 because a written assertion is the financial statement element. It has to be a written assertion by management. That, we would want to be documented in the engagement letter, as well, and we would want to, again, have all parties sign that acknowledging responsibility and restricting the distribution. We would want to, again, make sure we have documentation to indicate that the engagement is adequately planned. Part of that would be an evaluation of our competence and our knowledge about the matter, and our ability to conduct the engagement. That would need to be documented in the work papers. Again, we want to obtain a representation letter from the responsible parties, and then we would want to document the procedures that were used, document that we completed all of the procedures that had been agreed-to and, again, document the specific findings without materiality threshold, and document the specific findings that resulted from the procedures.

AAR

One final question, you've been, essentially, reconciling these statements throughout our discussion here. To summarize, how would the practitioner effectively use these statements for agreed-upon procedures engagements?

Dr. Munter

What the practitioner really should do is, look at these-while there are two documents, look at them as one document that addresses agreed-upon procedure engagements. As in other attest engagements, there are additional things we need to consider about whether we are knowledgeable about the matter, whether there is objective criteria which are not as important or they're more assumed in a financial statement realm. We have the same kind of relationship between SAS No. 75 and SSAE No. 4 as we do between the generally accepted auditing standards and the attestation standards. They serve as an umbrella and allow practitioners to extend their reporting responsibilities beyond just the financial statements. The same thing is happening here, but as we get beyond the financial statements, the practitioner needs to take greater care in evaluating the assertion, and its ability to be evaluated objectively, the knowledge, and things like that.

Again, the other thing that I can't overemphasize is that whether we're talking about a SAS or an SSAE engagement, when we're reporting the results, we report the findings, we disclaim an opinion, but we do not give negative assurance. The critical change that is being made here is in any agreed-upon procedure engagement, whether it's financial statement related or not, we would not be allowed to give negative assurance.

For agreed-upon procedures engagements on prospective financial information under SSAE No. 4, the prospective financial statements must include a summary of significant assumptions. In addition, for agreed-upon procedures engagements performed pursuant to SSAE No. 3 and performed under SSAE No. 4, management evaluates the entity's compliance with specified requirements or the effectiveness of the entity's internal control structure over compliance.

The practitioner should report all findings from application of the agreed-upon procedures. As Dr. Munter indicated the concept of materiality does not apply to findings to be reported in an agreed-upon procedures engagement unless the definition of materiality is agreed to by the specified users. Any agreed-upon materiality limits should be described in the practitioner's report.

The practitioner's report on agreed-upon procedures engagements under SSAE No. 4 should be in the form of procedures and findings. The practitioner's report should contain the elements similar to an engagement performed under SAS No. 75, if applicable, except that:

1. A reference to the assertion and the character of the engagement should be made instead of to the financial statement component.

2. A statement that the practitioner was not engaged to, and did not, perform an examination of the assertion, a disclaimer of opinion on the assertion, and a statement that if the practitioner had performed additional procedures, other matters might have come to his or her attention that would have been reported.

3. For an agreed-upon procedures engagement on prospective financial information, all items included in SSAE No. 1.

The date of completion of the agreed-upon procedures in an SSAE No. 4 engagement should be used as the date of the practitioner's report. As in a SAS No. 75 engagement, a practitioner may find a representation letter to be a useful and practical means of obtaining other representations from the responsible party. The need for such a letter may depend on the nature of the engagement and the specified users. Examples of matters that might appear in the representation letter include a statement that the responsible party has disclosed to the practitioner:

1. All known matters contradicting the assertion.

2. Any communication from regulatory agencies affecting the assertion.

The responsible party's refusal to furnish written representations determined by the practitioner to be appropriate for the engagement constitutes a limitation on the performance of the engagement. In such circumstances, the practitioner should do one of the following:

1. Disclose in his or her report the inability to obtain representations from the responsible party.

2. Withdraw from the engagement.

3. Change the engagement to another form of engagement.

SSAE No. 4 is effective for reports on agreed-upon procedures engagements dated after April 30, 1996. Earlier application is encouraged.

The Public Oversight Board is an independent body charged with overseeing and monitoring the quality control programs of public accounting firms that audit publicly-held companies. The POB reports its findings to the SEC and Congress. The POB is currently distributing a new report which proposes that corporate boards of companies and their accountants adopt a more active approach to the auditing process, focusing more on the quality of a company's financial reporting rather than its general acceptability. The POB has stated that it expects companies and accounting firms to adopt the suggestions.

In a follow-up to the Kirk Committee Report, which was discussed in the November 1994 A&A Report, this report summarizes the findings of the Advisory Panel on Auditor Independence, known as the Kirk Committee, that was appointed in 1994 by the POB. Jerry D. Sullivan, executive director of the POB stated that we have compiled a list of all the public companies with revenues in excess of $250 million, and we are distributing the report to their CEOs and CFOs. The SEC is aware of our undertaking as are the major stock exchanges, and we hope they would rally support.

Dr. Munter joins us now to discuss the POB's report.

AAR

Now, this latest report distributed by the POB summarizes the findings of the Kirk Committee Report which you and I discussed last November on this program. Could you give us a brief overview of the recommendations of the Kirk Committee before we look at the POB's report?

Dr. Munter

The Kirk Committee was concerned about the relationship between auditors and management and was looking for ways to establish a greater degree of independence between management and auditors. The real thrust of that report was that the auditors should view the audit committee as its client rather than management as a client, and have more of a direct linkage to the audit committee-in facilitating the audit, in scheduling it, and negotiating, and all of that-and thereby establish more of an independence with respect to the client organization. In addition to that, the Kirk Committee also called upon the auditor, in that light, to meet more frequently with the audit committee at the beginning of the engagement, and if there are any problems that come up during the engagement, as well as is typically done, at the end of the engagement. So just to change, really, the focus of the client-auditor relationship instead of being with management to the audit committee level.

AAR

Why is that, and what are the responsibilities of management?

Dr. Munter

Let me start with the responsibilities of management first. Management has the primary responsibilities for the financial statements as we well know, and part of that, of course, is to develop applicable accounting principles, to make appropriate estimates, to ensure that there is adequate disclosure about all material items. All of that responsibility is, and continues to be, the responsibility of management. Now, the problems we run into are that the auditor, of course, is there to give an independent opinion about the appropriateness of the financial statements, the appropriateness of the accounting principles, and the reasonableness of estimates, but what happens over time is, as you pointed out, it's management, generally, who selects the auditor, who has negotiated the fee. As you have a continuing engagement over a series of years, you develop a closer and closer working relationship between management and the auditors, and it makes it more difficult for the auditors to maintain that objectivity that's really necessary to, not only express an opinion on the financial statements, but also to evaluate things like the quality of the accounting principles. The Public Oversight Board committee makes that distinction, saying that, really, there's a difference between the principles being used by management being generally accepted, as we use that term, versus the principles being the best ones that are available.

For example, we might have a situation-we see this very commonly-where companies will use time-based depreciation methods. Whether it's straight line or accelerated method you're basing it on time. They might have readily available information where they can be depreciating it based on activity, whether it's machine hours, or units of output, or something like that. In actuality, the activity-based depreciation method would be a better depreciation method than would straight-line. Straight-line would be generally acceptable, but it's really not the best principle that could be used in the circumstance. The Public Oversight Board is really doing two things: trying to establish more of that independence by viewing the audit committee as the client rather than management, but then also trying to elevate the responsibility of the auditor beyond just expressing an opinion on financial statements, going a step beyond that and reporting to the audit committee about the quality of the accounting principles as well.

AAR

Does the POB Report discuss the role of the auditor as a professional advisor as the Kirk Committee Report did, and if so, what is that role?

Dr. Munter

The POB Report is very similar to the Kirk Committee in that regard, and by the way, it's not really a major surprise that we see that. Donald Kirk who, of course, chaired the Kirk Committee is now a member of the Public Oversight Board. Obviously a lot of those thoughts that had been expressed in the previous report are now in the POB Report as well. Part of the advisory role is working more with the audit committee on the quality of the accounting principles, the quality of management decisions and making sure they are being properly reflected in the financial statements.

In addition to that, there is also the consideration about the quality of accounting estimates, and the timeliness with which those estimates are reviewed. We are really going beyond just the more factual-based presentation that we have historically seen, where the auditor delivers the audit report to the audit committee, reviews the things that we find in SAS No. 61-if there have been any problems with management, things like that, and going beyond that, in taking much more of a proactive advisory role on the quality of the financial statement presentation, the aggressiveness of management or conservativeness in their accounting principles, and things like that. It does recommend a much more active role for the auditors in its relationship with the audit committee.

AAR

There's been a recent trend of holding the board of directors more accountable to shareholders. In their report, the POB suggested that audit boards increase their oversight, work directly with the auditors, and expand the role of auditors. Did the POB have any recommendations regarding audit committee charters?

Dr. Munter

Yes, they did. What they recommended is, the audit committee charters directly incorporate these recommendations into their charter of operation. It would be the audit committee who hires and retains the auditors, and negotiates fees, rather than management. It would be the audit committee who oversees the beginning of the audit process, coordinates the timing of field work and the relationship with management. Then, the audit committee would expect to have reports from the auditor more frequently. In addition to just the annual presentation of the audit results, you'd expect that the audit committee would meet with the auditor at the beginning of the engagement, perhaps during the engagement, and then at the end to review the findings. Again the audit committee would receive information from the auditors beyond just the audited financial statements in the attached audit report, but other information as well, perhaps meeting with them quarterly, if you're talking about a public company when the auditor reviews the 10Q information. You have a much more continuous relationship develop between the auditor and the audit committee. What the Public Oversight Board recommends is to codify that into the charter of the audit committee, which then leads to a greater likelihood that those things will actually become a reality.

AAR

What kinds of things should the auditor discuss with the audit committee regarding accounting principles and financial statement disclosures?

Dr. Munter

That, I think, is a big issue, as we were talking a bit ago about the quality of accounting principles as opposed to just their appropriateness. There's several aspects of that: one, being the notion of, is it the best principle that could be used in the circumstance, or is it just one of many that might be acceptable-things like depreciation, as I mentioned a moment ago, inventory methods, and things like that. Beyond that, also, we have a lot of issues involving estimates which, of course, are a substantial part of the financial reporting process. There the auditors really need to take a much more careful look at how the estimates are developed, how carefully they are evaluated by management, how frequently they are monitored and updated, and things like that, which gets again to the quality of the accounting principles that are being used. Then, beyond that, is the disclosure issue. The concern the Public Oversight Board expresses is that many companies meet the strict letter of the law or the letter of the standards. They'll disclose whatever the absolute minimum is, but relatively few go beyond that. A lot of the accounting standards have specified disclosures and then things that are encouraged, and very few will go beyond just that bare minimum.

So, the other thing on the disclosure issue is, again, looking at the quality of the financial statement presentation. Yes, they have the whatever the specific standards require, but do they have other information that would really be useful to the financial statement readers. Again, it would call upon the auditor to make that evaluation. Now, importantly, that would not be part of the audit opinion that is issued with the financial statements, but would be part of the information that would be conveyed to the audit committee. n

The GASB is working on several specific issues that must be resolved before the Exposure Drafts on the reporting models are issued in June 1996. The October agenda included several of these items-Conceptual Framework, codification of reporting model proposals, and asset and revenue recognition standards related to property taxes. The staff has conducted research in each of these areas and presented several position papers for the Board's consideration. In addition, the Board began its deliberations on a new project to revise guidance for investments held by governmental entities.

Financial Instruments-Investments

This project is focusing on the valuation of equity securities, debt securities, mutual funds, and investment pools. The guidance will apply to all governmental entities except defined benefit pension plans and Internal Revenue Code 457 deferred compensation plans. The GASB has issued statements requiring fair value reporting for those investments. The FASB Exposure Draft, Accounting for Certain Investments Held by Not-for Profit Organizations, was reviewed in the October 1995 Audio Governmental Accounting Report and included an overview of the basic principles and definitions related to valuation of investments.

Ms. Sue Weiss, the FASB not-for-profit project manager, provided background on the FASB deliberations for FASB Statement 115 and the Exposure Draft on investments held by not-for-profit organizations. Venita Wood, the GASB project manager, presented an overview of the current GASB guidance in Statement 2, Financial Reporting of Deferred Compensation Plans Adopted under the Provisions of Internal Revenue Code Section 457; Statement 10, Accounting and Financial Reporting for Risk Financing and Related Insurance Issues; and Statement 25, Financial Reporting for Defined Benefit Pension Plans and Note Disclosures for Defined Contribution Plans.

These presentations provided an educational background for the Board members. The specific issues that will be included in the GASB Exposure Draft were discussed at the November meeting.

Conceptual Framework

The Concepts Statement that will be issued in conjunction with the reporting model project will provide the general guidance criteria. One of the more significant issues is the classification of revenues and expenses. In the commercial sector, transactions are generally grouped into two categories-"exchange" and "nonexchange"-but this scheme does not work as well in the governmental environment. Governments generally have more transactions that fall into the "nonexchange" category and the variance among the various types of transactions within the category makes it more difficult to develop only one set of general criteria.

Keep in mind that the Concepts Statement will set the tone for specific guidance that is developed on individual practice issues, account classes, or types of transactions. The general guidance in the Concepts Statement must be flexible so that the variance in specific issues does not create conflict with the general guidance to satisfy practical application of generally accepted accounting principles. For instance, when you really get tangled in a transaction trying to figure exactly what the entry should be, you can always go back to the "T-account method" to break the complex issues into broader terms and map out the transaction record. Concepts Statements should provide the "T-account" for the development of specific accounting standards.

The Board reviewed staff position papers that outlined basic principles and considerations for classifying governmental revenues and expenses. Revenues, as tentatively approved by the Board, should fall into three classes:

1. Exchange and Pseudo-Exchange Revenues, with subclasses for each;

2. Derived Tax Revenues with exchange-derived and non-exchange transfer-derived subclasses; and

3. Nonexchange Revenues, with payor-voluntary and payor-involuntary subclasses.

The accrual-basis expenses or losses would then fall into Class 1, Exchange and Pseudo-Exchange; and Class 3, Nonexchange Revenues, to parallel the revenues.

The next issue that was discussed by the Board was how to develop the general recognition criteria for each of the classes. At some point, the specific recognition issues must be resolved in a Statement of Standards to provide guidance that can be implemented on a practical basis. However, the Concepts Statements should provide the starting point for the development of Standards.

The Board reached some tentative conclusions, but the staff will be continuing research to finalize the Exposure Draft of the Concepts Statement before issuance next June.

Governmental Business-Type

Activities

You probably noticed in the Preliminary Views document that there were several reporting issues yet to be resolved. The rest of the Board's October discussion was focused on the open items that must be addressed before the Exposure Draft is issued. This list included the following.

1. Entities should be permitted to issue the core financial statement proposed in the Preliminary Views documents separately from a comprehensive annual financial report. These "lifted" reports will require explanatory footnotes for nonmajor funds and component units.

2. General purpose financial statements of primary governments and components units should include both financial reporting perspectives in order to be considered to have been prepared in accordance with generally accepted accounting principles, or GAAP. Separate reports on funds, on the other hand, should only include the fund perspective.

3. Guidance on interim reporting will be deleted from the Codification and its focus will shift solely to annual financial reporting.

4. GAAP for proprietary funds will no longer be described as "those applicable to similar businesses in the private sector." This phrase will be replaced by the shorter term, business-type activities, used in the Preliminary Views documents.

5. The revision to the Codification will not provide guidance on when assets and liabilities should be assigned to proprietary funds.

6. The provisions for segregating subsidies from interfund collections, suggested in the Invitation to Comment, should be used in the Exposure Draft on the reporting model. There will be more emphasis on transfers to distinguish between the two types of transfers and to encourage direct reporting of certain revenues in funds.

7. The disclosures that discuss the differences between modified-accrual basis and accrual basis recognition of accruals will be modified to include the entity-wide perspective and expanded to address other similar accruals such as compensated absences.

The Board's discussion also included a review of the research on the asset and revenue recognition related to property taxes. There were no conclusions reached and this issue will be carried over to another meeting.

In November 1994, GASB issued interim reporting standards for one component of other postemployment benefits-healthcare plans administered by defined benefit pension plans. This statement was issued at the same time that accounting and reporting standards for pension plans and employers were issued. Statement 25, Financial Reporting for Defined Benefit Pension Plans and Note Disclosures for Defined Contribution Plans, and Statement 27, Accounting for Pensions by State and Local Governmental Employers, were discussed in the February and March Audio Governmental Accounting Reports.

Several respondents to the Exposure Draft on the reporting standards for healthcare postemployment benefits suggested that this guidance should have been delayed until the Board finished the OPEB project. The Board disagreed with this approach, however, and issued Statement 26 as an interim standard to provide more complete guidance for pension plan financial reporting.

In May 1990, the Board issued Statement 12, Disclosure of Information on Postemployment Benefits Other Than Pension Benefits by State and Local Governmental Employers. This statement does not provide guidance for financial reporting by the plans; it only addresses the employer's financial reporting. During the deliberations on the pension reporting standards, resulting in Statements 25 and 27, the Board decided that healthcare benefits were significant and that interim guidance should be issued.

Statement 27 amended one paragraph of Statement 12. The original requirements in Statement 12 allowed governmental entities to apply the disclosure requirements for defined benefit plans to the postemployment healthcare benefits, if these benefits were funded through the PERS. Separate disclosure of the funding progress and funding status for postemployment healthcare benefits was encouraged, but not required. Employers could elect to follow the guidance in Section P20 of the Codification, entitled, Pension Activities-Employer Reporting, for the disclosures instead of the requirements of Statement 12, or P50. If employers elected to follow P20, they were also required to disclose the health inflation assumption in addition to other significant actuarial assumptions required by P20. In addition, the disclosures about the funded status and funding progress should be calculated in a manner consistent with the calculations required by P20.

Statement 27 changes these requirements only slightly, but the distinctions are important.

First, if sole or agent employers apply the measurement and recognition requirement of Section P20, they are now required to follow disclosure guidance in P20 as well. Remember that P20 was completely revised by the issuance of Statement 27.

Second, if the postemployment healthcare benefits are administered through a defined benefit pension plan and both the plan and the employer follow the disclosure guidance in P20, both entities should follow the same measurement principles.

Third, the most significant change, the information on postemployment healthcare benefits, must be segregated from the information on pension benefits.

Statement 26 was issued to provide reporting guidance for defined benefit pension plans that administer postemployment healthcare plans. As the Board deliberates the balance of accounting and reporting standards for all other postemployment and postretirement benefits, they are trying to determine whether the accounting and reporting standards in Statements 25 and 27 should be used for these fringe benefits as well. The final decisions may change the interim guidance of Statement 26.

Statement 26 does allow governmental entities to apply the accounting standards of Statement 27, regarding employer accounting. Statement 25, regarding plan reporting, however, is applicable to pension benefits only. Since Statement 26 was issued at the same time, postemployment healthcare benefits were specifically excluded from Statement 25 and addressed in Statement 26.

The provisions of Statement 26 apply to all defined benefit pension plans that administer postemployment healthcare benefits. That includes single-employer, agent multiple-employer and cost-sharing multiple-employer plans, regardless of whether the funding is actuarially based or pay-as-you-go. Statement 26 actually places special emphasis on separating the postemployment healthcare benefits from the pension benefits in the plan. Paragraph 6 states, "When postemployment healthcare benefits are provided through a defined benefit pension plan, those benefits and the assets accumulated for their payment are considered, in substance, a postemployment healthcare plan administered by but not part of the pension plan. This distinction is made for financial reporting purposes only, the actual administration or the actuarial analysis of the plan may not make this distinction."

The financial statements required for the postemployment healthcare benefit plan include:

1. a statement of post-employment healthcare plan net assets,

2. a statement of changes in postemployment healthcare plan net assets, and

3. notes to the financial statements.

These financial statements should be prepared in accordance with the pension plan reporting standards established by Statement 25.

These are the same financial statements required by Statement 25. If the statements are presented as a pension trust fund of the financial reporting entity of the employer, then the captions will change slightly. Current reporting standards do not use the "net asset" concept, so "Net assets held in trust for postemployment healthcare benefits" becomes "Fund balance reserved for postemployment healthcare benefits." Generally, the pension trust fund operating statement is not consolidated with other proprietary funds, so the format of the operating statement, Statement of Changes in Postemployment Healthcare Plan Net Assets, is not modified for presentation in the pension trust fund. Statement 26 includes example financial statements that illustrate the reporting requirements.

Disclosure standards were set by Statement 12, Disclosure of Information on Postemployment Benefits Other Than Pension Benefits by State and Local Governmental Employers. Remember that these requirements were amended by Statement 27 to require segregation of pension benefit information from postemployment healthcare benefit information. In addition, the notes should include a brief description of the eligibility requirements for postemployment healthcare benefits and the required contribution rate(s) of the employer(s).

For plans issuing separate financial statements, all required financial statement information should be presented separately for pensions and health care in combining financial statements. If the financial statements are included with the financial statements of the financial reporting entity, such as in the pension trust fund, then combining statements are not required. However, the statements must reflect the separate fund balances and net increases or decreases in fund balance for pension benefits and health care benefits, respectively.

Statement 26 also discusses reporting requirements for the required supplementary information, or RSI, related to postemployment healthcare benefits. The RSI for pension plans includes a schedule of funding progress, a schedule of employer contributions, and related note disclosures for these two schedules. This information is not required for the postemployment healthcare plan. However, if the information is presented, the RSI should include all information that is required for pension plans. Again, the data for pensions should be segregated from health care, using either separate schedules or separate columns in combining schedules.

Statement 26 does not require the application of the pension benefit measurement principles, parameters in Statement 25 and 27, to postemployment healthcare benefits. The statement does, however, stress that the measurement of information in both RSI schedules should be consistent and the disclosures should describe the measurement methods and assumptions. The disclosures should include the healthcare inflation assumption. In addition, employers and plans should use the same methods and assumptions if the respective financial statements include similar information about the postemployment healthcare benefits.

The effective date for this pronouncement is the same as the other pension accounting and reporting statements, for periods beginning after June 15, 1996. Early implementation is encouraged, but Statement 25 should be implemented in the same year.

Statement 26 is based on the Board's decision that pension plans should apply the same financial statement standards for pensions and health care. Statement 26 added only two disclosures to the requirements of Statement 25 and 27: one, a brief description of eligibility requirements, and two, the employer's contribution rate(s) for postemployment healthcare benefits. However, the Board is still deliberating whether other postemployment benefits should apply the pension benefit accounting and reporting standards. Discussions thus far have compared the GASB pension standards to the related guidance from FASB for commercial enterprises in an effort to determine whether the principles underlying the FASB standards are relevant for governmental entities. The accounting and reporting standards for other postemployment and postretirement benefits will not be exposed for comment until next year, so this interim guidance is subject to change. n

The GASB has released the second due-process document for the Reporting Model projects, the Preliminary Views. This document presents the continuing evolution of governmental financial statements. Statement 11, Measurement Focus and Basis of Accounting - Governmental Fund Operating Statements, was issued in May 1990. Statement 11 introduced the first suggestion that governmental funds' financial reporting needed significant changes to keep pace with the growing complexity in operations. At first, the answer might appear simple: Governmental funds should adopt the accrual basis and measurement focus used for business-type activities and in the private sector. Unfortunately, the transition is just not that simple. The concepts inherent in the governmental fund model are based on requirements and reporting objectives unique to the governmental sector.

Although Statement 11 was included in the GASB Codification, the implementation was delayed indefinitely. The GASB decided that implementing the income statement provisions of Statement 11 without resolving the corresponding balance sheet issues would not be appropriate. So in June 1993, Statement 11 was effectively put on hold until the Board could complete the reporting model project.

Discussions about the balance sheet presentation, user needs and expectations, and the objectives of governmental financial reporting started with the Statement 11 concept of accrual basis accounting in the governmental funds. The research associated with the preparation and analysis of the 1993 Discussion Memorandum, Reporting Contributions, Subsidies, Tap Fees, and Similar Inflows to Enterprise and Internal Service Funds and to Entities Using Proprietary Fund Accounting, was used as a reference point for examining alternatives for the business-type activities. And finally, information from the Service Efforts and Accomplishments research and the Capital Asset Reporting project provided a basis to explore changes in reporting of the account groups.

The next phase of the deliberations produced an Invitation to Comment, or ITC, Governmental Financial Reporting Model, in early 1994. The ITC proposed a new level of aggregated financial statements called the "Top of the Pyramid", or TOP. This level was intended to present an additional financial statement for those users who are not content with the disaggregated information presented in the combined statements with fund-type consolidations. Responses did not indicate much support for the TOP alternatives presented in the ITC.

The GASB then developed the "dual perspective" approach for governmental financial statements. The Preliminary Views document issued in June 1995 includes the explanation for the basis of this approach, and it requests comments on these proposals. Financial statements that illustrate the Board's objectives are also included.

The first question about the PV is most likely, "What is the difference between the TOP and the dual perspective?" The theoretical difference may be more distinctive than the practical difference. In theory, the TOP statements were based on a progression of the financial statements from the individual fund level to the condensed format. The progression included reconciliations and adjustments to allow modified accrual accounting in the governmental funds and require accrual basis accounting in the TOP statements.

The "dual perspective," on the other hand, presents two different types of financial statements. The entity-wide statements focus on the "government as a whole," whereas the fund perspective continues the current model, with a few revisions. There is no "reconciliation" of the two statements, since they present entirely different financial information.

In reality, however, the general ledger system must support the financial statements for both perspectives and include the underlying transactions in order to produce either type of financial statement and both types of financial statements. In the PV, the Board clearly discourages a disclosure that provides a reconciliation between the two perspectives. Unfortunately, preparers will not be able to avoid this reconciliation, even if it is not a formal part of the financial statements. Governments likely will be faced with very complex general ledger systems to support this reporting concept. It will be interesting to see how responses to the PV vary from the responses to the ITC.

The remainder of our session provides an overview of the PV document and highlights the most significant changes. The PV provides an excellent narrative to explain the basis for the Board's proposal. Readers are encouraged to study the document carefully and examine the illustrative financial statements to gain a more comprehensive understanding of the Board's proposals. This project represents the most dramatic change in governmental financial reporting. Responses to this due process document will directly impact the final standards.

Summary of Key Provisions

The Summary of Key Provisions summarizes the primary issues in the PV. Respondents are encouraged to comment on any issue, but the Board is particularly interested in views on these issues. In addition, the illustrations of the financial statements include explanations in shaded boxes to highlight specific items that may prompt comments.

The key provisions of the PV are as follows:

1. To best meet the differing needs of diverse user groups, core financial statements for governmental entities should include two financial reporting perspectives-a fund perspective and an entity-wide perspective.

2. The fund perspective preserves the nature of traditional fund accounting and, to a large extent, the display characteristics of the current model.

3. Financial statements presented at the fund perspective include:

a. Separate Balance Sheets for governmental and proprietary funds;

b. Statement of Revenue, Expenditures, and Changes in Fund Balance for governmental funds;

c. Budgetary Comparison Statement for annually budgeted major governmental funds;

d. Statement of Cash Flows, using the direct method, for proprietary funds; and,

e. Statements for fiduciary funds will include a Statement of Net Assets and a Statement of Changes in Net Assets.

4. Business-type activities should be reported as proprietary, that is, enterprise and internal service, funds. The criteria for using proprietary fund accounting have been revised. A government may choose the proprietary fund approach for any activity, but it must use proprietary fund accounting if any one of the following criteria is met:

a. The activity issues debt that is secured solely by a pledge of net revenues.

b. State or local laws or regulations require the activity to recover costs of providing services.

c. Pricing policies for establishing fees are designed to recover costs of providing services.

5. For business-type activities, all resource inflows, regardless of restrictions on their use, should be reported in the operating statement.

6. Total equity for proprietary funds at the fund perspective should be reported in capital and noncapital components, rather than as contributed capital and retained earnings.

7. The requirement for an entity-wide perspective is based on the Board's conclusion that users also need aggregated information about the governmental entity as a whole to help users assess the long-term effects of current-period transactions and events associated with governmental activities.

8. At the entity-wide perspective, revenue from exchange transactions should be recognized when earned.

9. The measurement focus and basis of accounting used at the entity-wide perspective also require the capitalization of capital assets and an allocation of the cost of their use to reporting periods.

10. Governments should be required to report the cost of infrastructure prospectively, unless the government has capital debt outstanding related to infrastructure assets.

11. Financial statements presented at the entity-wide perspective include:

a. a Statement of Net Assets,

b. a Statement of Activities, and

c. a Statement of Changes in Capital Assets and Long-term Liabilities.

12. The difference between a governmental entity's assets and liabilities is its net assets. Net assets should be reported in two components - capital and noncapital. Restrictions on net assets will be reported at the fund perspective.

13. To heighten the usefulness of both perspectives, the presentation of "Management's Discussion and Analysis of Financial Condition and Results of Operations," or MD&A, is required to be presented with the core financial statements.

Chapter 1

Chapter 1 presents an overview of the Reporting Model project and the progression from the ITC to the current proposal in the PV. There is also a table that outlines the principal features of the financial reporting perspectives. This table is an excellent reference for understanding the scope and importance of this project.

Chapter 2

Chapter 2 explores the objectives of financial reporting and the dual-perspective approach. The Board believes that governments are faced with two primary objectives in financial reporting: (1) accountability for current financial resources and (2) operational accountability. These two objectives are fundamentally different and require separate reporting perspectives.

Accountability for current financial resources is the basis for the current model and the fund accounting principles for governmental entities. Users of the financial statements are eager to assess whether governmental have utilized current resources in accordance with legislative or regulatory restrictions. The emphasis on current resources arises from the notion that the current legislative body cannot impose restrictions on a future legislative body, in theory or in practice. And, the concept of "current" does not necessarily follow the commercial accounting definition of a fiscal year. More often, "current" implies that the standing legislative body can appropriate uses of the financial resources.

Accountability for operations, on the other hand, is the basis for commercial accounting principles. The focus of these principles incorporates the "matching concept" that strives to recognize expenses associated with specific revenues as the underlying events occur. Since any event can create either long-term assets or liabilities to be repaid from future cash resources, operational accountability must recognize noncurrent assets and liabilities, as well as currently available resources.

The Board believes that the traditional reporting focus of accountability for current resources is still important. Improvements are necessary to respond to the changing needs of users of the financial statements. However, the basic reporting model should not be abandoned.

There are users who are more interested in operational accountability. The Board believes that this reporting format would also be useful for setting priorities, evaluating the service delivery, and assessing the capacity to continue or expand services. Therefore, the dual perspective approach is offered as a reporting model that provides information to a broader range of user needs.

Chapter 3

Chapter 3 explains the "fund perspective" and outlines the changes proposed for the current model. The changes are briefly described as follows:

1. The "fund-type" combinations are replaced with presentations of "major funds." Non-major funds are grouped by fund type, but there are no totals for fund types.

2. Account groups are not reported with the fund perspective financial statements.

3. The budgetary comparison statement is expanded to present both original and final amended budget.

4. The criteria for use of proprietary fund accounting are revised.

5. Business-type activities should not apply FASB pronouncements issued after November 30, 1989, unless specifically made applicable to state and local government entities by GASB pronouncements.

6. Business-type activities are required to present a classified Balance Sheet that distinguishes between current and noncurrent assets and liabilities.

7. The contributed capital equity account will be deleted for business-type activities.

8. Equity of business-type activities will be reported as capital, noncapital restricted, and noncapital unrestricted.

9. Restricted assets should be reported when external restrictions on asset use change the nature or normal understanding of the liquidity of the asset.

10. The Statement of Revenue, Expense, and Changes in Equity for business-type activities should separately report operating, nonoperating, and extraordinary transactions.

11. The Statement of Cash Flows for business-type activities should use the direct method of presenting cash flows from operating activities.

12. The definition of fiduciary funds is narrowed to only include those funds that are used to account for assets held by a governmental unit that are not available to support its programs.

13. Fiduciary funds are only reported in the fund perspective statements.

Chapter 4

Chapter 4 explains the new proposal for an entity-wide perspective statement. This perspective presents financial statements for the government as a whole. The reporting entity concepts are not substantially different from the current model, but the content and format are dramatically different. Significant changes that we have not previously highlighted in this discussion include the following:

1. The entity-wide statements should be prepared using the flow of economic resources measurement focus and the accrual basis of accounting for all activities.

2. The Statement of Net Assets and the Statement of Activities should include prior-year data.

3. The Statement of Net Assets should be presented in a format that displays "assets less liabilities equals net assets." Assets and liabilities should be presented in order of their relative liquidity.

4. Net assets should be reported in two components-capital and noncapital.

5. The Statement of Activities should be presented using the "net program cost" format. The statement presents program expenses reduced by direct program revenue. Non-program revenue and extraordinary items are reported separately to determine the entity-wide "excess" or "deficiency" measurement for the period.

6. The Statement of Changes in Capital Assets and Long-term Liabilities may be presented in a single statement or two separate statements. Capital assets and liabilities are not associated with individual funds.

Chapter 5

Chapter 5 presents another new component of the core financial statements, Management's Discussion and Analysis of Financial Condition and Results of Operations, or MD&A. The report sounds much like the transmittal letter currently included in governmental comprehensive annual financial reports. The PV explains that the MD&A does not replace the transmittal letter, but it does move certain items from the transmittal letter to the MD&A. The PV does not really explain the differences between the transmittal letter and the MD&A. The minimum requirements for elements of the MD&A are intended to provide guidelines, but management is primarily responsible for the contents. The following minimum information should be included:

1. analysis of the two-year period covered by the entity-wide statements.

2. explanation of the objectives of the two financial reporting perspectives.

3. an objective analysis of the causes of significant changes in financial statement amounts from the previous year to the current year.

4. analysis of significant variations from budgeted revenue and expenditures.

5. description of debt activity.

6. discussion of interperiod equity.

7. discussion of currently known trends.

Chapter 6

Chapter 6 presents the illustrative core financial statements. Readers should carefully review these statements to obtain a better understanding of the Board's objectives. The statements also include highlighted explanations that readers may want to include in comment letters.

Conclusion

As we mentioned at the beginning of this session, the reporting model presents the most significant proposals for revising governmental financial statements. Many users are confused by the complexity, concerned about the lack of long-term information, and convinced that the current model does not reflect the changes in the governmental sector. The choice of not making changes is no longer an option. How the revisions are incorporated is the primary consideration. Public comment to this due process document and the forthcoming exposure draft is critical to shaping the future of governmental financial statements.

It has been more than three years since the U.S. Supreme Court handed down its opinion on the capitalization of costs in Indopco, but the aftereffects of that ruling continue to rock the world of corporate taxation. After all, the Indopco case began with the concept that capitalization of costs does not require that there be a separate, identifiable asset. [Indopco, Inc. v. Commissioner, 112 S. Ct. 1039 (1992)] In fact, the U.S. Supreme Court began with the proposition that, under our current taxing structure, capitalization of expenditures is the norm; and that taxpayers must have specific authority for any exception to that norm. That assumption makes sense, especially in the context of a friendly corporate acquisition, where it would be difficult to argue that the taxpayer did not receive significant long term benefits from the transaction.

We will discuss the Tax Court's most recent examination of the deductibility of takeover costs in a few minutes, but first, let's focus on one of those unintended consequences of the Indopco decision. It is difficult to find an American business that is not actively investigating the implementation of a process known as justintime manufacturing. This radical redesign of existing manufacturing processes requires that the precise number of parts that are needed be brought to the next stage of the production process at the appropriate time. In other words, there is no workinprocess inventory tying up a company's space or its money.

What connects justintime manufacturing to the Indopco decision is a ruling by the IRS requiring the capitalization of costs associated with JIT implementation. According to a recent, but still unpublished, technical advice memorandum, the IRS would require that the company, which has been identified

as Danneher Corporation, capitalize:

(1) the costs of reconfiguring manufacturing equipment; (2) materials and supplies to implement justintime manufacturing; (3) workforce training costs; and (4) consulting fees related to workforce training management.

We will get Bill Raby's analysis of the Service's application of Indopco in the manufacturing process in a few minutes. But first, let's take a look at the latest controversy involving the deduction for costs incurred in a corporate takeover.

During the takeover frenzy of the 1980s, A.E. Staley Manufacturing and its parent holding company, Staley Continental, were the targets of a hostile takeover bid by a British conglomerate. Unlike Indopco and other friendly acquisition cases, Staley spent more than one year in trying to repel the takeover and in trying to line up a white knight.

Over that period, Staley incurred more than $20 million in costs, consisting mainly of fees paid to its investment bankers, lawyers, and other advisors in connection with fighting the ultimately successful tender offer. Yet, according to the IRS and to a majority of Tax Court judges, under the Indopco doctrine, Staley, even though it was a hostile, rather than friendly, takeover, must capitalize those costs. After all, none of the $23 million in question was expended in connection with ongoing Staley operations; it all related to the change in ownership. In the majority view of the Tax Court, the rule should be that any expenses relating to a change in corporate ownership are not deductible. [A.E. Staley Manufacturing Co. v. Commissioner, 105 T.C. No. 14 (1995)]

As you might expect, most of our listeners do not regularly deal with large corporations that are spending huge sums on fighting lawsuits in Delaware and on finding white knights. So, before we get to the rationale of the Tax Court's decision in Staley, we asked Bill Raby to comment on the relevance of cases like A.E. Staley and National Starch.

Dr. Raby

I think if anything, there are probably more situations with closely held businesses, where you have succession problems or where you're going to sell the business or where you're going to go out and acquire a business than there are with the very large corporations. They don't get the publicity, but the transactions are there, the expenditures are being incurred, and if you look in your own clientele, it's happening there right today.

ATR

Let me ask you. It would be difficult to say that these succession planning issues, these friendly acquisition issues, that these aren't producing future benefits. Right?

Dr. Raby

Right.

ATR

Is the Tax Court really saying to us that almost any kind of change in corporate ownership is going to require a capitalization of costs?

Dr. Raby

That's what the Tax Court is saying up to a point. The whole point before Staley was hey, if we can show that this is really an unfriendly takeover, because Indopco, which is the National Starch thing, was a friendly type of transaction. Many people surmised if we can have an unfriendly type of transaction, then we ought to get deductions. Staley is saying that isn't the point, guys. The point is this is a reorganization, recapitalization. It is a change with future benefits, friendly or unfriendly. It seems to me that what it does is to put us on guard, that if we're going to get deductions for at least some of this, we have to now start thinking in a different fashion.

ATR

I agree with you. That's certainly what the majority in Staley is saying, but I noticed that there were some strong dissenting opinions here; I mean is this signed, sealed and delivered?

Dr. Raby

Oh no, not yet, at all. There is in fact, a bankruptcy court case involving Federated Stores. [Federated Department Stores, Inc., BCDC Ohio, 921 U.S.T.C. 50,097]

ATR

The Campeau takeover of Federated.

Dr. Raby

And that case is distinguishable from Staley, but it certainly is supportive of the idea that at least some of these costs can be deductible, and I think that's where it's going to come down. I don't think that the appeals court is going to reverse the Tax Court. I don't think it's going to buy the dissenting opinions. But I think from a planning standpoint, it doesn't matter. From a planning standpoint, it seems to me that it's becoming very clear. What you need to do is to document what it is, the expenses that you're incurring, and tie it to things that aren't the things that happened. You see, what happened in Staley is that you had an awful lot of effort going to repelling the invaders and then, you had a smaller amount of effort going to the question of implementing the invasion once we had decided that there was no more point in fighting.

ATR

And in a way it's interesting that you mentioned the Campeau takeover of Federated, because obviously there's going to be alternatives that a company investigates, but they're going to drop some of them. Some of them don't turn out to be feasible. Could you make a case that those expenses could be losses under IRC §165?

Dr. Raby

That's exactly the case that you're going to be making. In a sense that's exactly the case that was made in Federated, because what you were dealing with was what's called a standstill agreement. In effect, you were making a deal and if you weren't able to carry through on that deal because there was a takeover, you were going to pay out, I forget what it was, $150 million or some such figure, and said the bankruptcy court and the district court affirmed it, that's deductible. By the same token, if you look into possibilities, at least the cost of looking into those possibilities ought to be deductible if they're abandoned. If you want an analogy, think of the oil drilling business, the dry well. Even for financial accounting purposes, you're going to write those costs off. And, here, to a much greater extent, I would guess in my experience, 70% to 80% or more of the cost that you incur in succession planning, trying to sell the business and so forth, really is focused on things that never come to fruition.

ATR

That's good because you brought us back to where we started. This recapitalization that involves the small company, the privately held company. As opposed to Federated Department Stores, or A.E. Staley Manufacturing, couldn't the IRS come back and argue that this was almost a constructive dividend for those shareholders of the close corporation?

Dr. Raby

Yeah, and in fact, you don't even have to have a close corporation. When National Starch came down, and now it's called Indopco, as I recall we discussed it in the context of hey, the motivation for this whole transaction was that the majority shareholders wanted to facilitate their estate planning. They wanted to be able to get out and liquidate their investment without rupturing the market for stock. It was publicly held, but a big block in a concentrated form. The same type of reasoning that led me to say then, hey, you know, they came out lucky, because all the IRS is doing is arguing about the deductibility. They didn't charge them with an imputed dividend, but very clearly, in the closely held situation, you're not going to find the IRS overlooking that so readily.

ATR

One final area I wanted you to address because we're talking about when the IRS brings up this Indopco argument since '92, and recapitalization is obvious. But, you know, over the past couple of years, particularly in the manufacturing area of the economy, we've seen an awful lot of restructuring and a lot of it is this justintime manufacturing. We've got this still unpublished technical advice memorandum that the announcers described, that the Danneher Corporation got, and that the Tax Executives Institute disliked so much. Clearly when you restructure your operations, you train people, you move your machinery around, you do what you do. You're producing current benefits, and by definition, you're producing future benefits. Why doesn't the IRS just say it's like advertising, or it's like continuing education, even though it produces both, based on the nature of it, we're going to let you deduct it currently?

Dr. Raby

I guess there's a continuum because if you start out with the proposition that nobody in their right mind incurs an expense, except to benefit the future, in theory, if you wanted to carry Indopco to its ultimate extreme, nothing is ever deductible. It has to be amortized over a day, a week, a month, a year, or something.

ATR

What if the future is the current taxable year?

Dr. Raby

Then you get the question of things that are part of the ongoing day-to-day adjustment that you have to the business. It's sort of like a ship. You're constantly moving the rudder as you proceed, but you don't necessarily make 180° turns very often. If I have a manufacturing plant, and I relocate that manufacturing plant from Rockford, Illinois, to say Tempe, Arizona, those costs are costs of a major restructuring. [They] probably need to be capitalized and amortized in some fashion.

ATR

No one's going to argue that one. But, you get the experts in here, and they say in terms of Rockford, if you move these machines over here, if you retrain some of these workers to do this, and if you do that, you can operate on this justintime principle, and you can really save yourself a lot of money.

Dr. Raby

I think my answer is that it's a matter of degree. Most of this type of thing is not of the same degree as moving the plant from Rockford to Tempe. Most of it is more like what you go through everyday. A new piece of software comes out-Windows 95-in your office. If you buy it, you've got to train people on how to use it. Very clearly, that's going to have continuing benefits for a long time, but it is unavoidable. If you are going to be a competitive manufacturer, you are going to have to adapt new things that come along. Justintime is one of those new things, and tomorrow it will be something else, and the day after that, not quite that fast, but, these things are constantly coming along: management by objective, quality control.

ATR

We've been through them all.

Dr. Raby

And if every time you had one of these things, you had to take and capitalize it, especially, if you didn't get to amortize it, in time, you would have so huge a mountain of goodwill, if you want to think of it that way, unamortizable capitalized items on the books, that the rest of the corporation would look, really rather small potatoes.

ATR

Let me ask you the last unrehearsed question, because you sparked my memory about a case that you and I discussed a few years ago, called Ithaca, Inc., about whether or not the manufacturer can even amortize the workforce. [Ithaca Industries, Inc. v. Commissioner, 941 U.S.T.C. 50,100 (4th Cir. 1994)] What did the court say?

Dr. Raby

The court said no. It is the type of question that isn't going to come up under present law because now that would be amortized over fifteen years, along with all this other excess stuff, but it was part of a game that we used to play, until the law got changed, in 1993, where what you would do would be to analyze the business and try to find the purchase price of that business attributable to various assets. And workforce in place was a very popular type of asset to attribute things to, except that the court said we aren't convinced that that is a separate asset. Unfortunately, one of the problems with Indopco is it rejected the separate asset theory, so you can't say that it is inconsistent for this technical advice memo to come out and nevertheless to disallow the amortization of the workforce in Ithaca.

Our first case stems from a longstanding controversy, where a cash basis taxpayer has inventories, but is not reflecting them, or its receivables, in its tax accounting. In this instance, Argo Sales Company, a regular C corporation, filed in 1985 for permission from the IRS to change to the accrual method of accounting. The company offered to report the resulting adjustment of $1.3 million over six years, or roughly $222,000 per year. Halfway through the six year period, in 1988, Argo Sales made a structural change that had the unintended effect of considerably complicating its tax life.

As you might have anticipated, based on the 1988 date, the company made an S election. Unfortunately for Argo, the landmark Tax Reform Act of 1986 did more than make the S corporation an attractive entity choice: it also introduced the concept of the built in gains tax into the Internal Revenue Code.

As originally envisioned in the repeal of the General Utilities doctrine, the Code did not define recognized built in gain to cover anything except the gain on the disposition of assets that were held at the beginning of the first S corporation year. In other words, assets-such as the receivables of a cash basis taxpayer, like Dr. Frank Leou and his professional corporation-might have a fair market value that exceeded their zero tax basis on the first day of the S corporation year. But unless these assets were disposed of, they would not produce built in gain or trigger any tax consequences.

Even if Argo Sales or its advisors considered the effect of the inventory adjustment, it is unlikely that they would have considered it to be an asset, much less subject to built in gain. Of course, the IRS viewed the three remaining years of $222,000 quite differently. To the Service, it was income that had been accrued for tax purposes prior to 1985, but had not been reported as income because of Argo's improper tax accounting.

As we have reported to you in different contexts, Congress in 1988-as part of TAMRA, or the Technical and Miscellaneous Revenue Act-added a subsection to the built in gain provision. The provision broadens the scope of IRC §1374 to encompass any item of income, such as accrued income and deductions, that is attributable to the pre-S years of the corporation. In addition, the amendment was made effective as though it, too, had been part of TRA '86.

As he has done on other occasions, Bill Raby returns to tell us how the Tax Court resolved this controversy. [Argo Sales Company v. Commissioner, 105 T.C. No. 7 (1995)]

Dr. Raby

In a word, almost, against Argo Sales. They said that the retroactive nature of the regulation was valid and, by implication, the retroactive nature of the statute was valid, and that these amounts were going to have to be reported as IRC §1374 built-in gain, both in terms of the numerator and the denominator, so to speak, both in terms of the limitation and also in terms of the current realization.

ATR

I guess that's the right decision in this particular set of facts, but there are a couple of things that I'm not clear about, and maybe you can help me. A few months ago, you told me about the difference between calculating recognized built-in gain on the one hand, and something you called NUBIG (net unrealized built-in gain). Which is going on here in Argo Sales, one or both?

Dr. Raby

Actually, both.

ATR

The court only talks about one.

Dr. Raby

The problem, of course, is that Congress-and probably the IRS and the people in Treasury-really never fully grasped what they had done when they put together IRC §1374. So, to get this to the point where the court decides this case, they actually had to have two amendments to the tax law. The net unrealized built-in gain is a limit on the aggregate amount of built-in gain you're going to realize. For a while, they didn't amend that. That is a net concept: you take assets at their fair market value, compare it with tax basis, and that becomes then the limit on how much individual assets-because you can have negatives as well as positives in this first one. Individual assets have their own built-in gain potential. After the law had been passed, Congress came along and amended it, at the insistence of the IRS, to make it clear that you could pick up things like the collections on receivables, and that you could pick up things in this second category, such as accounting adjustments.

ATR

A few months ago, we talked about Dr. Frank Leou and some others who came under this TAMRA '88 amendment to IRC §1374, but that's something else that I was unclear about. [Leou v. Commissioner, T.C. Memo 1994-393] At one point-maybe it was the Carlton case, maybe it was something else-you told me that the Supreme Court talked about these retroactive changes, retroactive amendments, made to look as if they were part of the law that was originally passed as being a good example of bait-and-switch taxation. Wouldn't this qualify as one of those examples?

Dr. Raby

Two things: the Supreme Court case (Carlton) said it was all right in that situation, because the retroactive change was only 13 months after the law was enacted. [U.S. v. Carlton, 114 S. Ct. 2018] Secondly, in this particular situation as with Dr. Leou, it's not clear just exactly what the law was. In the Carlton case, what they were doing was changing something that was crystal clear. But Dr. Leou, for example, I would have argued that what happened to him probably was implicit in the '86 Act, and all that happened in '88 as to him, was a clarification. In terms of the accounting change adjustments that we're dealing with here, I'm not so sure that there was anything in the '86 Act that implicitly picked these things up. The '88 change then made it possible to report these in the current unrealized gain recognition area, but neglected to do anything about that NUBIG concept, the net unrealized built-in gain.

A year later they came back, and they changed the law as to that to say that anything that came in here had to be reflected up here. The constitutionality of that, I think, could have been open to question, whereas here, somebody presumably relied on the law as it was. But it isn't quite the same kind of a provision that says you have a right to do something; it's a question of whether something really is clearly covered or not. I think the taxpayer would have had a very good argument, although the court rejected that argument, I think the argument was fairly good that the regulations being retroactive as they were, coming along as late as they did in the game-now they weren't finalized until 1994-that is a somewhat unconscionable reach. And I would go back to our Tate & Lyle decision that we talked about some time back, which dealt with a regulation being made retroactive-a regulation in a clarification context, which is really what this could be regarded as. [Tate & Lyle, Inc. and Subsidiaries v. Commissioner, 103 T.C. No. 37 (1994)]

ATR

You never know. In some cases, is three years too much? Is six too many? It's the classic dilemma.

Dr. Raby

Right. I don't know how much it is, but the fact is that in a planning context, at least under today's law, we know that these accounting changes are going to be picked up. We know that if we make a change to the accrual basis, that is going to be picked up. If we don't and we stay on the cash basis, our collections of receivables are going to be picked up. There is still a little play, incidentally, between these definitions that allows you, if you sell your receivables, to wind up paying less in the way of built-in gains tax than if you collect the receivables, and that's an interesting sort of a twist. But from the standpoint of planning, there's not much to be done. If you're in a controversy, you still have the card that this is unconstitutional. That's a very long shot, and you have to have a client who has a lot of faith and is willing to take this pretty far up through the court system.

ATR

The bottom line, whether it be Argo Sales or somebody else: the client comes into you, and they're currently a C corporation. They're considering either making an S election or going the LLC route, depending on whether or not they want to keep their entity. Is this a time for somebody who's a cash basis taxpayer, who maybe should have been on the accrual basis-is this the time to change the accounting methods and maybe minimize or even eliminate the tax consequences?

Dr. Raby

I don't think it makes much difference. At one time, it looked like you might have a windfall. That's what the Argo Sales case and the statutory amendments that it's based upon did away with. Now about the best that you can do is to sell your receivables to a related party and make your accounting methods change at a later point in time.

The other thing, though, is when you talk about the option of an S election and an LLC, you're talking about options that have two very different tax consequences. I can make an S election and I don't trigger an immediate tax consequence, although I may have built-in gain. But if I go ahead and make an LLC out of it, I'm really liquidating the corporation, and I'm going to have perhaps a lot of unrealized gain, realized at that point, even though I'm not really pulling it out of the business solution. So we don't see a huge amount of interest in going from say, a corporation that's a C corporation to an LLC in quite that direct a route. Now, there are some circuitous routes that people may be taking with possible problematical tax consequences. n

Our first topic deals with building and maintaining a successful financial planning practice. And what can be more basic to the orientation of a practice than the planner's approach to the mixture of products and services being offered, resulting in pricing decisions as well as a fee structure for clients.

Of course, every coin has two sides, and every story has at least two sides. This is as true in questions of ethics and professional responsibility as it is in questions of courtroom advocacy, where the two antagonists present their arguments before a court of law.

Over the past several months, we have featured updates on financial planners who have made the decision to become registered investment advisors and to take a more active role in the implementation of their clients' financial plans. Naturally, this is just one side of the story.

The flip side of the coin stems from the time-honored viewpoint that public confidence in any profession can only exist with the knowledge that each practitioner of that profession is objective and independent. In other words, the public must understand and appreciate the fact that the individual practitioner's motives are professional, not commercial.

This was not widely viewed as an issue when most people who provided financial planning services were subject to their own professional codes of conduct, which, in turn, provided sanctions against anyone whose professional conduct could be perceived as compromised or conflicted. But two great shifts have occurred in recent years: first, the rapid growth of, and demand for, financial planning services has led to the emergence of an army of financial planners, specifically and deliberately unconnected to any other professional calling; and second, the changes in professional norms that no longer prohibit the acceptance of commissions in connection with a professional engagement.

Despite the hoopla over accepting referral fees based on the amount of funds under management, there are a growing number of financial planners who believe that it is essential to their practice, and to their clients' success, that all of their professional recommendations be unequivocally developed and transmitted without any appearance of bias. These planners take the view that they can best help clients in evaluating available financial products and strategies, as well as in advising them on whether their selections are most appropriate in meeting their goals.

Many of these fee-only financial planners are members of the National Association for Personal Financial Advisors, or NAPFA, organized as a means of fostering the growth of comprehensive financial planning, without product sales, commissions or finder's fees. Andrew M. Hudick serves as president of NAPFA, as well as a principal in the Roanoke, Virginia-based firm, Fee-Only Financial Planning. Mr. Hudick joins us this month, via telephone interview, for his perspective on the future of fee-only planning.

AFPR

Let me ask you a base line question before we get started. Isn't there a lot of pressure particularly in the marketplace for financial advisors whether they be CPAs or other professionals to accept commissions for their financial planning services rather than relying solely on fees?

Mr. Hudick

I think so. I think a lot of the pressure comes from their competition. They see what their neighbors or other folks in town are doing. Not so much competition from their clients. I would suspect that, at least in our business, many of the clients that we have come to us specifically because we do not accept a commission.

AFPR

But you know something, many of the clients, we talk about this huge group of baby boomers who are going to be inheriting this mass of wealth over the next decade or so and these are people who are largely used to having their services being subsidized by commissions. They've dealt with people who earn their living on a commission basis. Are they going to be continuing to come forward and put themselves in the market for financial planning services if they have to pay the full price?

Mr. Hudick

Well I think the costs are less with a fee advisor. Years ago that might not have been the case, but I think now with technology that it's a whole lot easier or a lot quicker for most financial advisors to do a financial review. We're talking comprehensive financial planning, so to do an insurance review, an investment review, a tax estate planning review is a whole lot easier now, at least in our office, than it was even two years ago. But certainly more than it was ten years ago. Technology makes things so much faster that actually our fees are less than they were years ago.

AFPR

Part of it is that initial fee, of course, and part of it is whether the client and you are happy with the arrangement and you continue on. To what extent is it somewhat counter productive if the implementation of the plan is always going to be in somebody else's hand? You're always counting on somebody else to implement what you've come up with in terms of insurance, in terms of whatever else it is that you've looked into.

Mr. Hudick

Well I think again that's relationship building. Most of your audience are CPAs and they would all have attorneys or insurance folks or investment folks that they've worked with and I think the idea of an organized financial plan and an implementation through the avenues of folks that they trust as other trusted advisors, would make that a pretty straight forward event.

AFPR

You'd hope that [would be the case] but the fact is that the main asset, the main thing that we have going is our relationship with the client, him or herself, in trying to stay as their trusted business advisor. I guess my question is, how can you be the quarterback of that team, even if you've worked with the lawyer or the insurance broker or whomever it is in the past, how can you be the quarterback of the team if the other players can overrule your signals?

Mr. Hudick

Well I think as a CPA aren't you the trusted advisor.

AFPR

Well, you'd want to be.

Mr. Hudick

Well you have that fiduciary obligation. I think it's a very real obligation. I think that you give up some of that if you take a commission. I think part of your conflict of interest issue would set itself out there and there may be a problem with your client, but I would think that the CPA as a professional has himself set up to be the quarterback or the person in charge of doing the comprehensive plan. They know the most important part of the client. They know the tax history of the client and all decisions are tax based decisions, insurance decisions or investment decisions, certainly estate decisions are tax based.

AFPR

I guess what I'm thinking about is that there are two sets of concerns. One of them as you say is ethical whether or not you take a commission, and the other is based on the marketplace.

Mr. Hudick

Right.

AFPR

And the fact is that there are a number of commission free products out there. Are you suggesting that it's okay to sell products as long as they're commission free or should the accountant CPA, the lawyer, whatever the professional is, ought to not be doing any product work whatsoever?

Mr. Hudick

Well I think the implementation phase demands that you do the product work. It's not really a sale if you're not receiving a commission. It's more of an implementation process and you've included that, at least we do, include that as part of a financial planning fee. Implementation is certainly a part of the financial planning process and we all know clients who, even through our best intentions, we've tried to get to implement and wouldn't so that the whole planning experience was more of an exercise in education than it was in a completed event.

AFPR

You're right. We call them an exercise in futility. I won't be as polite as you are.

Mr. Hudick

But if you charge a fee you've been, in a sense, you've been compensated for the energy you've put forth for that client and then it was their choice not to proceed as opposed to if you were on a commissioned basis and you felt compelled to get them into a product that they weren't comfortable with in order to get your compensation.

AFPR

Part of it as you say is based on the technology. I'm wondering to what extent there are now networks of broker dealers or other people who can provide the kind of coordination and back office support that you need if you want to have a fee-only practice.

Mr. Hudick

Well I think that's where we encounter the horns of the dilemma. With some of these back office providers, you charge a fee for implementation through the provider, and I guess we can talk about brand names, but there are a variety of basically generic products where you would put the client's assets into a program and then collect a quarterly or an annual fee for managing those assets through the program. You know, you might make a case that the fee, that 1% management fee, is really no different than a commission.

AFPR

Well, I would certainly make that case. Wouldn't you.

Mr. Hudick

Well, it all depends on when we speak. I think a lot of financial planners call themselves fee only and do that and do indeed charge a fee for assets under management which, in my mind, is really not a whole lot different than a 1% commission that's generated. You know, the SEC, the Securities and Exchange Commission, says that a 12(b)(1) fee of less than 1% is not considered a commission, and as such you do not have to have a broker's license in order to sell a mutual fund for instance that pays a 12(b)(1) fee of 0.5%.

AFPR

One way to look at it is that 1% threshold. Another way to look at it would be how you receive the fee whether you receive it as a check from the client for the engagement or whether you receive it as part of somebody else's fee that they are getting for assets under management or the sale of products or whatever else. To what extent ought people to be thinking about the source of their funds?

Mr. Hudick

Well obviously that's a nice segue into a brief discussion of at least my volunteer role this year as president of NAPFA, the National Association of Personal Financial Advisors, and indeed we have that rule as a part of our membership that all compensation that a financial planner receives must be received directly from the client.

AFPR

Well it's good to know that you are not alone in these views. So tell me how is NAPFA doing in terms of either attracting or retaining members whose practices really are limited to fee-only financial planning.

Mr. Hudick

Well, we're limited to comprehensive fee-only planning. We won't accept just a tax practitioner or just a money manager who charges fees. We believe in a holistic concept so you must be, for each client, you must be willing to do an insurance review, an investment review, a tax review, an estate planning and retirement planning review and generally some kind of a cash flow or balance sheet program would be instituted. You'd need all that data in order to do a comprehensive review.

We just had our membership renewal season pass. Ninety-nine percent of our folks renewed. We lost about three or four members this year. Our memberships are at an all time high. We're just above the 500 person number and you may have read in some of the press articles that have been generated recently that we've sort of upgraded or streamlined our membership criteria.

AFPR

Are there new requirements in terms of either accreditations or experience that people are going to have to fulfill before they join or is it streamlined in some other sense?

Mr. Hudick

Well I guess we've streamlined the categories. There's been some confusion in the past as to who actually was a member of NAPFA. We've had affiliated people who've used the fact that their an affiliate of NAPFA which we set up a category for folks who wanted to get our newsletter, etc., but who are not really practitioners or were not practicing under our membership rules who've held themselves out to be affiliated members, which is sort of a misnomer, so we've eliminated the category.

To be a member of NAPFA you need to submit a financial plan, a comprehensive financial plan, so we can see that you are indeed practicing that way. We have an attestation sheet that you must sign that asks a variety of questions including things like is 100% of your income derived solely from payments from the client. We review your ADV. We require three years experience and we require some designation whether it be a CFP, a PFS, a CHFC, some designation that does indeed say that you've had some training, some base line training.

AFPR

As you look across the present membership, is there any group among that CFP, CPA, PFS, certified financial analyst that predominates or is it a pretty broad range group?

Mr. Hudick

Well it's a pretty broad range. I think somewhere around 70% or so of our members are CFPs. Obviously, CFP is the predominant membership designation that can be earned.

AFPR

Obviously, yours isn't the only group that's doing this. Are we likely to see some kind of shake out or do you think that there's a niche where you also talk about doing comprehensive fee-only planning is there enough that the organization has a good future?

Mr. Hudick

Well, I guess from my own selfish viewpoint, I wouldn't want my planner [working] for me if he didn't know my entire financial situation. You know a lot of folks who do planning tend to concentrate on one specific area whether it be for financial reasons or competency reasons, but I think that if I were to hire a financial planner I would want that planner to look at my entire situation. There's so many places where a mistake can be made if you don't have all the financial information in front of you.

AFPR

I guess that's why I like the quarterback analogy. I want him to look at my entire financial situation but if he needed help in the pension and retirement area, I want him to be able to call in somebody who really knew about employee benefits or had a CLU or whatever the issues were.

Mr. Hudick

Well I think in the code of ethics for CFPs and certainly for CPA-PFSs you are not allowed to practice outside your area of expertise and I think all of us have a threshold of where we're comfortable whether it be in tax law or employee benefits or estate planning where we can do maybe many client's situations because it's a repetitive event. But there are areas where it gets outside our expertise because we only see that topic or that question once every so often and we have outside people who specialize in those areas.

AFPR

That makes sense. If you were to talk about your own practice in Roanoke, what area is it that you feel most comfortable in? Where is it that you see the greatest need and the greatest source of consumer need right now?

Mr. Hudick

Well I think part of the genesis of our conversations months ago came from the fact that I've always thought that, and I built my practice that way, that as the tax practitioner or as the CPA, that person was the person to advise the clients in all areas because, while that might be difficult for many people, taxes [for example] are a difficult area to master. If you've got that ability or aptitude you can certainly coordinate from the tax angle many of the client's other decisions.

I would suspect that many of your subscribers are CPAs and as such they can get some training if they are not comfortable in making insurance decisions or investment decisions; they can get some training in those areas or get someone certainly to help them until they build up a level of confidence. A CPA should be the quarterback and that's really how we've structured our practice. We do tax work for many of our clients and use that tax meeting a lot of times in February and March as the meeting where we prepare the balance sheet and ask some of the questions to keep us moving through the year together.

AFPR

Well it certainly makes a lot of sense. In terms of the structure, do you feel that NAPFA provides you with the outreach, the ability to contact people outside your immediate office or do you also see people joining some of these regional alliances or other affiliations in order to broaden their net?

Mr. Hudick