Review of

Volume 35, Number 1SPECIAL ACCOUNTING ISSUE: Summer-Fall 2014

Winner of the AUBER* Award for quality in publication*Association for University Business and Economic Research

46Years of Publication

BusinessSummary of the New FASB and IASB Revenue Recognition Standards Scott Streaser, Deloitte & Touche LLP, New York

Kevin Jialin Sun, The Peter J. Tobin College of Business, St. John’s University, New York

Ignacio Perez Zaldivar, Deloitte & Touche LLP, New York

Ran Zhang, The Peter J. Tobin College of Business, St. John’s University, New York

Lease Accounting Change: It’s Not Over Yet Joan DiSalvio, Silberman College of Business, Fairleigh Dickinson University, New Jersey

Nina T. Dorata, The Peter J. Tobin College of Business, St. John’s University, New York

Statement of Comprehensive Income: New Reporting and Disclosure Requirements Patrick A. Casabona, The Peter J. Tobin College of Business, St. John’s University, New York

Timothy Coville, The Peter J. Tobin College of Business, St. John’s University, New York

The Private Company Council: Financial Reporting Standard Setting for Private Companies Alexander K. Buchholz, Brooklyn College of the City University of New York

Biagio Pilato, The Peter J. Tobin College of Business, St. John’s University, New York

New Consolidation Requirements Under IFRS Sylwia Gornik-Tomaszewski, The Peter J. Tobin College of Business, St. John’s University, New York

Robert K. Larson, Carl H. Lindner College of Business, University of Cincinnati, Ohio

The PCAOB’s Proposed Changes to the Auditor Reporting Model: An In-depth Overview for the Classroom and Beyond Veena L. Brown, Sheldon B. Lubar School of Business, University of Wisconsin-Milwaukee

Joseph E. Trainor, The Peter J. Tobin College of Business, St. John’s University, New York

Cloud Computing and the Cloud Service User’s Auditor I. Hilmi Elifoglu, The Peter J. Tobin College of Business, St. John’s University, New York

Yildiz Guzey, Beykent University, Turkey

Ozlem Tasseven, Dogus University, Turkey

Strategic Planning for Metropolitan and Regionally-Focused Accounting Programs Alan Reinstein, Wayne State University, Michigan

Mark Higgins, University of Rhode Island, Kingston, Rhode Island

James E. Rebele, Robert Morris University, Moon Township, Pennsylvania

Review of Business is published two times per year and is distributed internationally to academicians, practitioners and libraries. Articles are refereed by members of the Global Review Board and by Corresponding Editors. The views presented in the articles are those of the authors and do not represent an official statement of policy by St. John’s University.

©2014, St. John’s University. Reproduction of material without the express permission of the publisher is prohibited. ISSN: 0034-6454

St . John’s University Queens, NY 11439718-990-7379reviewofbusiness@stjohns.edu

Review of Business

Board of AdvisorsThomas Anderson SVP-Chairman American Express Global Banking American Express Co.

James Christmas Vice Chairman Petrowhawk Energy, Inc.

Vincent Colman Vice Chairman PricewaterhouseCoopers, LLP

Vincent D’Agostino Managing Director JP Morgan Chase Co.

Diane D’Erasmo Executive VP HSBC Bank USA

Pascal Desroches Senior Vice President and Controller Time Warner, Inc.

Frank Fusaro President Forum Personnel, Inc.

Joseph Gentile Chief Operating Officer Leerink Swann

Thomas Goldrick Retired -Chairman/CEO State Bank

Peter Johnston Managing Director, Global Securities and Clearing Operations Goldman, Sachs and Company

Robert Kalenka COO, Investor Communications Solutions Broadridge Financial Solutions, Inc.

Salvatore LaGreca Chief Financial Officer Preciseleads.com

Peter Micca Partner Deloitte & Touche, LLP

Kathryn Morrissey Sr. Vice President Global AT&T

Gary Muto President Ann Taylor Loft

Robert Orlich President & CEO Transatlantic Reinsurance Co.

Paul Reilly EVP, Finance and Operations, and CFO Arrow Electronics

Robert Rooney EVP and Chief Operating Officer Affinion Group

Larry Ruisi Retired - President & CEO Loews Cineplex Entertainment, Inc.

Thomas Scaturro Senior Vice President and Controller Wells Fargo

Victoria Shoaf, CPA, Ph.D. Dean The Peter J. Tobin College of Business St John's University

Edward Smith Partner (Retired) KPMG LLP

Michael Strianese President & CEO L3 Communications

Peter Tobin CFO (Ret.), Chase Bank and Dean (Ret.) The Peter J. Tobin College of Business

John Tutunjian Chief Executive Officer Gourmet Events, Inc.

Paul Wirth Finance Director & Global Controller Morgan Stanley

The Peter J. Tobin College of BusinessVictoria Shoaf, CPA, Ph.D. R. Mitch Casselman, Ph.D. Brandon Sweitzer, M.A. Dean Associate Dean Associate Dean

Linda M. Sama, Ph.D. Donna M. Narducci, Ed.D. Associate Dean Associate Dean

Review of BusinessIgor Tomic, Ph.D. Maxine Brady Fran Vroulis Editor Associate Editor Secretary

Corresponding EditorsAlexander Brem, Ph.D. Luiz Paulo Lopes Favero, Ph.D. Fernando Tejarina Gaite, Ph.D. David Gowing, MScA, B.A.ScUniversity of Erlangen University of São Paulo ETSI Informatica University of Windsor Nuremberg, Germany São Paulo, Brazil Valladolid, Spain Windsor, Canada

Table of Contents Volume 35, Number 1 SPECIAL ACCOUNTING ISSUE | Summer-Fall 2014

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From the Editor 2 Igor M. Tomic

From the Special Accounting Issue Editors 3 Patrick A. Casabona and Sylwia Gornik-Tomaszewski

Reviewers 6

Research Papers:Summary of the New FASB and IASB Revenue Recognition Standards 7 Scott Streaser, Deloitte & Touche LLP, New York Kevin Jialin Sun, The Peter J. Tobin College of Business, St. John’s University, New York Ignacio Perez Zaldivar, Deloitte & Touche LLP, New York Ran Zhang, The Peter J. Tobin College of Business, St. John’s University, New York

Lease Accounting Change: It’s Not Over Yet 16 Joan DiSalvio, Silberman College of Business, Fairleigh Dickinson University, New Jersey Nina T. Dorata, The Peter J. Tobin College of Business, St. John’s University, New York

Statement of Comprehensive Income: New Reporting and Disclosure Requirements 23 Patrick A. Casabona, The Peter J. Tobin College of Business, St. John’s University, New York Timothy Coville, The Peter J. Tobin College of Business, St. John’s University, New York

The Private Company Council: Financial Reporting Standard Setting for Private Companies 35 Alexander K. Buchholz, Brooklyn College of the City University of New York Biagio Pilato, The Peter J. Tobin College of Business, St. John’s University, New York

New Consolidation Requirements Under IFRS 47 Sylwia Gornik-Tomaszewski, The Peter J. Tobin College of Business, St. John’s University, New York Robert K. Larson, Carl H. Lindner College of Business, University of Cincinnati, Ohio

The PCAOB's Proposed Changes to the Auditor Reporting Model: An In-depth Overview for the Classroom and Beyond 59

Veena L. Brown, Sheldon B. Lubar School of Business, University of Wisconsin-Milwaukee Joseph E. Trainor, The Peter J. Tobin College of Business, St. John’s University, New York

Cloud Computing and the Cloud Service User’s Auditor 76 I. Hilmi Elifoglu, The Peter J. Tobin College of Business, St. John’s University, New York Yildiz Guzey, Beykent University, Turkey Ozlem Tasseven, Dogus University, Turkey

Strategic Planning for Metropolitan and Regionally-Focused Accounting Programs 84 Alan Reinstein, Wayne State University, Michigan Mark Higgins, University of Rhode Island, Kingston, Rhode Island James E. Rebele, Robert Morris University, Moon Township, Pennsylvania

About the Review of Business and Author SubmiSSion And review GuidelineS 96

GlobAl review boArd 98

From the Editor

It has been our tradition to produce special issues in fields where policies and rules change with some frequency. This is a special issue on the accounting profession,

with a focus on topics that have received much attention as of late. Practitioners as well as academicians have participated in developing the articles.

As in the case of all such issues, a ‘special issue editor’ was assigned to manage the flow of articles and the review process. The reviewers are experts in their field,

and while each did a “blind review” of an article, we publish their names now to show much gratitude for their time and service.

IGOR M. TOMIC, PH.D. Editor, Review of Business

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From the Accounting Issue Co-Editors

This Special Accounting Issue of the Review of Business contains eight significant articles discussing recent important developments in financial accounting, reporting, auditing,

and accounting education.

The first article, Summary of the New FASB and IASB Revenue Recognition Standards, explains the accounting profession's new guidance on how entities should recognize

revenue from contracts. The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) finalized its project to develop a joint revenue recognition standard in May 2014, when the FASB and IASB issued Accounting Standards Update (ASU) 2014-09 and IFRS 15, respectively. The new guidance moves away from the current risks and rewards model, and adopts a contract- and control-based approach. Now, an entity would be required to identify whether a contract with a customer exists, and allocate the estimated transaction price to the separate performance obligations embedded in the contract. Revenue can only be recognized by an entity when (or as) a performance obligation is satisfied by transferring the control of promised goods or services to the customer.

This article provides a detailed explanation of the new revenue recognition require-ments, and points out that the impact on entities of changes in the amount and timing of rev-enue recognition as a result of adopting the new standard may be significant. However, the impact will vary based on the performance obligations identified in the contract by an entity and the allocation of the transaction price to those performance obligations.

Lease Accounting Change: It’s Not Over Yet is the second article. It discusses the inadequacies of the accounting profession’s existing rules for lease accounting, and

the steps the FASB and IASB are taking to rectify them. For one class of lease, for example, neither the liability for future rent payments nor the leased asset appears on the lessee’s balance sheet. This type of transaction has been often criticized since it allows lessee companies to keep assets and liabilities “off balance sheet” and does not represent the economic substance of the transaction. It also reduces the transparency and comparability of financial statements among companies.

Therefore, in 2006 the IASB and the FASB initiated a joint project to revise leasing rules. Subsequently in November 2013, after considering the vast amount of feedback from various proposals, the boards discussed and tentatively decided on its re-deliberations plan. This plan focuses on most key aspects of the lease accounting proposal, including the lessee accounting model, lessor accounting model, lease classification, lease term and other matters. This article explains the tentative decisions to revise lease accounting rules that have occurred through early 2014.

The third article, Statement of Comprehensive Income: New Reporting and Disclosure Requirements, explains the new financial reporting and disclosure requirements for

comprehensive income (CI), which resulted from the joint efforts of the FASB and IASB. An entity's comprehensive income (CI) for a period, which includes its current period net income plus or minus changes in the components of other comprehensive income (OCI), provides extremely important financial information that assists investors and creditors to more fully understand the changes in owners' equity and the future cash-flow generating ability of the entity.

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The changes in the components of OCI (as discussed in detail in the article), are not reported directly in the income statement until such amounts are realized, even though they can have a profound effect on an entity's equity, and hence, the wealth of its stockholders. However, because of the way entities previously reported changes in the components of OCI, this important financial information was often overlooked and not sufficiently understood. Therefore, both the FASB and IASB revised their guid-ance to enhance the transparency in the way entities should report and disclose CI and changes in OCI. This article describes and illustrates the FASB's new presentation and disclosure requirements for the statement of CI and its components and highlights some important implementation considerations.

The Private Company Council: Financial Reporting Standard Setting for Private Companies, the forth article, offers a comprehensive look at the creation,

responsibilities, membership, agenda, and accomplishments of the Private Company Council (PCC). This 10-mamber body was established by the Financial Accounting Foundation (FAF) in May 2012 to assess reporting needs of U.S. private companies and to help develop guidance addressing these needs.

The article provides a timeline of events leading to the creation of the PCC and explains its advisory role in standard setting for private entities. During the short pe-riod of time since its inception, the PCC has been able to convince the standard setter, FASB, to simplify standards for private companies in three different areas: (1) account-ing for goodwill; (2) consolidation of lessors in certain common control leasing ar-rangements; and (3) hedge accounting for certain types of swaps. Future PCC agenda is also addressed in the paper.

New Consolidation Requirements under IFRS, the fifth article, explains key provisions of the new international standard IFRS 10, Consolidated Financial

Statements, issued by the IASB. The standard, effective for most entities in 2013, introduced the new single control model used to determine which investee should be consolidated. The new approach combines the concept of power and exposure to variable returns to determine whether control exists.

Control exists under IFRS 10 when the investor has power, exposure to variable returns, and the ability to use that power to affect its returns from the investee. The article discusses a due process leading to this standard, including an attempt to con-verge international standards with U.S. GAAP. Eventually the IASB and the FASB did not agree upon a single consolidation standard. Consequently, U.S. GAAP maintains two consolidation models: the voting interest model and the variable interest entity model. The paper explains the differences on consolidation between the two sets of standards.

The PCAOB’s Proposed Changes to the Auditor Reporting Model: an In-depth Overview for the Classroom and Beyond, is the sixth article. It overviews the

audit standard setting process, as it applies to an auditor report. Written from the historical perspective, the article explains the current PCAOB’s proposal for changes to the existing auditor reporting model. The most significant change would involve documenting and reporting the critical matters encountered during the audit.

The article also discusses the new basic elements and clarifying language under the proposed standard, as well as expended responsibilities for other information included in the auditor report. Discussion of the proposed changes is enhanced by an illustrative sample of the new audit report. The authors then explain in two appendi-ces how their paper can be used in the classroom as a case project.

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Cloud Computing and the Cloud Service User’s Auditor, the seventh article, deals with the implications of increasingly popular Cloud computing for the service

user audit function. Cloud computing is defined and service delivery models, as well as development models, are described. Because Cloud computing is a large scale outsourcing of IT operations, the service user remains accountable for these operations, and the auditor of the service user needs assurances about the controls at the Cloud service provider.

The article provides details about the attestation standard and evaluates available reporting choices under this standard, dealing with risks associated with Cloud computing. Furthermore, possible questions for the Cloud computing user’s auditor are addressed. These issues are very important as in increasingly common Cloud computing arrangements the risks associated with the information technology are an integral part of the financial reporting risk.

The last article, Strategic Planning for Metropolitan and Regionally-Focused Accounting Programs, details the challenges facing educational institutions and

individual academic units, such as overcapacity, increased competition, rising costs, a declining population of prospective traditional students who face a difficult job market when they graduate, etc. How universities and academic programs respond to these challenges will largely determine their future relevance and viability.

Using input gathered from participants at American Accounting Association meetings, the authors explain how metropolitan and regionally-focused accounting programs can remain competitive, maintain their enrollments, and even be success-ful. Academic institutions and accounting programs must understand and evaluate their environments and then plan curricula, courses, and related activities to best prepare students for careers in a highly competitive job market. This article explains the specifics of how this may be achieved.

This volume would not be possible without the support and collaboration of people involved in the publication process. First of all, as the guest co-editors

of this special accounting issue, we would like to thank Dr. Igor Tomic, Editor of the Review of Business, for his support and encouragement. In addition, we would like to thank all the reviewers for their expertise and insightful comments. All manuscripts were blind reviewed by academic and professional experts, and each manuscript was revised at least twice before final acceptance.

PATRICK A. CASABONA, Ph.D.The Peter J. Tobin College of Business, St. John’s University, New Yorkcasabonp@stjohns.edu

SYLWIA GORNIK-TOMASZEWSKI, DBAThe Peter J. Tobin College of Business, St. John’s University, New Yorkgornikts@stjohns.edu

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Reviewers

The field of accounting is constantly evolving. Thus, experts in the field were engaged to review the articles, to ensure that they incorporate the current rules, regulations and processes of the accounting profession.

The articles in this issue were reviewed by the following:

David Burns Ernst & Young Professor of Accounting, Carl H. Lindner College of Business University of Cincinnati, Ohio

Timothy Kolber Senior Manager, Accounting Standards and Communication Department Deloitte & Touche, LLP, Connecticut

Mark Crowley Director, Accounting Standards and Communication Department Deloitte & Touche, LLP, Connecticut

Joan DiSalvio Assistant Professor, Silberman College of Business, Department of Accounting, Taxation and Law, Fairleigh Dickinson University, New Jersey

Adrian Fitzsimons Professor and Department Chair, Accounting and Taxation, The Peter J. Tobin College of Business, St. John’s University, New York

Elizabeth A Gordon President International Accounting Section of the American Accounting Association; Associate Professor of Accounting; Merves Fellow, Fox School of Business, Temple University, New Jersey

Benjamin Silliman Associate Professor, Accounting and Taxation, The Peter J. Tobin College of Business St. John’s University, New York

and

The Peter J. Tobin College of Business Review of Business reviewers.

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Summary of the New FASB and IASB Revenue Recognition StandardsScott Streaser, Deloitte & Touche LLP, New York sstreaser@deloitte.com

Kevin Jialin Sun, The Peter J. Tobin College of Business, St. John’s University, New York sunj@stjohns.edu

Ignacio Perez Zaldivar, Deloitte & Touche LLP, New York igperez@deloitte.com

Ran Zhang, St. John’s University, New York Ran.zhang12@my.stjohns.edu

Executive Summary

The joint task force of the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) finalized its project to develop a joint revenue recognition standard on May 28th, 2014, when the FASB and IASB issued Accounting Standards Update (ASU) 2014-09 and IFRS 15, respectively (“the Standard”). The new standard, Revenue from Contracts with Customers, moves away from the current risks and rewards model, and adopts a contract- and control-based approach. Specifically, an entity would be required to identify a contract with a customer and assign the transaction price to performance obligations embedded in the contract. Revenue can only be recognized when (or as) a performance obligation is satisfied by transferring the control of promised goods or services to the customer. The standard applies to all entities and replaces most current industry-specific guidance.

While the provisions of the new revenue recognition standard are substantially converged under International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (U.S. GAAP), minor differences continue to exist. Except where specifically noted otherwise, this article discusses the new framework and important

changes to the current revenue recognition standards under U.S. GAAP only.

To illustrate the effect of the change in this article, we apply the provisions of the new revenue standard to a hypothetical contract between a telecommunications company and a customer, in which the company promises to transfer a bundle of goods and services consisting of: (1) a subsidized handset, and (2) a non-cancellable service contract to the customer for fixed consideration. The example demonstrates that under the new standard, revenue recognition of the bundled contract will be accelerated when compared to current revenue recognition guidance. Specifically, revenue allocated to the sale of the handset upon delivery will increase, and revenue later will decrease.

Background

Since formally agreeing to work jointly on the revenue project in 2002, the FASB and IASB have collaborated on the joint task of issuing a converged revenue recognition standard. The goal of the task force is to develop a more robust and consistent framework for revenue recognition, as well as to increase the comparability of revenue recognition practices across entities, countries, and industries. The boards issued Exposure Drafts of the proposed

Accounting Standards Update (ASU) in June 2010 and revised Exposure Drafts in November 2011. The final standard was issued on May 28th.

This article discusses the changes from the current revenue recognition guidance and certain challenges in applying the new standard. To illustrate the effect of the change, we use an example to give the readers a better understanding of the effects of implementing the new standard.

The new standard, Revenue from Contracts with Customers, moves away from the current risks and rewards model, and adopts a contract- and control-based approachThe effective date of the ASU for public entities applying U.S. GAAP is annual and interim periods beginning after December 15, 2016. The effective date for nonpublic entities is annual reporting periods after December 15, 2017, and interim reporting periods within annual reporting periods beginning after December 15, 2018. Nonpublic entities may also choose from one of three alternate adoption dates: (1) the public entity effective date, (2) annual reporting periods beginning after December 15, 2016, including interim periods thereafter (i.e., same initial year of adoption as public entities, but allows nonpublic entities to postpone adopting the ASU during interim reporting periods during that year), and (3) annual reporting periods beginning after December 15, 2017, including interim periods therein (i.e., one year deferral). The effective date of the standard for entities that apply IFRS will be for fiscal years beginning on or after January 1, 2017. Early adoption will not be permitted under U.S. GAAP, while entities under IFRS will be permitted to early adopt the standard.

In the initial year of adoption, entities have the choice of retrospectively applying the new

standard, or adopting a modified transition approach. The modified transition approach requires entities to apply the new revenue standard to contracts not completed as of the date of adoption, and to record a cumulative adjustment to beginning retained earnings in the year of adoption.

Core principle of the Standard

Under current U.S. GAAP, revenue can only be recognized if it is: (1) realized or realizable, and (2) earned. The core principal of the new standard states that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.

The ASU is based on a control approach, which is different from the risks and rewards approach under current U.S. GAAP and IFRS. The current risks and rewards approach stipulates that transfer of a good or service to a customer has occurred when risks and rewards are transferred to a customer and the seller has relinquished control over the goods or services. In contrast, the boards decided in the ASU that an entity should assess the transfer of a good or service by considering when a customer obtains control of that good or service. The ASU defines control as “the ability to direct the use of and obtain substantially all of the remaining benefits from the asset.” The boards argue that the existing approach creates difficulty when judging the completion of the risk and rewards transfer to customers. The boards provided an example of their assertion in paragraph BC118 of the ASU:

“If an entity transfers a product to a customer but retains some risks associated with that product, an assessment based on risks and rewards might result in the entity identifying a single performance obligation that could be satisfied (and hence, revenue would be recognized) only after all the risks are

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9Summary of the New FASB and IASB Revenue Recognition Standards

eliminated. However, an assessment based on control might appropriately identify two performance obligations—one for the product and another for a remaining service such as a fixed price maintenance agreement. Those performance obligations would be satisfied at different times.”

… an entity should assess the transfer of a good or service by considering when a customer obtains control of that good or service.

The new model requires a five-step approach to apply the core principle. All of the five steps are mandatory:

Step 1: Identify the contract with a customer.

Step 2: Identify separate performance obligations in the contract.

Step 3: Determine the transaction price (this is the amount the entity expects to be entitled to under the contract).

Step 4: Allocate the transaction price determined to separate performance obligations.

Step 5: Recognize revenue when (or as) the performance obligations are satisfied (i.e. when (or as) control of good or service is transferred to customer).

First Step: Identify the Contract with a Customer

The first step in applying the core principle is to identify the contract with a customer, which must meet the following criteria: (1) the contract has commercial substance; (2) all parties have approved the contract and are committed to perform their respective obligations; (3) each party’s rights are identifiable; (4) payment terms are identifiable;

and (5) it is probable that the entity will collect the consideration that it expects it will be entitled to in exchange for the goods or services that will be transferred to the customer.

An entity would not recognize revenue from a contract that fails to meet the criteria until all performance obligations in the contract have been satisfied, all (or substantially all) promised consideration is collected (or the contract is canceled), and the consideration collected is nonrefundable. A contract does not need to be in a written format (i.e., it can be oral or implied by the entity’s customary business practices). The key to a contract is enforceability under applicable law.

In the above criterion (5), the word “probable” has a different meaning under U.S. GAAP than under IFRS. Under U.S. GAAP, probable means the event is “likely to occur”, whilst in the IFRS, probable means “more likely than not”, which is a lower threshold than “likely to occur.”

Under the Standard, contracts may be required to be combined with other contracts entered into at or near the same time with the same customer (or parties related to the customer) if one or more of the following criteria are met: (a) the contracts are negotiated as a package with a single commercial objective; (b) the amount of consideration to be paid in one contract depends on the price or performance of the other contract; (c) the goods or services promised in the contracts (or some goods or services promised in the contracts) are a single performance obligation.

A contract modification can be approved in writing, orally, or in accordance with another customary business practice. If the contract modification does not meet the criteria in the Standard to be accounted for as a separate contract, an entity should first evaluate whether the remaining goods or services in the modified contract are distinct (see the Second

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Step in the next paragraph) from the goods or services transferred on or before the date of the contract modification. If the remaining goods and services are distinct, the entity should allocate to the remaining performance obligations the amount of consideration included in the transaction price that has not yet been recognized as revenue. If the remaining goods or services are not distinct, (i.e., they are part of a single performance obligation that is partially satisfied at the date of contract modification), the entity should update the transaction price, the measure of progress toward complete satisfaction of the performance obligation, and should record a cumulative catch-up adjustment to revenue for the entity’s progress to date.

Second Step: Identify the Performance Obligations in the Contract

An entity should identify all separable promised goods and services in a contract. A performance obligation is a promise to transfer to the customer a good or service (or a bundle of goods or services) that is distinct. If a promised good or service is not distinct, an entity should combine that good or service with other promised goods or services until the entity identities a bundle that is distinct. The Standard indicates that goods and services are distinct if both of the following criteria are met: (1) the promise to transfer the good or service is separable from other promises in the contract and (2) the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer.

Third Step: Determine the Transaction Price

The Standard defines the transaction price as the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (e.g., some sales taxes).

The transaction price can be a fixed amount or can vary due to discounts, rebates, refunds, credits, incentives, performance bonuses/penalties, contingencies, or price concessions. Variable consideration can be included in transaction price only if the entity has sufficient experience and evidence to support that the amount included is not subject to significant reversals.

… contracts may be required to be combined with other contracts entered into at or near the same time with the same customer (or parties related to the customer) if [certain] criteria are met…

An entity would estimate the amount of variable consideration in a contract either by using a probability-weighted approach (i.e., expected value) or by using a single most likely amount, whichever is a better estimate of the amount to which the entity will be entitled. An expected value approach is typically more appropriate when an entity has a large number of contracts with similar characteristics. A most likely amount approach is typically more appropriate if a contract has only a small number of possible outcomes (e.g., the chance of receiving a performance bonus is either 100% or 0%).

Generally under current U.S. GAAP, impairment losses related to receivables should be presented as a separate line item within expenses. The Standard indicates that the transaction price is determined based on the amount to which the entity expects to be entitled, regardless of the collection risk. As stated in step one above, if collectability is not probable, a contract may not exist.

Noncash consideration received in exchange for promised goods or services is measured at fair value. If an entity cannot reasonably estimate

allocate the discount proportionately to all performance obligations in the contract, except when the entity has observable evidence that the entire discount belongs to only one or some of the performance obligations in the contract.

Fifth Step: Recognize Revenue When (or as) the Entity Satisfies a Performance Obligation

The Standard requires that an entity recognizes revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (that is, an asset) to a customer when (or as) the customer obtains control of that asset. Under the Standard, an entity first evaluates whether the control of a good or service is transferred over time. If a performance obligation does not meet the criteria to be satisfied over time, the performance obligation is satisfied at a point in time.

Indicators of the point in time that a customer has obtained control of a promised asset (and that an entity has satisfied its performance obligation) include: (1) the entity has a present right to payment for the asset; (2) the customer has a legal title to the asset; (3) the entity has transferred physical possession of the asset; (4) the customer has significant risks and rewards of ownership of the asset; and (5) the customer has accepted the asset.

For recognizing revenue over time, two methods are used: output methods (preferred) and input methods. Paragraph 606-10-55-17 of the ASU, and paragraph B15 of IFRS 15, state that “output methods recognize revenue on the basis of direct measurements of the value to the customer of the goods or services.” While output methods can be the most faithful depiction of the entity’s performance towards complete satisfaction of a performance obligation, many entities may be unable to directly observe the outputs used to measure progress without undue cost. Accordingly, the use of an input method may be required.

11Why Are Spanish Companies Implementing Downsizing?

the fair value of the noncash consideration, it shall be measured indirectly by reference to the standalone selling prices of the goods or services provided.

Fourth Step: Allocate the Transaction Price to the Performance Obligations in the Contract

For a contract that has more than one performance obligation, an entity would allocate the transaction price to each performance obligation at an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for satisfying each performance obligation.

In other words, an entity would allocate the transaction price to each performance obligation on a relative stand-alone selling price basis. The best evidence of a stand-alone selling price is an observable price at which a good or service is sold separately by the entity. If the good or service is not sold separately, an entity will be required to estimate its selling price by using an approach that maximizes the use of observable inputs. Acceptable estimation methods include the expected cost plus a margin approach, the adjusted market assessment approach, or the residual approach.

“…output methods recognize revenue on the basis of direct measurements of the value to the customer of the goods or services.” Paragraph 606-10-55-17 of the ASU, and paragraph B15 of IFRS 15

An entity may only use the residual approach if the entity sells the same good or service to different customers for a broad range of amounts, or if the entity has not yet established a price for a good or service and it has not previously been sold. If a customer receives a discount for purchasing a bundle of goods or services, an entity is required to

Summary of the New FASB and IASB Revenue Recognition Standards

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An entity that uses an input method to measure progress towards complete satisfaction of a performance obligation must exclude the effects of inputs that do not depict the entity’s performance in transferring control of goods or services to the customer (e.g., the cost of unexpected amounts of wasted materials). If an entity is not able to reasonably measure the outcome of a performance obligation (e.g., in the early stages of a contract), but the entity expects to recover the costs incurred after satisfying the performance obligation, the entity shall recognize revenue only to the extent of the costs incurred until it can reasonably measure the outcome of the performance obligation.

The Standard requires more extensive disclosure than current U.S. GAAP.

Similar to current U.S. GAAP, the Standard indicates that revenue should not be recognized for goods or services that are expected to be returned (or refunded). With regards to warranties, an entity may continue to apply the guidance in ASC 460 to accrue for warranty obligations that assure goods or services comply with agreed-upon specifications. The inclusion of an extended warranty in a contract that guarantees a product’s performance beyond the agreed-upon specifications should be accounted for as a separate performance obligation.

Disclosure Requirement

The Standard requires more extensive disclosure than current U.S. GAAP. The objective of the disclosure requirements under the Standard is to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. An entity is required to disclose the following in its annual report:

1. Disaggregation of revenue into categories that can describe “how the nature, amount, timing, and uncertainty of revenue and cash flows are affected by economic factors”

2. Information about contract balances

3. Assets recognized from the costs incurred to obtain or fulfill a contract

4. Information about performance obligations

5. Description of significant judgments used in recording revenue

6. Determining the timing of satisfaction of performance obligations

7. Transaction price allocation methods and assumptions

8. Remaining performance obligations

Telecommunications Industry Example

The telecommunication industry appears to be one of the industries most affected by the Standard. Under current U.S. GAAP, most telecommunication companies report revenues and costs associated with a subsidized equipment sale when the equipment is transferred to the customer, and subsequently recognize revenue as they perform the relevant services (e.g., generally based on monthly attribution). This accounting treatment results in a loss when subsidized equipment is sold, even though the contract overall is profitable due to the recognition of additional revenues over the duration of the contract. IFRS does not have detailed guidance to account for such transactions. Most European telecommunication companies have therefore analogized to U.S. GAAP in practice (Citi Research, 2014). The boards acknowledged that the current standards do not reflect the underlying economic substance of the transaction described above.

13Summary of the New FASB and IASB Revenue Recognition Standards

In comparison, the Standard requires the allocation of the contract’s transaction price to the handset and service performance obligations. Specifically, the Standard requires an entity to allocate a discount proportionately to all performance obligations in the contract unless the entity has observable evidence that the entire discount belongs to only some performance obligations in the contract.

Because the entity in our example (Company T) does not have observable evidence that the entire discount belongs to only some of the performance obligations in the contract, the discount would be allocated proportionately to Company T’s two performance obligations based on the stand-alone selling prices of the equipment and the service contract, respectively.

We have used an example from the telecommunications industry to illustrate how revenue would be recognized under the Standard. The example included in this article has been made relatively simple in order to illustrate how an entity would apply the principles of the Accounting Standards

Update. Contracts with customers entered into by companies in the telecommunications industry may include a large range of devices, voice and data service options, pricing plans, financing options, early-termination or opt-out features and penalties, as well as many other variables not contemplated in this example. Entities will be required to use judgment in applying the Standard to contracts containing these elements and will be required to apply forthcoming interpretive guidance that will be released by standard setters such as the FASB or its implementation groups and regulators such as the SEC.

The telecommunication industry is likely to be significantly affected by the adoption of the new revenue standard due to [its] widespread use of bundled contracts that include … equipment (i.e., a phone) and a service (i.e., voice and data service).

Example

Assume the following facts:

1. Company T sells its standard handset for $150 to customers who concurrently enter into a 2-year service contract with the entity.

2. The cost of a handset to Company T is $500.

3. Company T sells its standard handset on a stand-alone basis for $600.

4. Company T’s wireless contract is non-cancellable and has a duration of two years.

5. Company T charges a service fee of $75 per month for unlimited voice and data service over the two year duration of its service contracts.

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Analysis:

Table 1 illustrates that the average subsidy for each handset sale is $350. The total revenue earned by Company T over the two year contract period, inclusive of the handset and service revenue, is $1,950 (the “transaction price”).

If a handset and a two year service contract were sold separately, total revenue would be

$2,400, of which handset revenue and service revenue represent 25% and 75%, respectively. Under the Standard, the allocation of total revenue is based on the stand-alone selling prices of the handset and service contracts.

Therefore, Company T would allocate 25% of the transaction price to the handset element and recognize revenue of $487.50 (=25% * $1,950) when control of the handset transfers to the customer, and allocate $1,462.50 (=75%

Table 1Row Formula Company T 20X3 Data

Handset Selling Price (1) $150.00 Handset Cost (2) $500.00 Subsidy (3) =(1) - (2) $(350.00)

Service Fee per Month (4) $75.00 Contract Length (Months) (5) 24 Revenue Over Contract (6) =(4) * (5) $1,800.00

Total Revenue with 2-year Contract

(7) =(1) + (6) $1,950.00

Stand-alone Handset Price (8) $600.00 Stand-alone Handset plus Average Service Revenue

(9) =(8) + (6) $2,400.00

% Handset Price of Total (10) =(8) / (9) 25%% Service Price of Total (11) =(6) / (9) 75%

Revenue Allocated to Handset (12) =(7) * (10) $487.50$ Increase from Current Standards

(13) =(12) - (1) $337.50

% Increase from Current Standards

(14) =(12) / (1) - 1 225%

Service Revenue Allocation (15) =(7) * (11) $1,462.50Monthly Service Revenue Allocation

(16) =(15) / (5) $60.94

$ Decrease from Current Standards

(17) =(16) - (4) $(14.06)

% Decrease from Current Standards

(18) =(16) / (4) - 1 (19%)

Summary of the New FASB and IASB Revenue Recognition Standards 15

* $1,950) to the voice and data service element which would be recognized as Company T provides such services to the customer over the two year service contract.

Under current U.S. GAAP, revenue recognized upon delivery of the handset would be limited to the $150 in this example. Subsequently monthly revenue would be $75 per month. The Standard would increase revenue recognized at inception of the contract by 225% and reduce the revenue recognized over time by 19%. Accordingly, Company T will realize accelerated revenue recognition as a result of adopting the Standard.

Summary

The FASB and IASB issued Exposure Drafts on the boards’ revenue recognition standard during 2010 and 2011. The final standard was issued by the respective boards on May 28th, 2014. The new standard adopts a contract- and control-based approach. An entity is required to identify whether a contract exists and allocate the estimated transaction price to the separate performance obligations identified in the contract. The entity is required to recognize revenue only after it transfers control of the promised goods and services to its customers and fulfills its performance obligation.

An industry that is likely to be significantly affected by the adoption of the new revenue standard is the telecommunication industry due to the industry’s widespread use of bundled contracts that include a promise to deliver equipment (i.e., a phone) and a service (i.e., voice and data service). Entities in the telecommunications industry may be required to accelerate their recognition of revenue if they identify separate performance obligations in bundled contracts. As demonstrated in our example above, the impact of changes in the amount and timing of revenue recognition as a result of adopting the new standard may be significant to entities and will vary based on

the performance obligations identified in the contract and the allocation of the transaction price to those performance obligations.

References

Crowley, M., Young, B., Zimmerman, A., and McAlister, L. 2013. Heads Up — Boards preparing to issue final standard on revenue recognition http://www.iasplus.com/en-us/publications/us/heads-up/2013/hu-rev-rec

Deans, S. and Fisher, T. 2014. The Standards IFRS 2014: An Investor’s Annual Guide to IFRS Accounting. Citi Research.

FASB Accounting Standards Update No. 2014-09. Revenue from Contracts with Customers (Topics 606).

IFRS 15, Revenue from Contracts with Customers

FASB Revenue Recognition Project Update http://www.fasb.org/cs/ContentServer?site=FASB&c=FASBContent_C&pagename=FASB%2FFASBContent_C%2FProjectUpdatePage&cid=1175801890084#summary

Executive Summary

The FASB and IASB initiated a joint project to revise leasing rules in 2006, and eight years later in 2014 are getting closer to a revised leasing standard, although challenges to a single approach remain. The objective of the parties is to transparently represent the economic substance of a leasing transaction on the financial statements to investors, without creating undue cost and complexity for preparers of financial statements.

The inherent nature of leasing is highly complex, defying simple solutions. However, the parties are getting closer to their objective. Under the approach most likely to be adopted, the majority of equipment and real estate leases would be recorded on balance sheet and require capitalization treatment. Small ticket and short-term leases will receive consideration separately from standard leases for lessees, and serious debate remains whether lessor accounting should be affected at all because it presently meets user needs.

Introduction

Many U.S. companies use leasing as a means to obtain property or equipment without expending a large initial cash outlay, while also maintaining a certain level of flexibility and avoiding the risk of asset obsolescence. Leases allow the lessee company the right of use (ROU) to an asset for a period of time in

exchange for periodic payments. For one class of lease, neither the liability for future rent payments nor the leased asset appears on the lessee’s balance sheet.

Back in 2005, the Securities and Exchange Commission (SEC) issued a report on off-balance sheet accounting and recommended that the Financial Accounting Standards Board (FASB) specifically address lease accounting as it allows companies to keep assets and liabilities “off balance sheet” and does not represent the economic substance of the transaction.1

Further, the off-balance sheet treatment of certain leases reduce the transparency and comparability between companies, as investors and others do not have an effective means of comparing companies with leased assets to those that purchase assets because the debt associated with the lease is buried in disclosure footnotes and requires substantial estimation and manipulation by interested users to calculate ratios that assess financial performance.

Timeline of Development of New Lease Standard

Subsequently, in 2006 the IASB and the FASB initiated a joint project to revise leasing rules. The companies most affected by the rule change are those that lease real estate and equipment for greater than twelve months.

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Lease Accounting Change: It’s Not Over YetJoan DiSalvio, Silberman College of Business, Fairleigh Dickinson University, New Jerseyjdisalvi@fdu.edu

Nina T. Dorata, The Peter J. Tobin College of Business, St. John’s University, New York doratan@stjohns.edu

In a recent survey by Deloitte, ninety-four percent of firms carrying leased assets would be affected by proposed changes to lease accounting rules. The change therefore has widespread impact.2

In March 2009, the FASB and IASB formally published and solicited comments on a discussion paper, Leases: Preliminary Views. In August 2010, the boards issued their original exposure draft, which generated more than 780 comment letters from stakeholders. Many respondents were of the view that the provisions within the original exposure draft would impose an undue burden on stakeholders while not meeting the objective to present the true economic substance of the right of use to an asset and its related contractual liability.

Preparers commented that the anticipated economic impact of the proposed change could result in violations in debt covenants by increasing debt ratios affecting financial and credit markets, and having far reaching consequences in real estate values and leasing companies.

As a result, the boards deliberated on a path forward for lease accounting and on May 16, 2013, a revised exposure draft (2013 ED) was issued by the FASB and IASB. The boards received in excess of 640 comment letters on this second proposal, almost all of which provided negative criticism of the proposal. In addition, as part of their outreach, the FASB and IASB hosted several roundtable discussions in various locations around the globe. The boards received a plethora of feedback and recommendations for the boards to consider.

In November 2013, after considering the vast amount of feedback, the boards discussed and tentatively decided on its re-deliberations plan. This plan would focus on most key aspects of the lease accounting proposal, including the lessee accounting model, lessor accounting model, lease classification, lease term, variable

lease payments, residual value guarantees, scope and scope exceptions, presentation and disclosure requirements, transition, and effective date.

The first significant joint redeliberations meeting occurred on January 23, 2014, at which time the IASB and FASB met to discuss alternative views on the lessee accounting model, lessor accounting model, lease term, short-term leases, and small-ticket leases. This meeting was followed up by joint meetings that were held on March 18th and 19th and April 23, 2014, at which time the boards discussed and made certain tentative decisions on these alternative views. The results of the March and April 2014 meetings are discussed in detail within this paper.

…in 2006 the IASB and the FASB initiated a joint project to revise leasing rules.

CURRENT LEASE ACCOUNTING RULES

FASB (U.S. GAAP):

Current lease accounting rules classify leases as either capital or operating leases. Capital leases are intended to reflect a form of lease whose economic substance is in fact an asset purchase with financing rather than a true asset rental because it confers on the lessee all the risks and rewards of ownership. U.S. GAAP has bright line rules that, if any one of which is true, would result in a lease being categorized as a capital lease.

These bright line rules include

1. ownership of the leased asset transfers to the lessee at lease end,

2. a written bargain purchase option exists,

3. the lease term equals or exceeds seventy five percent of the economic life of the asset, and

17Lease Accounting Change: It’s Not Over Yet

18

4. the present value of the lease payments equals or exceeds ninety percent of the fair value of the asset .

Conversely, an operating lease does not transfer to the lessee all the risks and rewards of ownership characteristic of a sale and is similar to a typical rental. 3

IASB (IFRS):

International accounting standards (IAS) employs a framework that classifies leases using a “risk and rewards” based approach. While this approach is similar to U.S. GAAP, it does not utilize the same “bright lines” rules but rather considers qualitative factors to identify whether all of the risks and rewards of ownership are transferred to the lessee, to determine whether a lease is in fact a finance lease (or capitalized under U.S. GAAP).

The companies most affected by the rule change are those that lease real estate and equipment for greater than twelve months.

The qualitative characteristics used to evaluate whether a lease is a finance lease under IAS are as follows:

1. ownership is transferred by the end of the lease term;

2. the user has a purchase option at a price sufficiently below fair value such that the user is expected to exercise it;

3. the lease term is for the major part of the economic life of the asset;

4. the present value of the lease payments is equal to substantially all of the fair value of the asset;

5. the assets are so specialized that only the user can use them without major

modifications;

6. the user must bear the cost of any losses incurred by the lessor that are caused by the user cancelling the lease;

7. the user benefits or is impacted by gains or losses from fluctuation in the fair value of the leased asset; or

8. the user has the ability to renew the lease at rates that are below market.

EFFECT OF 2013 EXPOSURE DRAFT ON LESSEES AND LESSORS

Impact on Lessee:

The 2013 ED met with resistance because of the widespread view that the cost and complexity associated with applying the proposed accounting would outweigh any benefits. For leases with a term greater than twelve months, a lessee would record a ROU representing its right to use the underlying asset for a period of time specified in the lease agreement and a corresponding lease liability representing its obligations for the arrangement.

A majority of all real estate and equipment leases would therefore be recorded on the balance sheet, similar to capital leases under current accounting. Further, the proposed accounting would significantly increase the required financial statement disclosures, which have been characterized as burdensome, complex, and costly for users.

… ninety-four percent of firms carrying leased assets would be affected by proposed changes to lease accounting rules.

There are certain implications and other consequences that may result from the revised

19Lease Accounting Change: It’s Not Over Yet

accounting. Because the balance sheet will be grossed up, several key ratios may be affected. For example, the debt to equity ratio will increase for lessees, potentially affecting debt covenants, which may result in violations and the potential need for companies to renegotiate their agreements with banks. Also the revised lease accounting might make a bank less willing to provide financing, given the increased debt recognized under the new rules.

Current lease accounting rules classify leases as either capital or operating leases.

Additionally, income taxes and deferred income taxes will increase. Further, operating margins and enterprise value/EBITDA will be affected. Finally, return on assets will decrease as companies recognize the leased assets and interest coverage ratio will also decrease as a result of the greater recognition of lease obligations.

Lessor Impact:

The lessor accounting model proposed in the 2013 ED similarly met with resistance for many of the same reasons cited for lessee accounting (i.e., the cost and complexity associated with the proposed guidance would outweigh the benefits.) Layered on top of these concerns is the widespread view that current lessor accounting is not deficient in meeting user needs, questioning whether and why there is a need to introduce new accounting for lessors if the current accounting is not broken.

Under the approach proposed in the 2013 ED, lessors of assets other than property would generally derecognize the underlying asset and record a receivable representing the portion of the asset that is being leased and a residual asset. Alternatively, lessors of property would generally recognize revenue on a straight line basis, similar to the current accounting for

operating leases.

Stakeholders have identified a number of potential concerns resulting from the proposed lessor accounting model. Lessees, for instance, may reduce or eliminate renewal options, and shorten lease terms to adjust to new patterns of financing asset acquisition without recognition of a lease liability. Also, lessors may take the approach of increasing rental payments because they must recover the leased asset’s value over a shorter time period.

Additionally, the increased cost to lease may encourage lessee’s to purchase rather than rent, affecting the real estate market. Further, lessors may reduce lease concessions in order to make up for lease improvements made for lessees. Finally, equipment lessors may anticipate lessees will purchase rather than lease equipment.

ISSUES DISCUSSED AND DECISIONS REACHED DURING MARCH 2014 JOINT LEASES MEETING

Lessee Accounting Model:

At the March 2014 joint meetings, the FASB and IASB discussed three alternative approaches to lessee accounting, all of which would keep the same underlying principle introduced in the 2013 ED. That is, for all leases with the exception of short term leases, the lessee would recognize a ROU and corresponding lease liability. While the boards discussed three alternative approaches, the discussion ultimately centered around two approaches, with the IASB tentatively supporting what is characterized in the agenda paper as Approach 1 and the FASB supporting Approach 3.

Approach 1 introduces a single-model approach where the leased asset would be accounted for as a financed purchase of the ROU asset. Lease classification would therefore

20

be eliminated. The IASB is of the view that this single model approach is more conceptually sound and would reduce application complexity.

In contrast, Approach 3 would retain a dual-model approach; the lease classification and subsequent accounting would be determined using classification criteria that is similar to that included within IAS 17 (i.e., eliminates the classification criteria of “property” and “other than property” as proposed in the 2013 ED.) The FASB believes that this approach would result in less dramatic changes to the income statement when compared to Approach 1 and would reduce the cost and complexity as preparers transition to the new accounting.

… the revised lease accounting might make a bank less willing to provide financing, given the increased debt recognized under the new rules.

Lessor Accounting Changes Proposed:

The FASB and IASB similarly discussed three alternative approaches for lessor accounting. Upon considering the argument that the cost of making a large-scale change to lessor accounting is not justified and supported by the benefits that would be obtained, the boards agreed on an approach similar to the existing capital/finance and lease models (i.e., would not significantly change the current lessor accounting model.)

Further, the FASB agreed to conform the classification criteria under U.S. GAAP to that of IAS 17 versus retaining the ASC 840 guidance, thereby eliminating some of the ‘bright lines’ rules that U.S. preparers are familiar with (e.g., whether the lease term is for 75 percent or more of the economic life of the asset or whether the present value of the lease

payments (including any guaranteed residual value) is at least 90 percent of the fair value of the leased asset.)

Though the boards generally agreed on the underlying approach for lessors, there were differing views about the accounting for sales-type leases. Specifically, differing views were whether or not the lessor should be permitted to recognize seller’s/manufacturer’s profit (i.e., any difference between the fair value and carrying amount of the leased asset). The FASB tentatively decided that the lessor should only be allowed to recognize selling profit at lease commencement if the lessee obtains control of the leased asset, with the lessor considering this from the lessee perspective.

Alternatively, if any portion of the risks or benefits of leasing the asset are transferred to a third-party, the selling profit would be deferred and recognized over the lease term. In contrast, the IASB tentatively decided on an approach that would allow the lessor to recognize selling profit upfront.

Lease Term and Reassessment:

Under the 2013 ED, lease term would include all noncancelable periods and all renewal or termination options in which the lessee has a significant economic incentive to exercise. Lack of clarity around this threshold resulted in numerous questions and much feedback during the outreach process (i.e., is ‘significant economic incentive’ the same or a different threshold than the FASB’s reasonably assured or IASB’s reasonable certain thresholds that currently exist).

The FASB and IASB considered this feedback and concluded that the ultimate threshold should be consistent with current accounting. Further, the boards tentatively decided to replace the ‘significant economic incentive’ criteria with ‘reasonably certain’, which is already known and understood in practice.

21Lease Accounting Change: It’s Not Over Yet

While the term ‘reasonably certain’ is new under U.S. GAAP, it would be akin to the ‘reasonably assured’ criteria and should not result in practice changes.

Specific to reassessment requirements, according to the 2013 ED, lessees and lessors would be required to continuously reassess lease term and make adjustments to the lease assets and liabilities when warranted. Outreach indicated that this would result in undue burden to preparers.

As a result, during the March meetings, the boards tentatively decided to limit the reassessment requirement to lessees only and require reassessment upon the occurrence of a significant event or changes in circumstances resulting from the actions of the lessee (i.e., the boards would not consider factors outside of the control of the lessee, such as market conditions.)

The 2013 ED introduced a short-term lease exemption for leases with a maximum term of 12-months or less when considering all renewal options.

At the April 2014 meeting, the boards tentatively agreed to define a lease modification as “any change to the contractual terms and conditions of a lease that was not part of the original terms and conditions of the lease.” For both lessor and lessee, a lease medication would be accounted for as a new lease when the lessee is granted an additional ROU, and that ROU contract can be priced as a standalone contract.

Otherwise, the lessee would not account for a modification as a new lease if the modification just expands the scope of the lease or if the modification results in a change in the consideration. In that case, the accounting

would require an adjustment to the leased asset and corresponding lease obligation. Any modification that reduces the scope of the original lease contract may result in a gain or loss recognition following adjustments to the leased asset and lease obligation.

Small Ticket Leases:

During the outreach process, the boards received much feedback on the cost and complexity for applying lease accounting to small-ticket leases.4 That is, small-ticket leases are those low dollar, high-volume leases not considered vital to a company’s primary business. To address these concerns, the boards discussed three potential accounting alternatives for small-ticket leases: (1) introducing an explicit materiality threshold for immaterial leases, (2) accounting for leases at a portfolio level, and (3) allowing for a specific small-ticket lease exemption.

The FASB and IASB considered, but overwhelmingly decided against a scope exception for those leases meeting an explicit materiality threshold. The boards are of the view that other standards under U.S. GAAP and IFRS provide sufficient guidance to address materiality considerations.

In contrast, the boards supported accounting for leases at a portfolio level, though there were differing opinions on how this guidance would be incorporated into the standard. The FASB was of the view that this guidance would be incorporated as part of the Basis for Conclusions, whereas the IASB wanted the guidance incorporated into the provisions of the standard.

Finally, the boards discussed a recognition and measurement exemption for those small-ticket items that are individually small in value and not specialized in nature. This exemption could potentially help alleviate the costs and

22

complexity of accounting for leases that are not integral to the business.

The FASB overwhelmingly disagreed with this exemption, highlighting that the aggregate value of these small-ticket leases might be material to the financial statements. Further, they noted that other accounting policies and practices, such as ASC 105, IAS 8, or a company’s capitalization policy, should be sufficient at identifying immaterial leases. In contrast, the IASB was supportive of this exemption.

Short-term Leases:

The 2013 ED introduced a short-term lease exemption for leases with a maximum term of 12-months or less when considering all renewal options. This new definition of “short-term” addresses daily and month-to-month rentals that currently do not meet the definition of short-term leases.

At their March meeting, the boards confirmed that a final standard would retain a short-term lease exception that would use 12 months or less as its qualifying criteria. The boards also tentatively decided to link the short-term lease exception to the definition of lease term versus considering all possible renewal options as proposed on the 2013 ED.

Finally, the boards tentatively decided to expand the disclosure requirements for short-term leases. Companies would need to disclose their short-term lease expense for the given period and certain qualitative information when the lease expense is not indicative of the expected short-term lease obligation, as may be the case if a lease arrangement was executed near the end of the period.

…a final standard would retain a short-term lease exception that would use 12 months or less as its qualifying criteria.

IT’S NOT OVER YET

The boards are expected to continue the redeliberations of the remaining lease accounting issues throughout 2014. There are numerous topics that are yet to be discussed. Ultimately, while it is expected that the volume of differences between U.S. GAAP and IFRS will narrow, the consensus on the choice in approaches remains to be seen.

References

Bishop, John, and Beth Paul. Point of View: Lease Accounting - Enhancing the Financial Reporting Model. Issue brief. PwC, 08 Oct. 2013. Web. 18 Mar. 2014. <http://www.pwc.com/us/en/cfodirect/publications/point-of-view/lease-accounting-financial-reporting-model.jhtml>.

Chasan, Emily, ed. "Rule Makers Still Split on Lease Accounting."Wall Street Journal. N.p., 18 Mar. 2014. Web. 18 Mar. 2014.

Deloitte Accounting Journal Entry. Leases-FASB and IASB Continue Redeliberations. Rep. N.p. Deloitte Development, 2014. Print.

Deloitte Business Analytics. Lease Accounting Survey Preparing for Implementation. Rep. N.p.: Deloitte Development, 2014. Print.

Endnotes1 See http://www.sec.gov/news/studies/soxoffbalancerpt.pdf

2 See http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/Documents/FinancialAdvisoryServices_FAS/us_fas_lease_accounting_report_012714.pdf

3 See Accounting Standards codification (ASC) 840-10-25-1

4 Small-ticket leases, as defined by the March 2014 agenda paper, “generally refers to high-volume, low-value leases.” Examples include copier machines, laptop computers, and office furniture.

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the transparency in the way entities should report and disclose CI and changes in OCI. The FASB issued additional important guidance in 2013. However, there are still some differences between the two sets of standards concerning the types of items reported in OCI and the requirements for grouping such items that may or may not be reclassified into net income.

The objectives of this article are to describe and illustrate the FASB's new presentation and disclosure requirements for the statement of CI and its components, and to highlight some important implementation considerations.

Introduction

This article deals with financial reporting requirements for comprehensive income (CI), primarily for U.S. companies. This accounting guidance resulted from the joint efforts of the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB), which began in April 2004, when the Boards agreed to undertake a joint project on financial statement presentation. The Boards issued a Discussion Paper on Financial Statement Presentation on October 16, 2008 but have not yet completed this project. However, the Boards considered as a separate matter the presentation of OCI. Although consideration of this issue was initially a joint project, ultimately the Boards issued separate amendments and updates to their respective standards.

Statement of Comprehensive Income: New Reporting and Disclosure Requirements Patrick A. Casabona, The Peter J. Tobin College of Business, St. John’s University, New York casabonp@stjohns.edu

Timothy Coville, The Peter J. Tobin College of Business, St. John’s University, New York covillet@stjohns.edu

Executive Summary

This article deals with financial reporting requirements for comprehensive income (CI), primarily for U.S. companies. This accounting guidance resulted from the joint efforts of the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB), which began in April 2004, when the Boards agreed to undertake a joint project on financial statement presentation. Although consideration of this issue was initially a joint project, ultimately the Boards issued separate amendments and updates to their respective standards dealing with comprehensive income.

An entity's comprehensive income (CI) for a period, which includes its current period net income plus or minus changes in the components of other comprehensive income (OCI), provides extremely important financial information that assists investors and creditors to more fully understand the changes in owners' equity and the future cash-flow-generating ability of the entity. The changes in the components of OCI (as discussed in detail later) are not reported directly in the income statement until such amounts are realized, even though they can have a profound effect on an entity's equity, and hence, the wealth of its stockholders. However, because of the way entities previously reported this information, it was often overlooked and not sufficiently understood.

Therefore, during 2011, both the FASB and the IASB revised their guidance to enhance

24

Comprehensive Income

Comprehensive income (CI) includes all changes in shareholders' equity during a period except transactions with shareholders (e.g., issuance or repurchase of stock and distributions, such as dividends). CI for any reporting period consists of net income, as reported in the income statement, plus or minus the current period's changes in OCI items that are not reported in the income statement. Accounting Standards Codification (ASC) 220-10-45-10A provides a detailed list of all of the components of other comprehensive income, including the following items which are presented in this article:

• Foreign currency translation adjustments (as explained in FASB ASC 830-30-45-12)

• Gains and losses (effective portion) on derivative instruments that are designated as, and qualify as, cash flow hedges (see paragraph 815-20-35-1(c)) -1)

• Unrealized holding gains and losses on marketable security investments designated as "available-for-sale securities" (ASC 320-10-45-1)

• Gains or losses associated with pension or other postretirement benefits (that are not recognized immediately as a component of net periodic benefit cost) (ASC 715-20-50-1(j))

• Prior service costs or credits associated with pension or other postretirement benefits (ASC 715-20-50-1(j))

• Transition assets or obligations associated with pension or other postretirement benefits (that are not recognized immediately as a component of net periodic benefit cost) (ASC 715-20-50-1(j))

The FASB previously decided that including OCI items in the income statement would clutter that statement and produce too much volatility in periodic income. Still, the FASB expressed as part of their objectives that the information obtained

from the reporting of comprehensive income, along with other information in the financial statements and accompanying disclosures, would help investors, creditors, and other users in evaluating an enterprise's future cash flows. In the FASB's Proposed Accounting Standards Update issued May 26, 2010, they also mentioned that useful information is provided by not only reporting total comprehensive income but also by reporting detailed information about the components of comprehensive income and changes in them.

Comprehensive income (CI) includes all changes in shareholders' equity during a period except transactions with shareholders

The FASB issued three accounting standard updates during 2011 and 2013, before they and their constituents were satisfied that the new requirements would produce informative and cost effective guidance on how comprehensive income and its components should be reported and disclosed in the financial statements. The following discussion summarizes and illustrates the key guidance in those standards which have reshaped the way entities are required to report and disclose such important information.

Accounting Standards Update No. 2011-05 Requirements

In June 2011, the FASB issued Accounting Standards Update (ASU) No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income to revise the manner in which entities would have to present and disclose comprehensive income in their financial statements. The previous guidance in FASB Accounting Standards Codification (ASC) 220-10-45-8 allowed three options for reporting comprehensive income: 1) total comprehensive income for the period, as well as components of OCI, could be reported below the total for net income in a single combined statement of income and CI, 2) in a separate statement of

25

comprehensive income that begins with net income, and 3) within the statement of owners’ equity.

The third, least informative method was the one predominantly used by reporting entities. Therefore, the guidance in ASU 2011-05 removed the third presentation option in ASC 220 but did not change the items that must be reported in OCI. This standard applies to all entities that provide a full set of financial statements. It also applies to investment companies, defined benefit pension plans, and other employee benefit plans that are exempt from the requirement to provide a statement of cash flows. It became effective for fiscal years beginning after December 15, 2011 for public entities and for fiscal years ending after December 15, 2012 for nonpublic companies.

Under ASU 2011-05, entities have the option to present total comprehensive income, the components of net income, and the components of OCI in either of the following two ways:

• A single, continuous statement of comprehensive income — Entities must include the components of net income, a total for net income, the components of OCI, a total for OCI, and a total for comprehensive income.

• Two separate but consecutive statements — Entities must report components of net income and total net income in the statement of net income (i.e., the income statement), which must be immediately followed by a statement of OCI that must include the components of OCI, a total for OCI, and a total for comprehensive income. A reporting entity may begin the second statement with net income.

The ASU did not change the current option for entities to present components of OCI gross or net of the effect of income taxes, provided that

such tax effects are presented in the statement in which OCI is presented, or disclosed in the notes to the financial statements.

In June 2011, the International Accounting Standard Board (IASB) also issued its corresponding guidance to amend International Accounting Standard (IAS) 1, Presentation of Financial Statements. The amendment, Presentation of Items of Other Comprehensive Income (Amendments to IAS 1):

• Requires that entities report net income and OCI using one of the two formats mentioned above for ASU 2011-05.

• Requires that items be presented in OCI separately as to those that may be subsequently reclassified into net income and those that will not be reclassified and, therefore, will remain in accumulated OCI. The tax effect of each grouping must be shown separately.

• Became effective for fiscal periods beginning on or after July 1, 2012.

The FASB issued three accounting standard updates during 2011 and 2013 … which have reshaped the way entities are required to report and disclose such important information.

Though the two Boards’ 2011 guidance essentially converged the requirements for presenting OCI, there remained differences between U.S. Generally Accepted Accounting Principles (GAAP) and IFRS concerning: (1) the types of items to be included in comprehensive income and (2) the requirements for grouping such items that may or may not be reclassified into net income.

• U.S. GAAP considers all items recorded in OCI as subject to reclassification into net income and, therefore, no separate presentation groupings are required.

Statement of Comprehensive Income: New Reporting and Disclosure Requirements

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• On the other hand, IFRS requires the presentation of items in OCI that ultimately may be reclassified into net income to be presented separately from those that will not be reclassified into net income. For example, reclassification adjustments do not arise from an OCI component resulting from changes in revaluation surplus recognized in accordance with IAS 16, Property, Plant and Equipment. No such OCI component exists under U.S. GAAP.

ASU 2011-05, as originally issued, required one additional very controversial reporting requirement. That is, under either of the two methods entities could use to report CI, they were also required to present reclassification adjustments out of Accumulated Other Comprehensive Income (AOCI) by component, in both the statement where net income is presented and the statement where comprehensive income is presented.

Prior to ASU 2011-05, entities had an option to present reclassification adjustments in either the statement in which comprehensive income is reported or in the notes to the financial statements (most entities used the second alternative).

The changes in the components of OCI … are not reported directly in the income statement until such amounts are realized…

During initial implementation of ASU 2011-05, constituents raised several concerns over this new requirement, which included:

• Availability of information required at a necessary level of detail would be difficult to obtain for certain components.

• There would be a potential cluttering effect of information in financial statements, especially the income statement.

• There was concern about the cost of preparing the level of detailed information required for interim reporting purposes.

• There were questions about how to apply the provisions to reclassifications out of AOCI that are initially recorded on the balance sheet.

Therefore, in December 2011 the FASB issued ASU 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05. This accounting standard update deferred the requirement for entities to present reclassification adjustments out of accumulated other comprehensive income (AOCI) by component in both the statement in which net income is presented and the statement in which OCI is presented (for both interim and annual financial statements).

During the deferral period, entities still needed to comply with the requirements in ASC 220 for the presentation of reclassification adjustments. Those requirements gave entities the option of presenting reclassification adjustments out of AOCI on the face of the statement in which OCI is presented or disclosing reclassification adjustments in the footnotes to the financial statements.

Exhibit 1, adapted from ASC 220-10-55-7, illustrates one format (required under ASU 11-05) for presenting the statement of comprehensive income (one continuous statement) for the year ended December 31, 201X, with gross amounts of other comprehensive income components, including their reclassification adjustments, shown net of tax effects.

(Note that additional disclosures would also be required to explain the effect of the reclassification adjustments on the various line items in the statement of income, as will be explained below.) Also, for simplicity, this example provides information only for a single period; however, most entities are required to

27Exhibit 1: Single Continuous Statement of Comprehensive income

(one continuous statement reporting income and comprehensive income)

Entity XYZ Company

Consolidated Statement of Comprehensive Income

Year ended December 31, 201X

Revenues $122,500

Expenses (32,000)

Interest income (expense) 5,000

Gain on sale of securities 4,000

Income from operations before taxes 99,500

Income tax expense (24,875)

Less: net income attributable to non-controlling interest

(14,925)

Equals Income attributable to XYZ shareholders 59,700

Basic and diluted earnings per share $0.51

Other Comprehensive Income, net of tax

Foreign currency translation adjustments (a) $ 1,000

Unrealized gains on available for sale securities (b)

Unrealized holding gains during period $ 2,500

Less: Reclassification adjustments included in net income

(1,500) $1,000

Defined benefit pension plans: (c)

Prior service cost arising during period (2,000)

Net loss arising during period (1000)

Less: Reclassification adjustment for amortizations of prior period costs included in net income

4,500 1,500

Cash Flow Hedges

Gains (Losses) on cash flow hedges 3,000

Less Reclassification adjustments included in income

(750) 2,250

Other comprehensive income for period 5,750

Comprehensive income $ 80,375

Less: net income attributable to non controlling interests ( 16,075)

Comprehensive income – attributable to XYZ shareholders $ 64,300(a) There was no sale of an investment in a foreign entity and therefore, no reclassification adjustment for

this period occurred.

(b) This illustrates the gross amounts reclassified out of accumulated comprehensive income by component. Alternatively, a net display can be used, with the disclosure of the gross amounts (current-period gain and reclassification adjustment) reported in the notes to the financial statements.

(c) This also illustrates the gross amounts reclassified out of accumulated comprehensive income. Alternatively, a net display can be used, with the disclosure of the gross amount (prior-service cost and net loss for the defined benefit pension plans less amortization of prior-service cost) in the notes to the financial statements.

provide comparative financial statements.

ASU No. 2013-02 Requirements1

After issuing a proposed ASU on CI in August 2012, the FASB decided not to reinstate the reclassification adjustment requirements in ASU 2011-05 but rather to issue a final standard in February 2013, ASU 2013-02, Comprehensive Income (Topic 220 Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income), An Amendment of the FASB Accounting Standards Codification.

The objective of ASU 2013-02 is to improve the transparency of changes in OCI, and items reclassified out of AOCI in the financial statements. It does not amend any existing requirements for reporting net income or OCI in the financial statements, such as the requirement to present components of OCI using either a single continuous statement of comprehensive income or two separate but consecutive statements (as required by ASU 2011-05).

ASU 2013-02 requires entities to disclose additional information about reclassification adjustments, including changes in AOCI balances by component, and information about significant reclassification adjustments out of AOCI, and their effect on net income. This ASU was effective for fiscal years, and interim periods within those years, beginning after December 15, 2012, for public entities. So for calendar year end public entities, this means it first became effective for the quarter ended March 31, 2013. Nonpublic entities were granted a one year deferral, specifically for fiscal years beginning after December 15, 2013, and interim and annual periods thereafter.

The following will provide a step by step explanation of the additional disclosure requirements added by ASU 2013-02, which are quite detailed, and which have been codified in ASC 220, Comprehensive Income.

First of all ASU 2013-02 expands the disclosure requirements for the presentation of changes in AOCI. It does this by requiring an entity

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Exhibit 2: AOCI Reclassification Adjustments Disclosure RequirementsEntity XYZ

Notes to Financial StatementsChanges in Accumulated Other Comprehensive Income by Component(a)

For the Period Ended December 31, 201X

Gains and Losses on Cash Flow Hedges

Unrealized Gains and Losses on Available-for-Sale

Securities

Defined Benefit Pension

Foreign Currency

Items Total

Beginning balance

Other comprehensive income before reclassifications

Amounts reclassified from accumulated other comprehensive income(b)

Net current-period other comprehensive income

Ending balance

$(1,200) $1,000 $(8,800) $1,300 $(7,700)

3,000 2,500 (3,000) 1,000 3,500

(750) (1,500) 4,500 – 2,250

2,250 1,000 1,500 1,000 5,750

$1,050 $2,000 $(7,300) $2,300 $(1,950)

(a) All amounts are net of tax. Amounts in parentheses indicate debits.(b) The Exhibit in ASC 220-10-55-17E provides more details about these reclassifications then presented here.

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• Present aggregate income tax amount parenthetically on income tax line.

2. Separate disclosure in the notes to the financial statements: •Disclosetheamountreclassifiedfrom AOCI and line item affected.

• Reference significant partial reclassifications to respective footnote for additional information.

If an entity has significant portions of OCI components being reclassified from AOCI to net income in "their entirety" in a reporting period (such as a realized gains and losses on cash flow hedges), the entity has the option to present these adjustments either parenthetically by the line item affected on the face of the statement where net income is presented or as a separate disclosure in the financial statement footnotes. However, this option is only allowed if an entity’s significant reclassification adjustments are being reclassified to the income statement in their entirety in a reporting period.

For example, if an entity has two components of AOCI (e.g., unrealized gains and losses on available for sale securities and gains and losses on cash flow hedges), both of which have significant amounts being reclassified to the income statement (as opposed to being reclassified to the income statement and balance sheet, which is what is referred to as a partial reclassification) in a reporting period, the entity has the option to present the income statement effects on the face of the financial statement where net income is presented, or in the footnotes.

However, if amounts for the cash flow hedge were instead being reclassified from AOCI to both the income statement and balance sheet, the entity would be required to present the information about both significant reclassification adjustments in its footnotes,

Statement of Comprehensive Income: New Reporting and Disclosure Requirements

to disclose the portion of the current period change in AOCI related to changes in each component of OCI and the amounts of those changes being reclassified out of AOCI. Both public and nonpublic entities are required to present this disclosure in both interim and annual periods.

The example in Exhibit 2, adapted from ASC 220-10-55-15A, shows how an entity may present this information in a tabular format within its footnotes to its financial statements, even though ASC 220 does not specify a particular presentation format. An entity may decide on the most suitable presentation of the information.

As illustrated in Exhibit 2, the change in each component of AOCI is separately presented, as well as the portion of the change attributed to reclassifications out of AOCI and current period changes in OCI, regardless of the significance of the amount. This example also presents the amounts net of tax. An entity can also elect to show the amounts before tax, but must continue to comply with the existing requirements in ASC 220-10-45-12, which requires an entity to present the income tax effect of each component of OCI and reclassification adjustments, as illustrated in ASC 220-10-55-8A.

The second new disclosure required by ASU 2013-02, which may be the more challenging for certain entities to present, deals with presenting information about "significant" items reclassified out of AOCI and the effects they have on net income. This information must be provided “in one location," in either of the following ways:

1. Face of statement where net income is presented (if eligible, as explained below): •Includebefore-taxsignificant reclassification amounts parenthetically on the line item in the income statement affected.

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since this information must be presented in one place in the financial statements.

If an entity elects to present the information on the face of the financial statement where net income is presented, it would show the pre-tax reclassification amount associated with the particular component of AOCI next to the line item affected, and the tax amounts for these reclassification adjustments would be presented parenthetically in the aggregate on the income tax line item. However, to comply with the existing requirements in ASC 220-10-45-12, an entity must then present the income tax amounts allocated to each component of OCI and reclassification adjustments elsewhere in its footnotes. (Nonpublic entities do not have to present this information in their interim reports.)

Exhibit 3 provides an example that illustrates how these required disclosures may be presented on the face of the income

statement, if an entity elected to present all its significant reclassification items in such a way. The example in this Exhibit illustrates only one of the components that had a significant reclassification adjustment from the example in Exhibit 2, and uses the same information for the component of OCI – gains and losses on cash flow hedges, presented in Exhibit 1.

(But remember that ASU 2013-02 requires information about all significant reclassification adjustments to be presented in one location, and the option to present them on the face of the income statement can only be elected if "all of the significant reclassification items are reclassified entirely to net income in a reporting period.")

Also note that if an entity does select this option in the current period, it may want to consider whether or not it will have amounts being partially reclassified in future periods, which would then require the entity to present

Exhibit 3: Example of Disclosing an AOCI Reclassification Adjustment on Face of Income StatementEntity XYZ

Statement of IncomeFor the Period Ended December 31, 201X (a)

(a) Note that the reclassification adjustment for cash flow hedges of $750 in the disclosure example provided in Exhibit 2, ties into the individual amounts that affected various lines in the income statement reported in Exhibit 3 as follows: $750 = $2,5001 - 2,0002 + 1,0003 – 5004 – 2505.

Revenues (includes $2,5001 accumulated other comprehensive income reclassifications for net gains on cash flow hedges)

Expenses (includes ($2,0002) accumulated other comprehensive income reclassifications for net losses on cash flow hedges)

Interest Income (expense) (includes $1,0003 accumulated other comprehensive income reclassifications for net gain on cash flow hedges)

Gain on the sale of securities (includes ($5004) accumulated other comprehensive income reclassifications for net losses on cash flow hedges)

Income from operations before tax

Income tax expense (includes ($2505) income tax expense from reclassification items)

Net Income

$ 122,500

(32,000)

5,000

4,000

99,500

(24,875)

$ 74,625

31Statement of Comprehensive Income: New Reporting and Disclosure Requirements

Details about AOCI Components

Gains and losses on cash flow hedges

Interest rate contracts

Credit derivatives

Foreign exchange contracts

Commodity contracts

Amortization of Defined Pension items

Prior service cost

Transition adjustment

Actuarial gain (loss)

Unrealized gains (losses) Available for Sale Securities

Total Reclassification Adjustments for period

Amount Reclassified from AOCI

$1,000

(500)

2,500

(2,000)

1,000

(250)

$750

$(2,000)

(2,500)

(1,500)

(6,000)

1,500

$(4,500)

$2,300

(300)

2,000

(500)

1,500

$(2,250)

Affected Line Item in the Statement Where Net Income Is Presented

Interest income/(expense)

Other income/(expense)

Sales/revenue

Costs of sales

Total before tax

Tax (expense) benefit

Net of tax (b)

(c)

(c)

(c)

Total before tax

Tax (expense) benefit

Net of tax (b)

Realized gain on sale of securities

Impairment loss

Total before tax

Tax (expense) benefit

Net of tax (b)

Net of tax (b)

(a) Amounts in parenthesis indicate debits to profit/loss.(b) Amount agrees with "Amounts reclassified from AOCI" line for each respective component displayed in the Changes in AOCI by Component disclosure.(c) These accumulated other comprehensive income amounts are included in the computation of the current period's periodic pension expense (which would be explained in further detail in the related pension footnote).

Exhibit 4: Example of Presenting Required Disclosures of AOCI Reclassification Adjustments in a FootnoteEntity XYZ

Notes to Financial StatementsReclassifications Out of Accumulated Other Comprehensive Income (a)

For the Period Ended December 31, 201X

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the information in its footnotes. In addition, the entity should consider whether presenting such information for several components of OCI on the face of the income statement may cause it to look cluttered, which was a criticism of ASU 2011-05.

As seen from Exhibit 3, adapted from ASC 220-10-55-17F, the amounts are presented before tax and the income tax line item shows the aggregate of the tax amounts. However, as mentioned earlier, an entity would need to disclose elsewhere the income tax expense or benefit allocated to each component of [OCI], including reclassification adjustments.

Exhibit 4, adapted from ASC 220-10-55-17E, provides an example of how an entity may elect or be required to present significant AOCI reclassification adjustments in a separate footnote, using a tabular format, rather than in the income statement provided for only one OCI component in Exhibit 3. Because the requirement is to present this information in a single location that is either on the face of the financial statements or in the footnotes, if an entity has one or more reclassification adjustments that are only partially being reclassified to net income in a reporting period (as illustrated in Exhibit 4, this applies to the pension component), it must present the information in its footnotes.

Entities are required to cross-reference to a related footnote that provides additional information about those significant "partial" reclassification adjustments that are not reclassified entirely to net income in a reporting period. As an example, if an entity has amounts being partially reclassified out of AOCI in a reporting period, such as those related to a defined benefit pension plan, as illustrated in Exhibit 4, it is permitted to cross reference to the related pension footnote that provides additional details.

The AOCI reclassification adjustments footnote disclosure in Exhibit 4 needs to include the income statement line items affected and the corresponding amounts. Both before-tax and net-of-tax presentations are acceptable. Also note that the subtotals for each component shown in the footnote disclosures of significant reclassification items in Exhibit 4 must agree to the comparable amount presented in the changes in AOCI by component disclosures, presented earlier, as required by the new guidance.

As can be seen from the example in Exhibit 4, the total reclassification adjustment of $750 (net of tax) for cash flow hedges, agrees with the $750 in Exhibit 2, which presents the required disclosure for the cash flow hedge component of AOCI. This is only required when the information about significant reclassification items are presented in the footnotes.

IMPLEMENTATION CONSIDERATIONS

ASC 220 and SEC's S-X Interim-Period Disclosures During Initial Year of Adoption:

As discussed in Deloitte & Touche, LLP Practice Alert 13-2, Comprehensive Income: Implementation Considerations During Initial Year of Adoption of ASU 2013-02, ASC 270-10-50-1 (as amended by ASU 2013-02) requires publicly traded companies that report summarized financial information at interim dates, to report at a minimum, the information about changes in accumulated other comprehensive income required by paragraphs 220-10-45-14A and 220-10-45-17 through 45-17B.

This same practice alert also suggests that public entities should consult the SEC’s condensed financial statement requirements for guidance on the extent and materiality considerations related to preparing disclosures about reclassification adjustments in interim financial reports. Although the applicable guidance on interim reporting for SEC

Statement of Comprehensive Income: New Reporting and Disclosure Requirements 33

registrants is in Regulation S-X, Article 10, “Interim Financial Statements,” it will not be discussed in this paper, since the interim-period reporting during the initial year of adoption has already passed for most entities.

Public entities would have complied with both the ASC 220 and the Securities & Exchange Commission’s (SEC) Regulation S-X requirements if they disclosed (1) changes in AOCI balances by component and (2) significant items reclassified out of AOCI in each of their quarterly filings during the initial year of adopting the ASU. Note that these disclosures are required if the entity elects to present only a single line item total for comprehensive income (i.e., not present individual components of OCI) in its interim financial statements, as permitted by ASC 220-10-45-18.

Format of ASU 2013-02's Required Disclosures:

Recall that entities are not required to use a particular format for presenting the required disclosures under ASU 2013-02. Such information may be presented on the face of the financial statements or disclosed in notes to the financial statements in either a tabular or descriptive format. Entities should evaluate the extent to which they have significant reclassification adjustments out of AOCI to determine which presentation would be most suitable for their financial statement users.

Entities that have many reclassification adjustments may wish to use the tabular format discussed in this paper, whereas entities with few reclassification items may elect not to use a tabular format but rather only describe the information in a footnote.

The FASB's recent guidance on reporting and disclosure of comprehensive income has significantly enhanced the prominence and clarity of the [financial] statement…

Disclosing the related Tax Effects:

As mentioned earlier, ASU 2013-02 permits an entity to present changes in AOCI by component and significant reclassification adjustments presented in an entity’s footnotes either before taxes or net of taxes. But significant reclassification adjustments should be presented on the face of the income statement before taxes, with the aggregate tax amount presented parenthetically on the income tax line. Regardless of the presentation selected for changes in AOCI by component or significant reclassification items in an entity’s footnotes, the requirements in ASC 220-10-45-12 must be followed.

This guidance requires an entity to present the amount of income tax expense or benefit allocated to each component of other comprehensive income, including reclassification adjustments, in the statement in which those components are presented or disclosed in the notes to the financial statements. Example 1 in paragraphs 220-10-55-7 through 55-8B illustrates the alternative formats for disclosing the tax effects related to the components of other comprehensive income.

Conclusion

The FASB's recent guidance on reporting and disclosure of comprehensive income has significantly enhanced the prominence and clarity of the statement of comprehensive income to users of financial statements. Investors and other financial statement users may not fully understand an entity's income statement in a period that contains OCI components recycled out of the statement of CI, without studying the changes in OCI during the period as well as related statement of CI disclosures.

For example, assume that net income for an entity increased by $2 million dollars during the period. Would that mean that the entity's wealth increased by $2 million? The answer would be no, if that increase in income was due to an unrealized gain on available-for-sale investments which had been reported as a component of

OCI in the prior period, and which is now being recycled into net income because the investment was sold and a realized gain was recognized this period.

Someone looking only at the income statement may otherwise think that the entity's wealth increased by $2 million during the period. However, an analysis of the changes in OCI for the period and related disclosures would reveal that while income increased by $2 million, OCI for the period decreased by the same amount, leaving total comprehensive income (and hence the wealth of the entity) unchanged. And as we said earlier, changes in the components of OCI are not reported directly on the income statement until such amounts are realized.

References

Deloitte & Touche, LLP. FASB Finalizes New Disclosure Requirements for Reclassification Adjustments Out of AOCI, Heads Up, Volume 20 Issue No. 5. Wilton CT. Deloitte & Touche, LLP, February 6, 2013.

Deloitte & Touche, LLP. Comprehensive Income: Implementation Considerations During initial Year of Adoption of ASU 2013-02, Practice Alert 13-2. Wilton CT. Deloitte & Touche, LLP, April 10, 2013.

Deloitte & Touche, LLP. Panel Discussion, Key Elements and Considerations of FASB’s New Major Converged Financial Accounting and Reporting Standards, presented at 2013 Annual Meeting of the American Accounting Association, August 6, 2013. Panelists: Patrick A. Casabona, Professor, Saint John’s University; Ignacio Perez, Adrian Mills, and Timothy Kolber, Audit & Enterprise Risk Services, Deloitte & Touche, LLP.

Financial Accounting Stands Board (FASB). Accounting Standards Update (ASU) No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. Norwalk, CT, FASB, June 16, 2011.

FASB, ASU No. 2011-12. Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05. Norwalk, CT, FASB, December 23, 2011.

FASB, ASU No. 2013-02, Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income, An Amendment of the FASB Accounting Standards Codification. Norwalk, CT, FASB, February 5, 2013.

FASB, Proposed Accounting Standards Update, Comprehensive Income (Topic 220): Statement of Comprehensive Income. Norwalk, CT, FASB, May 26, 2010.

International Accounting Standards Board (IASB). Presentation of Items of Other Comprehensive Income, (Amendments to IAS 1). London, UK: IASB, June 2011.

Securities and Exchange Commission’s Regulation S-X, www.sec.gov/about/forms/forms-x.pdf

Endnotes1 The discussion of ASU 13-02, presented in this paper, is based in part on a portion of the presentation delivered by Deloitte & Touche, LLP, Panel Discussion, Key Elements and Considerations of FASB’s New Major Converged Financial Accounting and Reporting Standards, at the 2013 Annual Meeting of the American Accounting Association, August 6, 2013.

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35

Introduction

For more than four decades the Financial Accounting Foundation (FAF), through the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB) has developed accounting standards for all U.S. companies, not-for-profit organizations, and governmental bodies. The Financial Accounting Standards Board promulgates accounting standards for U.S. companies. The Board’s principal objective is to issue standards that provide investors, lenders, and other users of financial statements with clear, comparable, and decision-useful financial information.

Over the years, the accounting standards developed by FASB have increased in complexity. These accounting standards, although appropriate and necessary for public companies, have not met the needs of the preparers and users of all entities that must issue financial statements in conformity with U.S. Generally Accepted Accounting Principles (U.S. GAAP). In developing these standards, the Financial Accounting Standards Board has not always been mindful of relevance, complexity, and costs versus benefits to all companies, private as well as public.

Not all of the FASB standards are suitable for private companies. To address the distinct

needs of private companies, the Financial Accounting Foundation Board of Trustees created the Private Company Council (PCC) in May 2012 to promulgate new standards and improve existing accounting standards for U.S. private companies.

The Private Company Council, overseen by the Financial Accounting Foundation, will determine whether exceptions or modifications to existing U.S. GAAP are required to deal with the needs of users of private company financial statements. The Private Company Council will also serve as the primary advisory body to the Financial Accounting Standards Board on the appropriate treatment for private companies for items under active consideration on the FASB’s technical agenda. This article examines the creation of the Private Company Council, its mission, organization and standard setting actions since its creation.

The accounting profession [needs to] focus on making exceptions and modifications to U.S. GAAP…responding to the needs of private companies…

Creation of the Private Company Council

The Securities and Exchange Commission regulates approximately 14,000 publicly traded

The Private Company CouncilFinancial Reporting Standard Setting for Private CompaniesAlexander K. Buchholz, School of Business, Brooklyn College of the City University of New York, New York abuchholz@brooklyn.cuny.edu

Biagio Pilato, The Peter J. Tobin College of Business, St. John’s University, New York pilatob@stjohns.edu

36

companies. These companies have financial reporting requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934. Accounting standards developed over the years have been primarily focused on public companies. As a result, accounting standards tailored to publicly traded companies, but imposed on private companies, have become burdensome and in many respects, irrelevant to the roughly 28 million private companies in the United States.

The vast majority of the 28 million private companies are very small businesses that have no financial reporting requirement other than filing basic tax returns. A significant number of private company financial statements were prepared in accordance with a special purpose framework. While the FAF was developing the PCC, the American Institute of Certified Public Accountants (AICPA) was simultaneously developing a new Financial Reporting Framework for Small-and-Medium-Sized Entities (FRF for SMEs).

This framework assists the small and medium-sized private company to prepare financial statements that clearly and concisely report what a company owns, owes, and its cash flows. The framework allows preparation of financial statements that are robust and relevant while avoiding complexity and costly U.S. GAAP compliance. This framework applies to small private companies that do not require financial statements prepared in accordance with U.S. GAAP; however, the framework does not apply to the private companies that require U.S. GAAP compliant statements or intend to go public someday.

Private companies have been required to prepare financial statements in accordance with U.S. GAAP, in order to comply with financial reporting and disclosure requirements by lenders, creditors, credit-rating agencies, and others. Private companies must issue audited, reviewed, or compiled financial statements. Those private companies that have

financial statements that contain departures or exceptions to U.S. GAAP must disclose the departure or exception in the accountant’s or auditor’s report. However, many private companies preparing U.S. GAAP financial statements do not have the accounting resources that are available to public companies. The increased cost of compliance to provide potentially irrelevant information has led more companies and users to accept qualified opinions (Elifoglu, Fitzsimons, and Silliman, 2012, p. 23).

[The] Financial Accounting Foundation has attempted several times to address this issue of differences between public and private company accounting needs.

The accounting profession has long needed an accounting standard-setting system that would maintain a high degree of financial reporting comparability for business entities, regardless of size and capital structure, while at the same time, showing the differences between public and private entities in measurement, recognition, and presentation of key financial information. The system needed to focus on making exceptions and modifications to U.S. GAAP for private companies, and respond to the needs of the private companies, rather than move toward a two U.S. GAAP system, one for public companies and the other for private companies.

Since its inception, the Financial Accounting Foundation has attempted several times to address this issue of differences between public and private company accounting needs. Over the years, 12 separate reports, studies, and formal recommendations on issues related to private companies were produced. More proactive measures, with regard to the needs of private companies, began in 2006, culminating in the creation of the Private

The Private Company Council Financial Reporting Standard Setting for Private Companies 37

Company Council in 2012. Compiled and edited below is a summary of those measures from the Financial Accounting Foundation Board of Trustees Establishment of the Private Company Council Final Report May 30, 2012: http://www.accountingfoundation.org/cs/ContentServer?site=Foundation&c=Document_C&pagename=Foundation%2FDocument_C%2FFAFDocumentPage&cid=1176160066778

Creation of the Private Company Financial Reporting Committee (PCFRC)

In 2006, the FASB created the Private Company Financial Reporting Committee (PCFRC). This 12 member committee was comprised of individuals involved with non-public business entities. The mission of the PCFRC was to provide recommendations to the FASB on issues related to private companies and to focus on how standard setting affects day-to-day technical activities of private companies.

The FAF Oversight Committee

In 2008, the FAF created the Standard-Setting Process Oversight Committee. This committee was responsible for oversight and evaluation of the adequacy, transparency, independence, and efficiency of the standard-setting process. The Committee was to monitor and evaluate the standard-setting processes of the FASB (agenda-setting, deliberations, finalization, implementation), as well as to monitor the progress and efficiency of agenda projects. The Committee was also to establish and oversee the post-implementation review of standards, monitor external influences (international, regulatory, state/local legislation, etc.), and commission independent studies/surveys.

FAF Listening Tour

In 2009, the FAF Board of Trustees began a nationwide “listening tour.” FAF Trustees and senior FAF leadership met with constituents to hear their views on the independent standard-setting process and issues affecting financial

reporting. A major concern voiced by many constituents was the cost and complexity of standards compliance for private companies. The constituents also communicated to the FAF that they were unsatisfied with the results of the collaboration between the FASB and the PCFRC. The views expressed indicated that the FASB was not responsive to the PCFRC’s recommendations. Additionally, the PCFRC was viewed as being ineffective in advancing the interests of private companies, citing the failure to develop and agree upon a framework for considering exceptions or modifications to U.S. GAAP for private companies.

Blue-Ribbon Panel on Standard Setting for Private Companies

In 2011, the Financial Accounting Foundation, the American Institute of Certified Public Accountants (AICPA) and the National Association of State Boards of Accountancy (NASBA) collaborated to create the Blue-Ribbon Panel on Standard Setting for Private Companies. The panel’s mission was to study and report on the issue of standard-setting process for private companies. In January 2011, the Blue-Ribbon Panel submitted a report with its recommendations , which included the creation of a new, separate, and authoritative standard-setting board like the FASB and GASB that would establish exceptions or modifications to U.S. GAAP for private companies.

FASB Initiatives to Improve Standard Setting for Private Companies

In addition to the work of the Blue-Ribbon Panel, the FASB worked independently to improve the standard-setting process for private companies. The FASB solicited input from private companies, had a series of roundtables on private company issues, and began to develop a framework for identifying differences in standards for private companies.

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The FASB also improved dissemination of information about proposed changes in U.S. GAAP, with a dedicated electronic portal for private company stakeholders to access information, and an electronic form to provide feedback. In this effort, the FASB specifically addressed private company concerns in projects related to goodwill impairment, impairment of indefinite-lived intangibles, fair value disclosure, and financial instruments, among others.

The Working Group

In March 2011, the FAF appointed several Trustees and senior FAF staff members to a “Working Group” to focus on standard setting for private companies. The Working Group received significant input from users and preparers of private company financial statements, practitioners, lenders, regulators and academicians. The practitioners who provided input were from large, mid-size, and small CPA firms, with considerable practices serving private companies. Top academicians with significant research on the accounting issues related to private companies also provided the Working Group with their input. The Working Group also reviewed more than 2,800 unsolicited letters recommending a separate standard-setting board just for private companies.

Initial Plan to Establish the Private Company Standards Improvement Council

In October 2011, the FAF announced its plan to create a new council having the authority to specifically deal with the issue of U.S. accounting standards for private companies. This new Council would replace the Private Company Financial Reporting Committee (PCFRC). The new Private Company Standards Improvement Council (PCSIC) would identify, propose, deliberate, and formally vote on specific exceptions or modifications to existing U.S. GAAP for private companies.

Although the new PCSIC could vote on changes to U.S. GAAP, the PCSIC was not an independent body, since the FASB would have to ratify any proposed changes. Further evidence of a lack of independence was that the chair of the PCSIC had to be a member of the FASB and appointed by the FAF Trustees. Users, preparers, auditors, and others stakeholders were encouraged to read the plan and provide the FAF with their comments by January 14, 2012.

FAF Sponsors a Webcast and a Podcast

In an effort to enable interested parties to learn more about the FAF’s proposal to improve accounting standard setting for private companies and to express their views, the FAF made use of a webcast and podcast.

Comment Letters

The FAF received 7,367 written comments on the FAF’s Plan to Establish the Private Company Standards Improvement Council. The responses consisted of 7,069 template form letters provided by the AICPA, and 298 non-form letters. Substantially all of the form letters expressed the view that the Financial Accounting Standards Board’s (FASB) PCSIC, as proposed, would not solve the problem of standard setting for private companies. The letters expressed the lack of independence from FASB, including the need for FASB ratification of any standard modification(s) suggested by the PCSIC.

Included in the Financial Accounting Foundation Board of Trustees Establishment of the Private Company Council Final Report was a breakdown of the comment letters received. From the final report, the non-form letters received from CPA practitioners from local and regional firms expressed the following comments:

• Frustration with the FASB’s past and

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current standard-setting process for private companies.

• The cost and complexity of some accounting standards.

• The lack of relevance of particular standards to some users of private company financial statements.

• The FASB is too focused on public companies.

• The PCSIC, as proposed, will be too similar in nature to the FASB’s Private Company Financial Reporting Committee (PCFRC), which they observe did not accomplish its objectives as originally intended.

• Neither the FASB nor the FAF Board of Trustees have enough members with private company experience.

• The FASB does not have adequate time to devote to private company standard-setting activities due to other priorities (such as convergence of international standards); therefore, a separate standard-setting body will be more responsive.

The mission of the PCFRC was to provide recommendations to the FASB on issues related to private companies… [especially] how standard setting affects [their] day-to-day technical activities…

The non-form letters supporting a separate independent standard-setting body stated the following comments:

• Skepticism that the PCSIC could achieve its objectives because the FASB historically has not recognized and responded to the needs of private companies and their financial statement users.

• Too much FASB dominance over the PCSIC, which may hinder the PCSIC’s ability to execute meaningful changes.

• Some FASB members appear to lack an adequate understanding of private company issues and challenges.

• Inherent difficulties for the FASB to reverse decisions previously reached for public companies when determining whether there should be differences for private companies.

Hosting Roundtables

A wide variety of constituents, including users, preparers, auditors, regulators, academicians, and other interested parties were asked to participate in a series of public roundtable discussions to share their comments on the FAF’s proposal on private company standard-setting. The four roundtable discussions were held from January through March 2012 in Atlanta, Fort Worth, Palo Alto, and Boston. The views expressed were both for and against an independent private company standard setter and permitting exceptions and modifications to U.S. GAAP. A summary of the views expressed at the roundtables were as follows:

• U.S. GAAP is the “gold standard” for financial reporting; no changes should be made.

• U.S. GAAP provides discipline in financial reporting for all companies, public and private.

• It is important to maintain consistency and transparency in standard setting.

• Setting separate standards would produce a two U.S. GAAP system Big GAAP/Little GAAP.

• Setting separate standards would result in a lack of comparability in financial reporting.

• Private companies have a big cost burden to bear in trying to implement standards meant for public companies.

• A separate, authoritative standard setting board for private companies would be more efficient and responsive than the current system.

Creation of the Private Company Council

After many years of outreach, study, and

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deliberation of the issues related to private companies, on May 24, 2012, the FAF Board of Trustees established the Private Company Council (PCC).

Key points regarding the responsibilities and operating procedure for the new Private Company Council are provided below with excerpts from Financial Accounting Foundation Board of Trustees Establishment of the Private Company Council Final Report May 30, 2012. Compiled and edited below are some of the key points from the report. For more detail see the full report: http://www.accountingfoundation.org/cs/ContentServer?site=Foundation&c=Document_C&pagename=Foundation%2FDocument_C%2FFAFDocumentPage&cid=1176160066778

Responsibilities of the Private Company Council

The principal responsibilities of the PCC are as follows:

• The PCC determines, based on criteria mutually agreed to by the PCC and the FASB, whether modifications or exceptions to existing nongovernmental U.S. GAAP are required to address the needs of users of private company financial statements. Any proposed changes to existing U.S. GAAP are subject to endorsement by the FASB and undergo thorough due process.

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

Membership and Terms

The Private Company Council is comprised of 10 members, including the Chair. All members, including the Chair, are appointed by the FAF Trustees. The Trustees may also appoint one or more members of the PCC as Vice-Chairs. The membership includes individuals

with backgrounds and experience in using, preparing, and auditing (including compilation and review) private company financial statements. Members of the PCC, including the Chair, will demonstrate an interest in and knowledge of financial accounting and reporting matters, experience working with private companies, and a commitment to improving financial reporting for users of financial statements.

The FASB solicited input from private companies, had a series of roundtables on private company issues, and began to develop a framework for identifying differences in standards for private companies.

Membership duration may be staggered to establish an orderly rotation of members and maintain appropriate continuity on the PCC. An orderly rotation promotes stability of membership, and considers the contributions of existing PCC members and the expected contributions from potential new members.

Roles and Responsibilities of the PCC Chair and Members

In addition to the responsibilities that apply to all PCC members, the PCC Chair is responsible for the following:

• Serving as the primary point of contact between the PCC and FASB members and staff, the FAF Board of Trustees, and private company stakeholders.

• Managing the PCC agenda, which is established by a supermajority vote of the PCC, in consultation with the FASB, stakeholders, and the other members of the PCC.

• Planning and leading PCC meetings.

• Implementing and directing the broad operating processes of the PCC.

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• Ensuring due process.

• Guiding discussions at PCC meetings to ensure an effective and timely communication of views and conclusions reached by the PCC.

• Preparing an annual operating budget.

• Providing input to the Trustees on the reappointment process for PCC members.

The PCC Chair works cooperatively with the FASB liaison member, the FASB Chairman, and the FASB Technical Director to accomplish the functions of the PCC and to help facilitate the work of the FASB with respect to private company standard-setting activities. The PCC Chair, in consultation with the FASB Technical Director, will assess the level of FASB staff and resources that are necessary to support the PCC and has input in decisions about the deployment, supervision, and evaluation of FASB staff specifically assigned to support the PCC. The PCC Chair is responsible for ensuring that the PCC is prepared to discuss and consider technical and other issues on its agenda in an effective and timely manner.

The PCC Chair is also responsible for providing periodic in-person and written reports to the special-purpose Private Company Review Committee of the FAF Board of Trustees. The PCC Chair will also provide quarterly written reports to the full FAF Board of Trustees.

FASB Liaison

The FAF Trustees will appoint a member of the FASB to serve as a liaison between the FASB and the PCC. The primary purpose of this liaison role is to serve as the main point of contact to facilitate communication and integration between the PCC and the FASB. The FASB liaison is not a member of the PCC.

FASB Staff Support

The FASB Technical Director will assign specific members of the FASB’s technical and administrative staff. Some staff will be dedicated, while others will be assigned as needed based on their specific technical expertise to support the PCC. In consultation with the PCC Chair, the FASB Technical Director will identify additional technical staff with specific subject area expertise for particular agenda projects as deemed necessary.

The assigned FASB technical staff will provide assistance and support to the PCC that will include the following:

• Performing research and outreach.

• Preparing and providing appropriate reference and background materials.

• Identifying various stakeholder views.

• Developing possible alternatives for consideration in addressing technical issues.

• Participating in meeting discussions.

• Analyzing and summarizing public comments and other stakeholder input.

• Drafting due process documents.

Assigned staff will also provide administrative support to the PCC Chair in organizing meetings, preparing meeting announcements, agendas, materials, minutes, and other public updates, and coordinating any additional PCC activities as determined to be appropriate. The Trustees expect that the PCC Chair and members will have a significant level of direct interaction with assigned members of the FASB staff.

Meetings

During its first three years of operation, the PCC will meet regularly, at least five times each year, with additional meetings held as the PCC Chair determines necessary for the PCC to effectively and efficiently perform its functions.

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PCC Agenda

It is anticipated that the PCC will initially focus on evaluating existing U.S. GAAP to identify standards that may require modifications or exceptions to address the needs of users of private company financial statements. Because a significant role of the PCC is to advise the FASB on projects under active consideration by the FASB, the PCC will refrain from adding separate (competing) projects to its agenda that are already under such consideration by the FASB.

PCC Process and Voting for Exceptions or Modifications to Existing U.S. GAAP

Applying the criteria included in the decision-making framework, the PCC will develop, deliberate, and formally vote on proposed exceptions to U.S. GAAP for private companies, using the decision criteria.

The PCC will take the following steps in reviewing and proposing exceptions or modifications to U.S. GAAP to address the needs of users of private company financial statements:

• Conduct a review of existing U.S. GAAP.

• Identify standards that require reconsideration.

• Develop, deliberate and vote on proposed exceptions or modifications, to be approved by a supermajority vote of PCC members (two-thirds of all PCC members).

• Provide to the FASB for endorsement any proposed exceptions or modifications to U.S. GAAP approved by the PCC.

• Expose for public comment any proposed exceptions or modifications endorsed by the FASB.

• Re-deliberate the proposed modifications or exceptions, taking into account stakeholder comments and other input received.

• Vote on the final changes. Final exceptions or modifications must be approved by a

supermajority vote of PCC members (two-thirds of all PCC members).

• Provide the final exceptions or modifications to the FASB for final endorsement in order to issue a final Accounting Standards Update (ASU).

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

PCC Role in Projects on FASB’s Agenda

For projects under active consideration on the FASB’s technical agenda, the PCC is the primary advisory body on issues concerning private companies. The PCC will work actively and closely with the FASB to provide recommendations for consideration.

FASB Endorsement Process

Under the endorsement process, the PCC will provide proposed and final exceptions or modifications to existing U.S. GAAP to the FASB for endorsement.

A majority (four out of seven) of FASB members must endorse proposed and final modifications or exceptions to U.S. GAAP prior to issuing a proposed or final ASU (respectively).

If the FASB does not endorse a proposed or final modification or exception, the FASB Chairman will provide to the PCC Chair, within reasonable time, a written document describing the reason(s) for the non-endorsement. The document will also include possible changes for the PCC to consider that could result in a decision by the FASB to endorse. This document will become part of the FASB’s public record.

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Oversight

The FAF Board of Trustees will create a special-purpose committee, the Private Company Review Committee (Review Committee), which will have primary oversight responsibility for the PCC for an initial three-year period.

The PCC will provide periodic in-person and written reports to the Review Committee. The PCC will also provide quarterly written reports to the full FAF Board of Trustees.

FAF Trustees’ Three-Year Assessment

The FAF Trustees will conduct an overall assessment of the PCC at the end of the initial three years assessment period to determine whether the objectives of the PCC are being met and whether further changes to the standard-setting process for private companies are needed. The need for amendments to operating procedures will be determined from time to time.

Amendments to Operating Procedures

The FAF trustees may alter or amend the operating procedures of the Private Company Council.

ACCOMPLISHMENTS OF THE PRIVATE COMPANY COUNCIL

I. PCC Issue No. 13-01B, "Accounting for Goodwill"

U.S. GAAP require that the goodwill of a reporting entity be tested for impairment. This test should be performed annually or more frequently, depending on whether a triggering event has occurred. A triggering event is any circumstance that would put the reporting entity’s fair value below that of its carrying value. In addition, there exists no specified time period for goodwill to be amortized as it is subject to the impairment test.

The amendments in this update, finalized during January 2014 as ASU 2014-02, allow an alternative for the measurement of goodwill. For those entities defined as private companies, goodwill should be amortized on a straight-line basis over 10 years. Private companies may also use less than 10 years if they are able to demonstrate that another useful life is more appropriate. An entity that does elect this treatment is still required to test for impairment whenever a triggering event is deemed to have taken place.

Whenever a triggering event has taken place, the private company has the option to first assess qualitative factors to determine whether the quantitative impairment test is necessary. If that qualitative assessment indicates that it is more likely than not that goodwill is impaired, the entity must perform the quantitative test to compare the entity’s fair value with its carrying amount, including goodwill (or the fair value of the reporting unit with the carrying amount, including goodwill, of the reporting unit). If the qualitative assessment indicates that it is not more likely than not that goodwill is impaired, further testing is unnecessary (ASU 2014-02, p. 2).

The goodwill impairment loss would be calculated as the excess of the carrying amount over fair value and is limited to the carrying value of goodwill. If elected, this accounting treatment should be applied prospectively for annual periods beginning after December 15, 2014, and interim periods within annual periods beginning after December 15, 2015, with early adoption permitted.

II. PCC Issue No. 13-02, "Applying Variable Interest Entity Guidance to Common Control Leasing Arrangements”

Prior to this amendment, U.S. GAAP required a reporting entity to consolidate an entity in which it has a controlling financial

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44interest. The two models used for making this determination are the voting interest model and the variable interest entity (VIE) model. The voting interest model defines controlling financial interest through majority ownership. The VIE model defines a controlling financial interest when the entity has both:

1. the power to direct the activities that most significantly affect the economic performance of the entity, and;

2. the obligation to absorb losses or the right to receive benefits of the entity that could potentially be significant to the entity. (ASU 2014-07, p. 3).

However, under this new amendment, finalized during March 2014 as ASU 2014-07, a private company lessee (the reporting entity) is now given an option not to apply VIE guidance to a lessor entity if:

(a) the private company lessee and the lessor entity are under common control,

(b) the private company lessee has a lease arrangement with the lessor entity,

(c) substantially all of the activities between the private company lessee and the lessor entity are related to leasing activities (including supporting leasing activities) between those two entities, and;

(d) if the private company lessee explicitly guarantees or provides collateral for any obligation of the lessor entity related to the asset leased by the private company, then the principal amount of the obligation at inception of such guarantee or collateral arrangement does not exceed the value of the asset leased by the private company from the lessor entity. (ASU 2014-07, p. 2)

Therefore, the lessor entity would not be consolidated into the financial statements of the private company lessee, nor would

the VIE disclosures about the lessor entity be included. However, there are other disclosures which would be required, as well as disclosures relating to related party transactions. The private company lessee would disclose:

1. the amount and key terms of liabilities recognized by the lessor entity that expose the private company lessee to providing financial support to the lessor entity and;

2. a qualitative description of circumstances not recognized in the financial statements of the lessor entity that expose the private company lessee to providing financial support to the lessor entity. (ASU 2014-07, p. 2)

This approach should be applied to all current and prospective lessor entities under common control. It will be effective for annual periods beginning after December 15, 2014, and interim periods within annual periods beginning after December 15, 2015, with early application permitted (ASU 2014-07, p. 3).

III. PCC Issue No. 13-03A, "Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps – Simplified Hedge Accounting Approach"

The amendment, finalized during January 2014 as ASU 2014-03, allows private companies the use of the simplified hedge accounting approach to account for swaps entered into for the purpose of converting a variable-rate borrowing into a fixed-rate borrowing. Under this approach, interest expense will be similar to the amount that would result if the entity had entered into a fixed-rate borrowing instead of a variable-rate borrowing and a receive-variable, pay-fixed interest rate swap. This approach allows private companies the ability to use a cash flow hedge accounting treatment, which is easier to apply and has more practical application than a fair value hedge approach. In order to apply this update, the following criteria must be met:

• Both the variable rate on the swap and the

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borrowing are based on the same index and reset period (for example, both the swap and borrowing are based on one-month London Interbank Offered Rate [LIBOR] or both the swap and borrowing are based on three-month LIBOR).

• The terms of the swap are typical (in other words, the swap is what is generally considered to be a “plain-vanilla” swap), and there is no floor or cap on the variable interest rate of the swap unless the borrowing has a comparable floor or cap.

• The repricing and settlement dates for the swap and the borrowing match or differ by no more than a few days.

• The swap’s fair value at inception (that is, at the time the derivative was executed to hedge the interest rate risk of the borrowing) is at or near zero.

• The notional amount of the swap matches the principal amount of the borrowing being hedged. In complying with this condition, the amount of the borrowing being hedged may be less than the total principal amount of the borrowing.

• All interest payments occurring on the borrowing during the term of the swap (or the effective term of the swap underlying the forward starting swap) are designated as hedged whether in total or in proportion to the principal amount of the borrowing being hedged. (ASU 2014-03, p. 3)

The need for amendments to operating procedures will be determined from time to time.

In addition, under this approach, a private company has the option to measure this swap at settlement value in lieu of fair value. Through the use of this approach, a private company would achieve the same income statement impact because “the settlement

value of the swap would be deferred to other comprehensive income and released to the income statement as the hedged interest payments affect the income statement” (Deloitte and Touche, 2013).

This amendment will be effective for annual periods beginning after December 15, 2014, and interim periods within annual periods beginning after December 15, 2015, with early adoption permitted. Private companies have the option to apply the amendments using either a modified or full retrospective approach (ASU 2014-03, p. 3).

IV. PCC Issue No. 13-03B, "Accounting for Receive-Variable, Pay-Fixed Interest Rate Swaps-Combined Instruments Approach"

This agenda item was removed by the PCC during its January 2014 meeting. The PCC decided to remove this item “because the swap and related variable-rate borrowing involve separate legal contracts that do not meet the requirements for a right of setoff” (FASB, 2014). It was agreed that conceptual issues identified under this approach would remain even if a criterion were added requiring that the swap and borrowing involve the same counterparty. In addition, the PCC felt that the issuance of ASU 2014-03, as discussed above, would at least somewhat simplify the process.

Future Agenda of the PCC: PCC Issue No. 13-01A, "Accounting for Identifiable Intangible Assets in a Business Combination"

U.S. GAAP requires an acquirer in a consolidation to recognize assets and liabilities, including intangible assets, at fair value. An intangible asset is defined as meeting either criteria listed below:

1. It arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.

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2. It is separable, that is, capable of being separated or divided from the entity and sold, transferred, licensed, rented, or exchanged, either individually or together with a related contract, identifiable asset, or liability, regardless of whether the entity intends to do so. (PCC-13-01A, p. 2)

The proposed amendment permits private companies to recognize separately from goodwill on the statement of financial position only those identifiable intangible assets that arise from the first criteria listed above. For those identifiable intangible assets acquired but not recognized, there would be a required qualitative disclosure. This item has been placed on the agenda as the feedback from private company financial statement users has been that intangible assets, apart from goodwill, may not cost effectively provide information which will impact any financial decisions.

Summary

The Private Company Council, overseen by the Financial Accounting Foundation, has been quite occupied since its establishment during May 2012. It has begun to examine the needs of private companies and to establish guidance which will assist with their needs. The Private Company Council is also serving as the primary advisory body to the FASB on the appropriate treatment for private companies on the FASB’s technical agenda. To date, the Private Company Council has been able to have the FASB issue three ASUs in order to simplify the accounting for private companies. It has also created an agenda of items it wishes to pursue in even further detail over the next several months. This article has examined the creation of the Private Company Council as well as its mission, organization and standard setting actions thus far.

References

AICPA, "Financial Reporting Framework for SMEs." AICPA. Web. 1 Apr. 2014. http://www.aicpa.org/INTERESTAREAS/FRC/ACCOUNTINGFINANCIALREPORTING/PCFR/Pages/Financial-Reporting-Framework.aspx

Deloitte and Touche. (2013, July 9). Saving Private Companies: FASB Proposes Alternative Accounting for Private Companies. Heads Up, 5.

Elifoglu, I. Hilmi , Adrian Fitzsimons, and Benjamin Silliman. "Separate Financial Reporting Standards and Standard Setting for Private Companies." Review of Business 32.2 (2012): 23-32. St. John's University Review of Business. Web. 1 Apr. 2014.

Financial Accounting Foundation Board of Trustees. (2012, May 30) “Establishment of the Private Company Council Final Report” Web. 1 Apr. 2014. http://www.accountingfoundation.org/cs/ContentServer?site=Foundation&c=Document_C&pagename=Foundation%2FDocument_C%2FFAFDocumentPage&cid=1176160066778

Financial Accounting Standards Board. “Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps—Simplified Hedge Accounting Approach,” FASB Accounting Standards Update No. 2014-03. (Norwalk, Connecticut, FASB 2014).

Financial Accounting Standards Board. “Accounting for Goodwill,” FASB Accounting Standards Update No. 2014-02. (Norwalk, Connecticut, FASB 2014).

Financial Accounting Standards Board. “Accounting for Identifiable Intangible Assets in a Business Combination.” FASB Exposure Draft Proposed Accounting Standards Update. File No. PCC-13-01A. (Norwalk, Connecticut, FASB, 2013).

Financial Accounting Standards Board. “Applying Variable Interest Entities Guidance to Common Control Leasing Arrangements,” FASB Accounting Standards Update No.2014-07. (Norwalk, Connecticut, FASB 2014).

Financial Accounting Standards Board 2014. Overview of Decisions Reached on Accounting for Receive-Variable, Pay-Fixed Interest Rate Swaps-Combined Instruments Approach. Norwalk, Connecticut, FASB. Available from http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176163806729.

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New Consolidation Requirements Under IFRSSylwia Gornik-Tomaszewski, The Peter J. Tobin College of Business, St. John’s Universitygornikts@stjohns.edu

Robert K. Larson, Carl H. Lindner College of Business, University of Cincinnatirobert.larson@uc.edu

Executive Summary

The rules governing the consolidation of economic entities have been controversial for many years. The abuse of Special Purpose Entities in the early 2000s started a debate in the U.S. and globally about consolidation standards, and the financial crisis in 2008 accelerated moves toward new and hopefully improved standards. While the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) started a joint project on consolidation, their collaboration ended with each organization issuing separate standards that are fairly well converged - but with some substantive differences.

This article explains key parts of the new IASB standard, IFRS 10, Consolidated Financial Statements, and goes on to describe the current differences between U.S. Generally Accepted Accounting Principles (U.S. GAAP) and International Financial Reporting Standards (IFRS) in the area of business consolidations. U.S. GAAP has two models for consolidation – one for voting interest entities (most corporations) and one for variable-interest entities (VIEs), while IFRS has one model for all entities.

Another key issue is that control is defined differently, with the result that entities consolidated under one standard might not be consolidated under the other. Especially when

voting rights drive consolidation, differences can arise as IFRS requires consolidation when de facto control occurs without majority voting stock ownership. The two frameworks also diverge on potential voting rights. These and other differences between U.S. GAAP and IFRS have significant implications for preparers and should be understood by users of financial statements.

Introduction

Providing informative consolidated financial statements useful to investors and creditors is one of the paramount objectives of financial reporting. Both the IASB and FASB have new consolidation accounting standards, in part as the result of the abuse of ‘off balance sheet vehicles’ by Enron and others, and the more recent financial crisis. Each Board, however, reached different conclusions as to the best way to avoid these corporate abuses of accounting standards in the future.

The quality of financial statements under IFRS depends on principles-based standards of consolidation that are devoid of ‘bright lines’ and yet are operational. It is challenging for accounting standard setters to establish good rules for determining which entities should be consolidated with a parent corporation, and issues to consider include: (1) assessing the circumstances involving structured entities; (2) judging de-facto control; and (3) considering principle-agent relationships (Reiland, 2011).

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(effective January 1, 2014). Concurrent with the issuance of IFRS 10 and IFRS 12, the IASB also issued IFRS 11, Joint Arrangements, requiring a single method to account for interests in jointly controlled entities. Furthermore, the Board amended IAS 27 to retain guidance for separate financial statements, and IAS 28, Investments in Associates and Joint Ventures, completing this way a new suite of consolidation standards. These standards tighten up the reporting requirements for the consolidation of subsidiaries and special purpose vehicles, and require the substance of joint arrangements to be revealed. In order to make IFRS 10, IFRS 11 and IFRS 12 easier to implement, in 2012, the IASB issued Consolidated Financial Statements, Joint Arrangements and Disclosure of Interests in Other Entities: Transition Guidance.

It is challenging for accounting standard setters to establish good rules for determining which entities should be consolidated with a parent corporation…Ultimately the IASB and the Financial Accounting Standards Board (FASB) could not agree upon a joint consolidation standard. U.S. GAAP maintains two consolidation models: the voting interest model focused on voting rights (applicable to most corporations), and the variable interest entity model (VIE) focused on a qualitative analysis of power over significant activities and exposure to potentially significant losses or benefits.3 Under U.S. GAAP, all entities are first evaluated to determine whether they are VIEs. Consolidation of all non-VIEs is assessed on the basis of voting and other decision-making rights (FASB 2014a, ASC 810-10).

Key Principles Included in IFRS 10

Exemptions from preparing consolidated financial statements and the consolidation procedures themselves did not change with the approval of IFRS 10, and therefore it has not

This article explains key parts of the new IASB standard and details significant differences between U.S. GAAP and IFRS in the area of consolidations.

The IASB issued a new standard on consolidation on May 12, 2011. The new International Financial Reporting Standard 10 (IFRS 10), Consolidated Financial Statements, replaced the consolidation content in International Accounting Standard 27 (IAS 27) IAS 27, Consolidated and Separate Financial Statements (IASB, 2008),1 and the interpretation SIC-12, Consolidation – Special Purpose Entities (SIC, 1998); and is effective for annual periods beginning on or after January 1, 2013.

The objective of IFRS 10 is to have a single consolidation model, based on control, applicable to all entities, regardless of the nature of the investee. The introductory material to IFRS 10 notes that the IASB thinks “the requirements in IFRS 10 will lead to more appropriate consolidation; that is, entities will consolidate investees only when they control them but, at the same time, will consolidate all investees that they control” (IASB, 2013, p. 10). The standard resulted from a comprehensive consolidation project started in 2002 to address inconsistencies in the requirements and application of IAS 27 and SIC-12,2 as well as to enhance convergence with U.S. GAAP.

The development of a new consolidation standard created a great deal of interest. The project was accelerated in 2008 as a result of the global financial crisis and the exposure draft issued that year generated a relatively large number of comment letters. Ultimately, the IASB split the project into two parts: Part 1: Consolidation and Disclosure, resulting in IFRS 10 and IFRS 12, Disclosure of Interests in Other Entities; and Part 2: Investment Entities. IFRS 10 and IFRS 12 were issued in 2011 while Part 2 in 2012 produced Investment Entities (Amendments to IFRS 10, IFRS 12 and IAS 27)

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Power arises from rights. IFRS 10 acknowledges that while in some cases assessing power may be straightforward, for example through voting rights granted by equity instruments, in other cases the assessment may be complex, such as when power results from contractual arrangements. Relevant activities indicating power over the investee might include determining operating policies, making capital decisions, appointing key management personnel, etc. Such evidence may help determine whether the investor has power, but alone is not conclusive (IFRS 10, Par. 12).

An investor has a right to variable returns from the investee when the investor’s returns may vary as a result of the investee’s performance (IFRS 10, Par. 15). Returns might include dividends, remuneration, and returns not available to other interest holders, such as scarce products, cost reductions, synergies, economies of scale, and proprietary knowledge.

An investor controlling an investee must also have the ability to use its power to affect its returns from the investee (IFRS 10, Par. 17). Exercise of power to affect the amount of the investor’s returns might include voting rights, potential substantive voting rights (e.g., options or convertible instruments), rights to appoint key personnel, decision-making rights within a management contract, and removal or “kick-out” rights.

Control should be assessed on a continuous basis. Significant judgment may be required to determine whether an investor has control over an investee. The following factors must be considered (IFRS 10, Appendix B, Par. B3):

affected most assessments of whether an investee should be consolidated. The main contribution of IFRS 10 is the new single control model used to determine which investees should be consolidated. Although under IAS 27 and SIC-12 a reporting entity was required to consolidate an investee if it controls the investee, the IASB revised the definition of control and provided detailed application guidance in order to develop a single control model applicable to all entities.

IFRS requires an entity that is a parent to present consolidated financial statements. A limited exemption is available to some entities. IFRS 10’s single consolidation model builds upon IAS 27 and SIC-12, but in defining control there are new links between power and returns. Now an investor must possess all of the elements presented in Figure 1 in order to be deemed to control an investee.

New Consolidation Requirements Under IFRS

POWER OVER THE INVESTEE VARIABLE RETURNS

Having existing rights that give the investor the current ability to direct the relevant activities that significantly

affect the investee’s returns

Exposure, or rights, to variable returns from investor’s involvement

with the investee

CONTROL

The ability to use power over the investee to

affect the amount of the investor’s returns

Figure 1The Control Model under IFRS 10

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a. The purpose and design of the investee

b. Relevant activities and how decisions about those activities are made

c. Can the investor direct the relevant activities

d. Does the investor have rights to variable returns from the investee, and

e. Does the investor have the ability to affect the amount of the investor’s returns.

Framework for Application of the Single Consolidation Model

The accounting firm KPMG LLP operationalized the new single control model in IFRS 10 by developing a framework for evaluating investments to determine whether they should be consolidated (KPMG, 2013a). Their framework consists of six steps and expands upon the discussion in the previous section:

Step 1: Identify the investee

Although control by an investor is generally assessed at the legal entity level, it can also be assessed over a silo that is a portion of an entity deemed to be a separate entity for accounting purposes. A portion of an investee is deemed a separate entity when, in substance (IFRS 10, Par. B77):

1. The specified assets and related credit enhancements, if any, are the only source of payment for specified liabilities of, or specified other interests in, the investee; and

2. Parties other than those with the specified liability do not have rights or obligations related to the specified assets or to residual cash flows from those assets.

The standard emphasizes that, in substance, all the assets, liabilities and equity of that deemed separate entity are ring-fenced from the overall investee.

If the assets, liabilities or other interests constitute a silo, then the investor must use IFRS 10 criteria to determine whether it controls the silo. If the investor controls the silo, the investor consolidates that portion of the investee. If, however, a party other than the investor controls the silo, the investor excludes the silo from consolidation (IFRS 10, Par. B78-79).

Silos commonly arise in the financial services sector and sometimes in the real estate sector. Silos are often associated with “securitization,” which turns receivables into cash by converting them into securities. For example, Bank A may establish and administer a special purpose vehicle V that enables two corporate clients, Company X and Company Y, to transfer trade receivables in exchange for cash. Vehicle V issues commercial paper to outside investors to fund the purchases, thereby acting as the refinancing vehicle for X and Y. There is no cross-collateralization of the transferred assets. Each transferring company, X and Y, must assess whether it controls its silo, which includes the receivables transferred as financial assets and the related commercial paper liability.

Step 2: Identify the relevant activities of the investee

Relevant activities must significantly affect the investee’s returns. Step 2 requires reviewing a spectrum of activities from operating and financing activities significantly affecting returns occur. IFRS 10 offers a wide range of activities to consider, including sales and purchase of goods and services; management of financial assets before and after default; selection, acquisition and disposal of assets; research and development; and funding activities (IFRS 10, Par. B11).

Step 3: Identify how decisions about the relevant activities are made

In Step 3, an analysis is performed to determine the relevance of voting rights in assessing

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whether an investor has power over the investee (IFRS 10, Par. B35-46). This analysis investigates the governance structure of the investee and requires significant judgment. If the investee is controlled via voting rights, the investor must determine which investor has voting rights sufficient to direct the investee’s relevant activities. In more complex cases, such as potential voting rights, many factors should be considered in deciding what is determinative in assessing power (IFRS 10, Par. B47-50). If the entity is designed so that voting rights are not relevant, the focus should be on the kinds of rights (IFRS 10, Par. 51-54).

IFRS requires an entity that is a parent to present consolidated financial statements.

Step 4: Assess whether the investor has power over the relevant activities

An investor with more than half of the voting rights has power when:

• Relevant activities are directed by majority vote (IFRS 10, Par. B35a), or

• The majority of the governing body directing relevant activities is appointed by majority vote (IFRS 10, Par. B35b).

Furthermore, the voting rights must be substantive and provide a current ability to direct relevant activities. Voting rights are not substantive if the investee is subject to direction by a government, court, administrator, receiver, liquidator or regulator (IFRS 10, Par. B37). Voting rights do not guarantee power if another entity, not acting as the agent of the investor, can direct the relevant activities (IFRS 10, Par. B36).

An investor with less than a majority of voting rights can also gain power through:

• Agreements with other vote holders – for example, contractual agreements may

enable the investor to control sufficient votes held by other investors to provide itself with power over the investee (IFRS 10, Par. B39)

• Other contractual agreements – for example, contractual agreements may allow the investor to directly control the investee’s manufacturing activities; if these are relevant activities, this may result in control by the investor (IFRS 10, Par. B40)

• Potential voting rights – for example, rights to obtain voting rights of an investee within an option or convertible instrument (IFRS 10, Par. 47-50)

• De facto power – ownership of the largest block of voting rights when the remaining rights are widely dispersed (IFRS 10, Par. B42-43), and

• A combination of the above.

Only consider substantive rights exercisable when decisions about the relevant activities of an investee need to be made, and the rights holder has a practical ability to exercise them. To determine substantive rights, ask the following questions (KPMG, 2013a):

1. Are there barriers that prevent holders from exercising the rights?

2. Do several parties need to agree for the rights to become exercisable or operational?

The consideration of potential voting rights in IFRS 10 is different than in IAS 27. Potential voting rights are defined in IFRS 10 as “rights to obtain voting rights of an investee, such as those within an option or convertible instruments” (IFRS 10, Par. B47). IFRS 10 specifies three factors to consider: 1) Use only substantive voting rights to assess power; 2) Examine the purpose and design of the potential voting right instrument and other

New Consolidation Requirements Under IFRS

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involvement the investor has with the investee (IFRS 10, Par. B48); and 3) Consider voting or other decision-making rights relating to the investee’s activities in combination with potential voting rights (IFRS 10, Par. B47 –B49).

…assess whether a link exists between power and returns.

Guidance on de facto control introduced in IFRS 10 is a significant change. IFRS 10 states explicitly that consolidation can happen even when an investor owns less than a majority of the investee’s voting interest. De facto control can occur when one significant investor owns less than 50% of the voting stock and all other stock is widely dispersed among investors who generally don’t exercise their voting rights. This is a significant difference with U.S. GAAP, which does not have a similar concept.

De facto control judgments are difficult to make because many qualitative factors must be considered. Primary considerations spelled out in IFRS 10, Par. B42 direct an investor to assess the size of investor’s holding of voting rights relative to the size and dispersion of holdings of other vote holders; potential voting rights, and other contractual arrangements. Application guidance in IFRS 10’s Appendix B provides examples of when factors may or may not be sufficient to determine an investor’s power. For example, an investor holding 48% of the voting rights with remaining voting rights held by thousands of shareholders holding less than 1% each may be a sufficient evidence of power. Conversely, an investor holding 45% of voting rights as compared to 11 other investors each with 5% is insufficient to constitute power.

If the analysis of primary considerations is not conclusive, investors should consider additional facts and circumstances. Such analysis may involve patterns of voting participation at previous shareholder meetings; evidence of practical ability to direct, including

appointment or approval of investee’s key management personnel, decision-making rights within a management contract, and removal or “kick-out” rights; special relationships such as when significant portions of investee’s activities are conducted on behalf of investor; and large exposure to variability in returns. Typically, greater weight is given to the actual ability to direct (KPMG, 2013a).

Step 5: Assess whether the investor is exposed to variability in returns

Variable returns result from the investee’s performance and can be positive, negative, or both. Variable returns is a broad concept and IFRS 10 identifies a wide range of possible returns, such as dividends and interest from debt securities, changes in an investment’s value, exposures arising from credit or liquidity support, tax benefits, access to future liquidity, economics of scale, cost savings, sourcing scarce products, and gaining access to proprietary knowledge.

Determination is based on the substance regardless of the legal form. For example, contractually-fixed interest payments could be highly variable if credit risk is high. Similarly, asset management fees contractually fixed could be considered variable returns if the investee has a high risk of non-performance.

Step 6: Assess whether there is a link between power and returns

The last step is to assess whether a link exists between power and returns. The key question is whether the investor is a principal or an agent. A principal may delegate some of its decision authority over the investee to the agent, but the agent does not control the investee when it exercises such power on behalf of the principal. In general, use of power by the investor to generate returns for itself makes them a principal. However, the use of delegated power to benefit others makes the investor an agent. IFRS 10 sets out a number of specific factors to consider in this analysis. The definitive considerations are presented in Figure 2.

53New Consolidation Requirements Under IFRS

Does a single party hold substantive rights to remove the decision maker without cause? (IFRS 10, Par. B65)

Is the decision maker’s remuneration commensurate with his skill level (IFRS 10, Par. B69-70)

Does the remuneration agreement include only terms, conditions and amounts that are customarily present in arm’s-length contracts for similar services (IFRS 10, Par. B69-70)

Continue the analysis using qualitative considerations

Investor is an agent

Investor is a principal

Investor is a principal

Yes

Yes

No

No

No

Yes

Figure 2Principal vs. Agent Determination Flowchart

Source: Adapted from PwC (2011)

If the previous considerations do not lead to a conclusion, investors should consider these four indicator groups:

• Scope of investor’s authority over the investee: Discretion over activities permitted by contracts/law Purpose and design of investee Involvement in design of investee

• Rights held by other parties: Number of parties required to act together to remove decision maker

• Remuneration of decision-maker: Magnitude/variability of investor’s remuneration relative to the expected returns

• Exposure to variability of returns from other interests in the investee: Magnitude/variability of investor’s total economic interest Whether the exposure differs from other investors.

Great scope of authority, greater rights, larger and more variable remuneration, and larger exposure to variability of returns from other interests in the investee may lead to the conclusion that the decision-maker is the principal.

Due to U.S. GAAP and IFRS differences in the definition of control, it is possible to reach different conclusions as to whether an entity should be consolidated with a parent.

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Determine whether control by investor is assessed at legal entity level or silo level.

Step 1Identify the investee

Identify activities that significantly affect the investee’s returns.

Step 2Identify the relevant activities

of the investee

Determine whether the investee is controlled by a majority of voting rights, less than a majority of voting rights, or rights other than voting rights.

Step 3Identify how decisions about

the relevant activities are made

Consider all facts and circumstances indicating inves-tor’s power over the relevant activities of the investee. De facto power can lead to consolidation of an investee even when an investor owns less than a majority of the investee’s voting interest.

Step 4Assess whether the investor has de facto power over the

relevant activities

Determine whether the investor is exposed to or has rights to variable returns from its investment. Variable returns may include share of net income, fees, and synergies available to the investor.

Step 5Assess whether the investor is exposed to variability in returns

Determine whether the investor is a principal or an agent. The principal controls the investee while the agent does not control the investee while exercising power on behalf of the principal.

Step 6Assess whether there is a link between power and returns

Figure 3Summary of the Six Step Framework for Application of the Single Consolidation Model

Comparison with Consolidation Models under U.S. GAAP

IFRS and U.S. GAAP are fairly well converged with respect to business consolidations. The general consolidation model is basically the same under IFRS and U.S. GAAP, but the IFRS definition of control is much broader than the definition under U.S. GAAP. Table 1 outlines some of the major differences between IFRS and U.S. GAAP.

55New Consolidation Requirements Under IFRS

Table 1Comparison of IFRS under IFRS 10 and recent amendments with current U.S. GAAP

IFRS Under IFRS 10 Current U.S. GAAP

Must all subsidiaries be consolidated?

Generally Yes, until Jan. 1, 2014. 2012 amendment now exempts qualifying investment entities from consolidating particular subsidiaries.

No, exceptions are still made for a few specialized industries.Also, may not happen if the subsidiary is in legal reorganization or bankruptcy.

How is Control defined and operationalized?

“Power-to-direct” model used. Control occurs when parent has:1. Power over entity.2. Rights to variable returns from entity.3. Ability to affect the amount of those returns from entity.

Voting rights not dominant factor to assess control. Control presumed if parent owns over 50% of entity’s voting stock. “De facto control” may exist without voting control.

“Controlling Financial Interest” / “Variable Interest” model underlies both variations - one for VIEs and another for non-VIEs. For non-VIEs, control is the continuing power to govern the financial and operating policies of an entity. Typically operationalized as a parent having over 50% of the voting stock of an entity. For non-VIEs, it generally follows the “voting interest consolidation” model.

Are potential votingrights considered in the determination of control?

Yes, potential voting rights considered if currently exercisable.

No, not generally considered.

Is Control assessed continuously?

Yes. For VIEs, yes. For non-VIES, no. Only reassessed when there is a change in voting interests.

Must uniform accounting policies be used throughout the consolidated group?

Yes. No, but theoretically desirable.

Silo Accounting? Applicable for all investees. Only applicable to VIEs.

Must parent and subsidiaries generally use the same reporting date when consolidating?

Yes. If not practical, then difference can be no more than 3 months. May require recognition of transactions in gap period.

No, but theoretically desirable; the difference can be no more than 3 months.

Are intercompany investments, balances, and transactions eliminated?

Yes. Yes.

Sources: Adapted from IASB, 2011; FASB, 2014a; Grant Thornton, 2013; PwC, 2013; and KPMG, 2013b.

U.S. GAAP has a distinct consolidation model for voting interest entities and a distinct model for variable-interest entities (VIEs), which are legal entities. All entities are first evaluated for consolidation as potential VIEs. If the entity is not a VIE, then it is evaluated for consolidation based on voting control. For a voting interest entity, a majority voting interest is determined to have control unless a single party has substantive kick-out or participating rights.

An entity is a VIE if any of the following exists (FASB, 2014a, ASC 810-10-15-14):

• It has insufficient equity to carry on its operations without additional subordinated financial support

• As a group, the equity holders are unable to make decisions about the entity’s activities

• It has equity that does not absorb the entity’s expected losses or expected return.

For VIEs, the primary beneficiary has control based on the power to direct the activities that most significantly impact the VIE’s performance and the obligation to absorb losses or the right to receive benefits of the VIE.4 There is no consideration of de facto control and potential voting rights in the U.S. GAAP VIE consolidation model.

Due to U.S. GAAP and IFRS differences in the definition of control, it is possible to reach different conclusions as to whether an entity should be consolidated with a parent. For example, U.S. GAAP does not consider potential voting rights whereas IFRS considers potential substantive voting rights (e.g., options or convertible instruments) in the control assessment process.

Similar to IFRS, the U.S. Securities and Exchange Commission (SEC) has a much broader notion of control. Specifically, under the SEC’s definition

control exists when one entity possesses the power to direct policies of another entity by ownership of voting shares, by contract, or by other means (SEC, Regulation S-X Rule 3A-02).

A few other differences between U.S. GAAP and IFRS are worth mentioning here. First, IFRS requires application of uniform accounting policies throughout the group of entities, while it is not required – although theoretically desirable – under U.S. GAAP. Unless impractical, IFRS requires that all entities in the consolidated entity have the same fiscal year; whereas U.S. GAAP more freely allows up to a three month difference. Unlike IFRS, non-VIEs under U.S. GAAP only have to assess control if a change occurs in the voting rights. And finally, under IFRS the silo accounting concept is applicable for all investees, while under U.S. GAAP it is applicable only to VIEs.

Consolidation policy for VIEs under U.S. GAAP will be updated soon as FASB completes a project entitled Consolidation: Principal versus Agent Analysis. This project stems from the FASB-IASB consolidation deliberations and started with FASB issuing proposed Accounting Standards Update, Consolidation (ASC Topic 810): Principal versus Agent Analysis in November, 2011. This project has three objectives (FASB, 2014b):

• Provide criteria to evaluate whether a decision maker is using its power as a principal or agent

• Eliminate inconsistencies in evaluation kick-out participating rights, and

• Amend rules for evaluating whether a general partner controls a limited partnership.

After collecting and analyzing comment letters, FASB recently decided to re-deliberate this proposal. The final update is expected in the second half of 2014.

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Amendments to IFRS 10

As previously mentioned, two amendments to IFRS 10 were issued by the IASB in 2012. The first enhanced the transition guidance to IFRS 10 after a short due process signaling urgency, and was spurred by the IFRS Interpretation Committee’s consideration of a request to clarify the meaning of the ‘date of initial application’ in IFRS 10’s transitional requirements. The amendment limits the requirement to provide adjusted comparative information to only the preceding comparative period.5

The second amendment, entitled Investment Entities, was developed from the IFRS 10 consultation process, where constituencies questioned the usefulness of the consolidated financial statements of investment entities. The amendment clarifies exemptions to consolidate subsidiaries for eligible investment entities, such as mutual funds, unit trusts, and similar entities. Instead, IFRS now requires fair value to measure those investments (IASB, 2012b).

…the IASB and FASB have not been able to agree on a common standard.

In 2014 the IASB exposed together a collection of three proposed amendments to IFRS 10 and IAS 28 in the Exposure Draft Clarifications to the accounting for interests in investment entities and applying the consolidation exemption. These proposed amendments were tentatively approved by the Interpretations Committee and are at a deliberations stage.

Conclusion

When Sir David Tweedie served as chair of the IASB, he testified before the U.S. Congress that, “There is a broad consensus among accounting standard setters that the decision to consolidate should be based on whether

one entity controls another. However, there is considerable disagreement over how control should be defined and translated into accounting guidance” (Tweedie, 2002). Over a decade later that statement is still valid as the IASB and FASB have not been able to agree on a common standard. Nevertheless, the standard on VIEs that the FASB issued after IFRS 10 was pronounced and the subsequent amendments the IASB made have moved their overall guidance regarding consolidations closer.

In order to minimize the ability of corporations to manipulate accounting standards for their own benefit, the IASB purposely wrote their consolidation rules in broad terms in order to address both current and future forms of business entities. Thus, IFRS 10 can be difficult to implement as the standard is holistic and principles-based, contains no bright lines and requires a lot of judgment. Corporations and their auditors need to carefully analyze their structured entities in order to determine whether they must be consolidated under IFRS. As the operationalization of control is quite different between IFRS and U.S. GAAP, corporations preparing consolidated financial statements under both sets of standards could have significantly different results.

New Consolidation Requirements Under IFRS

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References

Deloitte. 2011. IFRS in Focus: IASB Issues New Standard on Consolidation. May 2011. London, UK: Deloitte Touche Tohmatsu Limited.

Financial Accounting Standards Board (FASB). 2014a. Accounting Standards Codification: Topic 810, Consolidation. Norwalk, CT: FASB.

FASB. 2014b. Active FASB Projects: Consolidation: Principal versus Agent Analysis. Accessed at: http://www.fasb.org/jsp/FASB/FASBContent_C/ProjectUpdatePage&cid=1176157176582#

Grant Thornton. 2013. Comparison between U.S. GAAP and International Financial Reporting Standards. Chicago, IL: Grant Thornton.

International Accounting Standards Board (IASB). 2008. International Accounting Standard 27: Consolidated and Separate Financial Statements. London, UK: IASB.

International Accounting Standards Board (IASB). 2011. International Financial Reporting Standard 10: Consolidated Financial Statements. London, UK: IASB.

International Accounting Standards Board (IASB). 2012a. Consolidated Financial Statements, Joint Arrangements and Disclosure of Interests in Other Entities: Transition Guidance. London, UK: IASB.

International Accounting Standards Board (IASB). 2012b. Investment Entities. London, UK: IASB.

International Accounting Standards Board (IASB). 2013. Effect Analysis: IFRS 10 Consolidated Financial Statements and IFRS 12 Disclosure of Interests in other Entities. September 2011 (updated July 2013). London, UK: IASB.

KPMG. 2013a. New IFRS Requirements for Consolidation. IFRS Institute Webcast broadcast on May 29, 2013. New York, NY: KPMG LLP.

KPMG. 2013b. IFRS compared to U.S. GAAP: An Overview. November 2013. New York, NY: KPMG LLP.

PricewaterhouseCoopers (PWC). 2011. Practical Guidance to IFRS; Consolidated Financial Statements: Redefining Control. July 2011. PWC.com.au.

PricewaterhouseCoopers (PWC). 2013. IFRS and U.S. GAAP: Similarities and Differences. October 2013. London, UK: PWC LLP.

Reiland, Michael. 2011. Consolidation: Identifying Subsidiaries under IFRS 10. SSRN Working Paper Series, 1-30.

Securities and Exchange Commission. REGULATION S-X Reg. § 210.3A-02. Available at: http://www.sec.gov/about/forms/forms-x.pdf

Standing Interpretations Committee of IASC. 1998. An Interpretation of IAS 27 - Consolidation – Special Purpose Entities (SIC-12). London, UK: IASC.

Tweedie, David. 2002. Oversight Hearing on "Accounting and Investor Protection Issues Raised by Enron and Other Public Companies." Prepared Statement of Sir David Tweedie, February 14, 2002.

Endnotes

1 IAS 27 Consolidated Financial Statements and Accounting for Investments in Subsidiaries was originally issued by the International Accounting Standards Committee (IASC) in 1989. In 2011 the 2008 version of the standard was superseded by an updated IAS 27 Separate Financial Statements and by IFRS 10 Consolidated Financial Statements.

2 Previously, IAS 27 contained control model based on voting rights while the SIC-12 framework addressed exposure to variable returns. A perceived difference in emphasis between IAS 27, focusing on the power to manage the investee, and SIC-12 focusing on exposure to a majority of risk and rewards; as well as lack of guidance within the standards led to an inconsistent application of the control concept (IASB, 2011; Deloitte, 2011; PWC, 2011).

3 This qualitative analysis is often supplemented with quantitative analysis (ex. ASC 810-10-55-53).

4 In the event that an entity does not have both power and benefits, it should be determined if a related party or de facto agent individually has power and benefits to assess control or, if these parties collectively have power and benefits, the party most closely associated with the VIE would have control.

5 In addition, the guidance provides a relief from certain disclosure requirements for periods before

IFRS is first applied (IASB, 2012a).

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The PCAOB's Proposed Changes to the Auditor Reporting Model: An In-depth Overview for the Classroom and BeyondVeena L. Brown, Sheldon B. Lubar School of Business,University of Wisconsin-Milwaukeebrownvml@uwm.edu

Joseph E. Trainor, The Peter J. Tobin College of Business, St. John's University, New Yorktrainorj@stjohns.edu

Executive Summary

After almost a decade of research, deliberation, and public input, the Public Company Accounting Oversight Board (PCAOB) appears poised to reach a conclusion on its proposal for changes to the auditor's reporting model. These changes, undoubtedly the most far-reaching in 70 years, would significantly impact what has largely been described as a pass/fail model of auditor reporting. Under current auditing standards, auditors of public companies typically follow illustrative examples of auditor reports originally adopted under SAS 58 by the Auditing Standards Board in 1988 (AICPA, 1988), and typically issue unqualified audit opinions with minor word variations from firm-to-firm.

The new model includes the reporting of critical matters encountered during the audit, as well as other provisions aimed to provide financial statement users with more relevant information about the auditor and the audit process. This paper presents the evolution of the auditor reporting model, discusses the proposed changes to the standards, provides a timeline detailing the process of developing the proposed standard, summarizes the changes to the standard auditor’s report, and presents unresolved issues regarding the proposed standard.

This paper is a valuable resource for students to acquaint themselves with the proposed model, the history of the auditor’s report, and an overview of the audit standard setting process. Accounting academics can use this paper in the classroom as supplemental material or assign it to students as a case project. Accordingly, we include two appendices with this paper. Appendix A provides learning objectives and implementation guidance, and Appendix B offers teaching notes with suggested questions and solutions.

Additionally, the paper provides a basis for investors, creditors, academic researchers, and practitioners to understand the history and current developments affecting the auditor reporting model. Auditors play a significant role in the quality of information available in the capital markets. In as much as our society depends on high-quality financial reporting for capital allocation decisions, understanding the nature and limitations of the auditor's report will be helpful to investors and creditors. Finally, the summary of the requirements and changes affecting the standard auditor’s report presented in this paper will be useful to time-constrained practitioners, investors, and creditors when evaluating the changes to the auditor’s reporting model.

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Introduction

According to the PCAOB, “The standard auditor's report identifies the financial statements that were audited, describes the nature of the audit, and presents the auditor's opinion as to whether the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of the company in conformity with the applicable financial reporting framework. The standard auditor's report is commonly described as a pass/fail model because the auditor opines on whether the financial statements are fairly presented (pass) or not (fail).” (PCAOBUS.org)

The current model of the auditor’s report has been criticized for years as being uninformative to the users, yet little has been done to address this concern.

The current model of the auditor’s report has been criticized for years as being uninformative to the users, yet little has been done to address this concern.1 In an effort to remediate the issue, The PCAOB has proposed a new auditor reporting standard that will significantly change the existing auditor reporting model (ARM or “the model”) and consequently the auditor’s report. The objective of this paper is to provide a historical context of the auditor reporting model, discuss the proposed changes, and provide a status update on the new standard as it relates to public companies.2

This paper is motivated by the significant changes proposed by the new standard and its implications for auditors, as well as preparers and users of the financial statements. The paper is beneficial to many, if not all, stakeholders in the capital markets. The descriptive and visual presentation of the history of ARM offers a quick reference which should be useful to all readers. The discussion,

summary and status update of the proposed changes should be valuable to practitioners and financial statement preparers and users who want to obtain knowledge about the standards but do not have the time or inclination to read the original source documents for the details.

In addition, academics will be interested in this paper as the proposed changes to the audit reporting model provide a ripe area for research, and our paper provides a contextual format to frame that research. The paper can also be used in the classroom, as it provides students with a context for evaluating the audit standard setting process. Appendix A offers learning objectives and implementation guidance, and Appendix B provides teaching notes for accounting instructors wishing to use this paper in a class project or as a teaching tool. The proposed standard has gone through a number of iterations, public comments, and roundtable discussions, which provides an excellent opportunity for students to study the nature of the audit standard setting process.

Finally, we believe various regulators and standard setters will also be interested in our paper as we summarize the issues identified by PCAOB board members in public statements as well as from a sample of comment letters from the public on the proposed standard.3

The remainder of the paper is presented as follows. We begin with a history of auditor reporting, followed by a discussion on the proposed auditor reporting standard, highlighting the significant elements of the new model. Next, we present readers’ response to the proposed standards, and we conclude with a brief discussion on the next steps.

History of Auditor Reporting

Prior to the stock market crash in 1929, audit reports were generally non-standardized, with relatively short statements attesting to the trueness, fairness, or correctness of companies’

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financial statements. Investors were left largely to their own devices to determine the level of assurance being communicated by the auditor. The reporting model underwent its first major standardization in 1934 when the New York Stock Exchange (NYSE) adopted regulations which required registrants to have audit reports that included both a scope and an opinion paragraph. These new regulations were the result of a joint project between the NYSE and the American Institute of Accountants (AIA) aimed at educating investors and on improving financial-reporting practices. The wording of the paragraphs required under NYSE listing regulations was put forth by the AIA (Church, Davis, and McCracken, 2008). The purpose of standardizing the auditor's report was to assist users in identifying non-standard reports.

Over the next 60 years, audit standard setters focused primarily on changes to the wording of the standard audit report, as well as how auditors should report on non-standard issues (Church, Davis, and McCracken, 2008 p. 73). In 1988, the ASB issued Statement on Auditing Standard (SAS) No. 58, Reports on Audited Financial Statements, which introduced today’s unqualified and modified opinion reports (AICPA 1988).

The most recent changes to the auditor's reporting model for public companies occurred when the PCAOB was created in 2003 and the subsequent adoption of Auditing Standard No. 1 (PCAOB 2004a) and Auditing Standard No. 2 (PCAOB 2004b).4 Auditing Standards No. 1 (AS No. 1) changed the title of the report to indicate that the audit firm is registered with the PCAOB and also changed the reference to generally accepted auditing standards (GAAS) to those standards adopted by the PCAOB. Auditing Standard No. 2 (later superseded by Auditing Standard No. 5) developed the framework for auditors to audit internal control over financial reporting (ICFR) and

created the reporting requirements under that framework.5

The proposed standard [is] geared to enhance the transparency of the financial statements and the informativeness of the auditor’s report.

Prior to this, auditing standards did not exist for the audit of internal controls and the auditor's subsequent reporting on the results of an internal control audit, other than those prescribed by SAS 70 for data service organizations. The model adopted by the PCAOB required audit firms to conduct a combined audit of the financial statements (FS) and an audit of the design and operating effectiveness of internal control over financial reporting (ICFR), but provide the firms with the option to present the audit opinion on the financial statements and the opinion on ICFR in one report or on two separate reports.6

On an FS audit, auditors may issue either an unqualified, qualified, adverse, or disclaimers of opinion. On an ICFR audit, the auditor may issue an unqualified or adverse opinion.7 In rare cases, a qualified opinion might be issued where the scope of the audit of internal control is impaired.

It is also important to recognize that U.S. GAAS for non-public entities continues to be promulgated by the Auditing Standards Board (ASB) of the American Institute of Certified Public Accountants (AICPA). Since the creation of the PCAOB, the ASB has continued its standard setting activities for non-public entities, some of which have been focused on the auditor's reporting model. The changes to the audit report for non-public entities are mainly non-substantive and consist primarily of format changes of existing content. The most notable change in the audit report narrative is an increase in the discussion of management's

The PCAOB's Proposed Changes to the Auditor Reporting Model: An In-depth Overview for the Classroom and Beyond

62Exhibit 1

The Proposed Auditor Reporting Model: the Standard Setting Timeline

1978 CAR Commissiona recommended changes

to the report 1987 Treadway Commissionb

recommended changes

2002 Sarbanes-Oxley Act passed by Congress

2005 PCAOB's SAGc roundtables on auditor

reporting model

June 2011 PCAOB issues Concept Release

Nov 2011 SAG meeting

Aug 2013 PCAOB issues proposed auditor

reporting standard

April 2014–PCAOB re-opened Concept

Release comment period & closed it on May 2.

Late 1990s and early 2000s accounting

scandals

2003 PCAOB created

2008 ACAPd recommends changes to reporting model

Sept 2011 PCAOB held Roundtable Discussion

Nov 2012 SAG meeting

Dec 2013 comment period on Proposed

Standard Closes

a Commission on the Auditors’ Responsibilities (CAR or the “Cohen Commission”)b National Commission on Fraudulent Financial Reporting (“Treadway Commission”)c Public Company Accounting Oversight Board (PCAOB)’s Standing Advisory Group (“SAG”) d Advisory Committee on the Auditing Profession to the U.S. Department of the Treasury (“ACAP”)

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responsibilities for the financial statements and the company’s internal controls. Further discussion of the reporting model for non-public entities is outside the scope of this paper.

Standard Setting Time Line

Exhibit 1 illustrates the standard setting timeline of the proposed auditor reporting standard. Concern over the communicative value of the auditor's report is not a new phenomenon; it has been on the minds of regulators, academics, and practitioners for quite some time. For example, in 1978 the Commission on Auditor's Responsibilities (CAR)8 reported that "Evidence abounds that communication between the auditor and users of his work – especially through the auditor's standard report – is unsatisfactory. The existing report has remained essentially unchanged since 1948 and its shortcomings have often been discussed." (CAR 1978 page xxiv). The Commission later discusses the expectations gap between the auditor's responsibility under GAAS and the public's expectations, and concludes that one of the main reasons for a lack of change to the auditor reporting model are concerns over increasing auditors’ legal liability.

…most of the responses received by the PCAOB regarding the proposed auditing standard oppose the inclusion of critical audit matters in the audit report

During the 1970s and 1980s several other commissions, most notably the National Commission on Fraudulent Financial Reporting (known as the "Treadway Commission") also made recommendations to change the auditor reporting model in 1987. At the time, the commissions had little effect on the standard setting process, so most recommendations were not implemented.

The 1990s were a dramatic time for the accounting profession. In the backdrop of the economic boom, many accounting firms expanded their professional practices beyond traditional audit and tax services at the encouragement of the AICPA. By the late 1990s and early 2000s, many accounting practices were obtaining a large portion of their revenues from non-audit services and the perceived bond between the auditor and their clients grew strong. Ultimately, a rash of high-profile accounting scandals led to the collapse of one of the then Big-5 accounting firms (Arthur Andersen) and the end of self-regulation of the accounting profession. Congress viewed the integrity of the financial reporting process in the capital markets as key to a successful and vibrant economy and thus created the PCAOB to restore investors’ confidence in the financial reporting process and to regulate the audits and auditors of public companies.

The earliest signs that the PCAOB had become interested in reviewing the auditor's reporting model appear in 2005 when the Standing Advisory Group (SAG)9 of the PCAOB discussed the auditor reporting model at two separate meetings under two distinct themes.10 The first theme focused on the determinants of how auditors make their reporting decisions, and the second theme focused on the outputs, principally the content of the auditor's report and the information conveyed (Church et al. 2008). No action was taken regarding the model subsequent to these meetings.

The next push for revisions to the auditor reporting model came in 2008 when the U.S. Department of the Treasury's Advisory Committee on the Auditing Profession (ACAP) recommended that the PCAOB undertake a standard-setting initiative to consider improvements to the standard auditor report.

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On June 21, 2011 the PCAOB issued a concept release titled "Concept Release on Possible Revisions to PCAOB Standards Related to Reports on Auditing Financial Statements" (PCAOB 2011). In this release, the PCAOB proposed the following changes to the audit report, (1) an auditor discussion and analysis, (2) required and expanded use of emphasis of matter paragraphs, (3) auditor assurance on items outside the financial statements, and (4) clarification of language in the standard auditor's report (PCAOB 2011).

In consideration of these changes, the PCAOB conducted a number of outreach activities including a roundtable discussion in September 2011, SAG meetings in November 2011, 2012, and 2013, and a number of public meetings throughout the process. These meetings sought to engage and solicit the thoughts and opinions of a broad constituency including auditors, academics, investors, preparers, regulators, and others involved in the capital markets. The PCAOB issued the proposed auditing rule in August 2013 and solicited public comment on the proposal on or before May 2, 2014.11

Exhibit 2The Proposed Auditor Reporting Standards:

A Summary of Significant Changes to the Auditor’s Report

Critical Audit Matters

• Identify critical audit matters

• Communicate, in the audit report, critical audit matters or that none were identified

• Describe in the audit report the considerations that led the auditor to determine that the matter was a critical audit matter

• Refer to the accounts and disclosures that relate to the critical audit matter, when applicable

• Document process of determining critical matters with sufficient detail to support the conclusions reached

Additional disclosures

• Provide additional wording stating that the auditor is independent in accordance with federal securities laws and PCAOB standards

• Disclose the auditor's length of tenure with the audit client in the audit report

• Adjust wording in audit report to reflect that the auditor is responsible for detecting material deficiencies in the financial statements, whether due to error or fraud

• Clarify in the audit report that the footnotes are an integral part of the financial statements

Responsibility for ‘other information’

• Evaluate (rather than merely read and consider) “other information” reported in filings containing the audited financial statements

• Add a new paragraph to the standard auditor report describing the level of auditor’s responsibility for other information

• Report any material misstatements or inconsistencies between audited financial statements and other information

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Proposed Audit Reporting Standards

Based on feedback received from comments letters and other outreach activities, the Board decided not to directly propose any of the alternatives presented in the Concept Release in the proposed rule.12 Instead, the proposed standard incorporates some of the fundamental concepts presented in the concept release into three main provisions geared to enhance the transparency of the financial statements and the informativeness of the auditor’s report. The provisions include communication of critical audit matters; the addition of new elements to the standard auditor’s report on auditor independence; clarification of the auditor’s responsibility for fraud and notes to the financial statements; and disclosure of the length of auditor tenure.

We discuss these provisions in more depth in the following sections.

Critical Audit Matters

One of the more significant requirements of the proposed changes to the auditor reporting model calls for the identification and reporting of critical audit matters. The PCAOB defines critical audit matters as those that involve the most difficult, subjective, and complex auditor judgments; pose the most difficulty to the auditor in obtaining sufficient, appropriate evidence; or pose the most difficulty to the auditor in forming an opinion on the financial statements (PCAOB, 2013 p. A1-6). If applicable, the auditor would modify the audit report to contain a description of the critical audit matter identified; the considerations that led the auditor to classify the matter as a critical audit matter; and refer to the accounts and disclosures related to the critical audit matter (PCAOB, 2013 p. A1-8).

Critical matters will be discussed in the auditor’s report under a section titled “Critical Audit Matters.” In this section, auditors

The PCAOB's Proposed Changes to the Auditor Reporting Model: An In-depth Overview for the Classroom and Beyond

would individually disclose matters identified as critical audit matters, discuss the nature of the critical audit matters, and state that the identification of these matters does not alter the auditor’s opinion on the financial statements and accompanying footnotes, taken as a whole. (See Exhibit 3 for an illustrative example of the new auditor’s report, with two paragraphs showing Critical Audit matters.)

In addition to the reporting requirements, auditors would also be responsible for properly documenting critical audit matters. In accordance with Auditing Standard No. 3, “audit documentation should be prepared in sufficient detail to provide a clear understanding of its purpose, source, and the conclusions reached” (PCAOB, 2004c p. A1-3). According to the current proposal, auditors’ documentation should be clear enough such that an experienced auditor with no previous connection with the engagement would understand the reasons for including and/or excluding certain matters as critical audit matters (PCAOB, 2013 p. A1-10).

New Basic Elements

The proposed ARM requires a number of new elements and clarifying language to the standard audit report under a section titled “Basis of Opinion,” to provide investors and other financial statement users with information about the audit and the auditor (PCAOB, 2013). Under the proposed requirements, auditors would be required to explicitly state in this section that they are required to be independent in accordance with United States federal securities laws and applicable rules and regulations of the SEC and PCAOB, and to provide information about the length of tenure with the audit client by stating the year the auditor first began serving as the company’s auditor.

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To the shareholders and board of directors of X Company

Introduction

We have audited the accompanying balance sheets of X Company (the "Company") as of December 31, 20X2 and 20X1, the related statements of operations, stockholders' equity, and cash flows, for each of the three years in the period ended December 31, 20X2, and the related notes (collectively referred to as the "financial statements"). These financial statements are the responsibility of the Company's management.

We are a public accounting firm registered with the Public Company Accounting Oversight Board ("PCAOB") (United States) and are required to be independent with respect to the Company in accordance with the United States federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission ("SEC") and the PCAOB. We or our predecessor firms have served as the Company's auditor consecutively since [year].

Basis of Opinion

Our responsibility is to express an opinion on the Company's financial statements based on our audits. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud.

Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures include examining, on a test basis, appropriate evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.

Opinion on the Financial Statements

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of [at] December 31, 20X2 and 20X1, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 20X2, in conformity with [the applicable financial reporting framework].

Exhibit 3Illustrative Sample of the New Auditor’s Report14

Report of Independent Registered Public Accounting Firm(Proposed changes are shown in Italics.)

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Critical Audit Matters

The standards of the PCAOB require that we communicate in our report critical audit matters relating to the audit of the current period's financial statements, or state that we determined that there are no critical audit matters. Critical audit matters are those matters addressed during the audit that (1) involved our most difficult, subjective, or complex judgments; (2) posed the most difficulty to us in obtaining sufficient appropriate evidence; or (3) posed the most difficulty to us in forming our opinion on the financial statements. The critical audit matters communicated below do not alter in any way our opinion on the financial statements, taken as a whole. [Include critical audit matters]

The Auditor's Responsibilities Regarding Other Information

In addition to auditing the Company's financial statements in accordance with the standards of the PCAOB, we evaluated whether the other information, included in the annual report on [SEC Exchange Act form type] filed with the SEC that contains both the December 31, 20X2 financial statements and our audit report on those financial statements, contains a material inconsistency with the financial statements, a material misstatement of fact, or both. Our evaluation was based on relevant audit evidence obtained and conclusions reached during the audit. We did not audit the other information and do not express an opinion on the other information. Based on our evaluation, we have not identified a material inconsistency or a material misstatement of fact in the other information.

[Signature] [City and State or Country] [Date]

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Also, in this section the auditor is required to provide clarification regarding the auditors’ responsibilities towards the notes to the financial statements and to the detection of misstatements. More specifically, the proposed standards require auditors to explicitly clarify that the financial statements under audit include the footnotes; that the audit includes procedures to assess the risk of material misstatement whether due to error or fraud; and that the auditor has responded to identified risks. These statements do not expand the auditors’ responsibilities, they merely clarify the auditors’ responsibilities in an effort to reduce the expectation gap between the perception of financial statement users and the reality of what auditors do, created by ambiguity of the existing auditor report. This section is positioned immediately after the Introduction paragraph of the auditor’s report. (See Exhibit 3 for the wording of this new paragraph).

Recently…the UK…and the EU…adopted changes or made preliminary agreements on audit reform, including rules that would require auditors to produce more detailed and informative audit reports.

Expanded responsibilities for “other information:” As it relates to other information, auditors continue to have certain responsibilities for information – other than the financial statements – that is included in a company’s 10-K or 20-F filed with the SEC, and information incorporated by reference in the annual report. Under existing auditing standards (AU Section 550), auditors have a responsibility to “read the other information and consider whether such information, or the manner of its presentation, is materially inconsistent with information, or the manner of its presentation, appearing in the financial

statements.” Moreover, the auditor is not required to perform procedures or corroborate other information in documents in which the audited financial statements appear unless he concludes that a material discrepancy exists between the audited financial statements and the other information.

The new standards, as proposed, effectively codify and expand auditors’ responsibilities with regards to other information. The proposed auditor’s report includes a section after “critical audit matters,” titled, “The Auditor’s Responsibilities Regarding Other Information.” This section adds new language to the auditor's report that describes the auditor’s responsibilities for other information, and states whether the other information contains a material inconsistency, a material misstatement of fact, or both (PCAOB, 2103) (See Exhibit 3 for an example of the wording to be included in this section.)

In addition to the new reporting requirement, auditors will also be required to evaluate the other information, effectively expanding their responsibilities in this area. The evaluation of other information focuses on four general areas (PCAOB, 2013 p. A2-3):

• Consistency of quantitative data contained within the other information and the audited financial statements and relevant audit evidence,

• Consistency of qualitative statements contained within the other information and the audited financial statements and relevant audit evidence,

• Other information not related to the financial statements, but contained within the other information and it’s consistency with relevant audit evidence and audit conclusions, and

• Mathematical accuracy of the information contained within other information

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Consistent with current auditing standards, the auditor has responsibilities when a material misstatement, material misstatement of fact, or both are identified. Generally, when a departure is identified, the auditor first requests management to correct the inconsistency in the other information. If management does not appropriately revise the other information, the auditing standard provides auditors with many responses depending on when the inconsistency is discovered. These responses may include reporting the matter to those charged with governance, withholding the auditor’s report, modifying the standard auditor report, and withdrawing from the engagement (PCAOB, 2013 p. A2-5).

Responses on the Proposed Standard

As of May 2, 2014, the PCAOB received 246 public comments regarding the proposed standards.13 The responses represent a very broad constituency of commenters from industry, academia, investors, trade-organizations, state CPA societies, governmental entities, advocacy groups, CPA firms, individual practitioners, as well as students. Compared to comments received from other PCAOB’s proposals, the comments on the auditor reporting model have received more than the typical number of responses, symbolizing the gravity of the debate. In comparison, the PCAOB’s proposal on auditor communications with audit committees and the proposal on related parties received 44 and 37 comments, respectively.

The responses vary in length from one page commentaries to more than 25 pages of criticism on the proposal. The side taken on the debate also differs considerably, ranging from investors’ support for the proposal at one end of the spectrum to auditors’ criticism on the other end. We review a random sample of 20 comment letters to identify common

themes addressed by constituencies. Consistent with the findings of Joseph V. Carcello, EY and Business Alumni Professor and the Executive Director of the Corporate Governance Center at the University of Tennessee, we find that most of the responses received by the PCAOB regarding the proposed auditing standard oppose the inclusion of critical audit matters in the audit report (Carcello, 2013 p.4).

Respondents also appear to be concerned about the cost versus benefits of the proposed standard, possible delays in delivery of the audit report due to additional audit procedures and document requirements under the new standard, the disclosure of information under critical audit matters that might not otherwise be required to be disclosed (e.g. going-concern deliberations, pending legal liability determinations, etc.), and the expansion of auditors’ responsibilities regarding other information, claiming a possible shift in the traditional role of the auditor into areas that are not appropriate. Surprisingly, respondents generally did not object to reporting auditor tenure, although several suggested that this information would be better suited in a proxy statement.

The debate regarding the proposed revisions to the auditors reporting model is not resolved.

Conclusion

Changes to the auditor reporting model proposed by the PCAOB are far reaching and significant, concurring with a general movement by regulators around the world for auditor reform. Recently, The Financial Reporting Council, the UK's independent financial regulator, and the EU Parliament adopted changes or made preliminary agreements on audit reform, including rules that would require auditors to produce more detailed and informative audit reports.

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Although the comment period on the proposed rule was initially closed in December, 2013 and more than 200 comment letters were received, the debate regarding the proposed revisions to the auditors reporting model is not resolved. The PCAOB held a public meeting in April 2014 to discuss the comments received and subsequently reopened the comment period.

It is speculated that a re-proposal may be necessary to close the gap between investors’ expectations and the proposed changes. If all goes as the PCAOB plans, the effective date of the proposed standards and related amendments would be effective for audits of financial statements for fiscal years beginning on or after December 15, 2015, subject to SEC’s approval. If such approval was granted, auditors, investors, and other capital market participants would see the first significant changes to the auditor reporting model in over 70 years.

ReferencesAICPA 1988. Reports on Audited Financial

Statements. Statement on Auditing Standards No. 58. New York, NY: Auditing Standards Board

Carcello, Joseph V. 2013. Comment letter to the PCAOB. http://pcaobus.org/Rules/Rulemaking/Docket034/205b_Carcello.pdf

Church, Brian K., Shawn M. Davis, and Susan A. McCracken. 2008. The Auditor's Reporting Model: A Literature Overview and Research Synthesis. Accounting Horizons, 22: 69-90.

Commission on Auditor’s Responsibilities (CAR). 1978. Report, Conclusions, and Recommendations. New York, NY

Kranacher, Mary-Jo. 2011. The Auditor Reporting Process: An Opportunity for Fundamental Change. The CPA Journal, 22: 69-90.

Public Company Accounting Oversight Board (PCAOB). 2004a. References in the Auditor's Report to the Standards of the Public Company Oversight Board. Auditing Standard No. 1. Washington D.C.: PCAOB

Public Company Accounting Oversight Board (PCAOB). 2004b. An audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of Financial Statements. Auditing Standard No. 2. Washington D.C.: PCAOB

Public Company Accounting Oversight Board (PCAOB). 2004c. Audit Documentation. Auditing Standard No. 3. Washington D.C.: PCAOB

Public Company Accounting Oversight Board (PCAOB). 2011. Concept Release on Possible Revisions to PCAOB Standards Related to Reports on Audited Financial Statements and Related Amendments to PCAOB Standards. http://pcaobus.org/Rules/Rulemaking/Docket034/Concept_Release.pdf

Public Company Accounting Oversight Board (PCAOB). 2013. The Auditor’s Report on an Audit of Financial Statement when the Auditor Expresses an Unqualified Opinion; The Auditor’s Responsibilities Regarding Other Information in Certain Documents Containing Audited Financial Statements and the Related Amendments to PCAOB Standards. http://pcaobus.org/Rules/Rulemaking/Docket034/Release_2013-005_ARM.pdf

Weirich, Thomas R., and Alan Reinstein. 2014. The PCAOB’s Proposed New Audit Report: Exploring the New Language and Elements. The CPA Journal, April: 24-25.

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APPENDIX A Case Learning ObjeCtives and impLementatiOn guidanCe

Overview of Learning Objectives

The primary objective of this learning-oriented case is designed to illustrate the auditor’s responsibilities related to financial reporting, particularly as it relates to the presentation of the auditor’s opinion report. Information in this paper also lends itself to a discussion of the potential impact on the investors, creditors and other stakeholders as a result of the additional information revealed by auditors pertaining to the detection of internal control deficiencies identified during performance of the audit, and the risk implications with the audited issuer.15

These issues can all be explored through a likely classroom discussion surrounding the real-world current event of this historic potential standard-setting rule. By incorporating changes to auditor reporting models recently implemented in other countries, students can explore issues and questions concerning the impact of culture and regulation; as well as the requirements of foreign issuers registered with the Public Company Accounting Oversight Board (PCAOB).

Implementation Guidance

This paper may be used to enhance the student’s understanding of the PCAOB’s standard setting process, and of auditor reporting for use in either an undergraduate or graduate auditing course. In addition, given similar recent changes in other countries and an overall direction towards international accounting and auditing standards, this paper could also be used in an international accounting course, or a governmental accounting course.

We recommend that this case be assigned individually in order to enhance the overall learning experience, as well as limit the likelihood that teams may divide responsibilities, and dilute learning in an effort to reduce time on-task.

Potential Enhancements

In order to facilitate an even deeper understanding of the proposed ARM as well as the PCAOB’s standard setting process, case questions could be added that require students to research the authoritative standards and demonstrate their knowledge by discussing the specific issues. Students could also be directed to review public comment letters, exposure documents, and roundtable transcriptions, and prepare summaries and/or analyze those materials. The cases may be assigned as independent projects or in teams.

Suggestions for project-oriented assignments

Students’ responses to these questions would depend on the extent and quality of their research. These projects are suitable as graduate level team or individual projects.

1. Go to the PCAOB website (www.pcaobus.org) and download the PCAOB latest Concept Release related to the auditor reporting model. Read the Release and formulate a response to the PCAOB on the Concept Release that was due May 2, 2014; assume one of the following roles:

a. An Investor

b. An Auditor

c. A Regulator

d. A Student

e. An Academic Professor

2. Accounting regulators in other countries (e.g. United Kingdom) recently changed their Auditor’s Reporting Model as well. Research and locate the new auditor’s reporting model in one of these countries and compare and contrast the changes made in that country’s report to the changes being proposed by the PCAOB in the United States.

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APPENDIX B teaChing nOtes

The following questions are suitable for undergraduate and graduate courses in accounting and auditing.

These suggested solutions should be viewed as relatively comprehensive answers to the proposed Auditor Reporting Model (ARM) questions. Instructors may elect to award full credit to the extent that students address the primary core of each question, and partial credit if, in the instructor’s judgment, the student has failed to address the primary question or has failed to provide sufficient citations where appropriate. The overview of the proposed ARM is designed to be scalable, and the suggested solutions presented below cover the comprehensive overview.

3. Using a timeline format, document the history of auditor reporting. Please include the responsible organization within each phase.

Suggested Solution:

• Prior to 1929 – Non-standardized reporting with short statements on trueness, fairness, or correctness of companies’ financial statements

• 1934 – Standardized report required by NYSE & AIA: must have scope and opinion paragraphs

• 1988 – ASB’s SAS No. 58, Reports on Audited Financial Statements, introduced the current version of the unqualified and modified opinion reports

• 2003 – Creation of the PCAOB fuels changes to the reports for public companies pursuant to AS 1 and AS 2 (later superseded by AS 5). The title of the report changed to include the word “registered” to indicate that a firm is a registrant of the PCAOB, and GAAS reference changed to “those standards adopted by the PCAOB.” AS 5

also requires firms to conduct an audit of internal controls over financial reporting (ICFR), integrated with the audit of the financial statements (FS). Firms must provide an ICFR audit opinion report together with the FS report (as one report) or separately (as 2 reports). ASB instituted increased disclosure of management’s responsibility for the FS and the company’s internal control, plus other minor format changes to the report of non-public companies.

4. Briefly describe the general stages of the PCAOB’s typical standard setting process. You may use the Standard Setting Timeline illustrated in Exhibit 1 as a reference.

Suggested Solution

• A problem is recognized and brought to the PCAOB’s attention (source is varied)

• SAG discuss item of interest and advises the PCAOB on its merit

• PCAOB issues a concept release to gather public opinion and comments on severity of the issue and overall impact, including cost/benefit analysis of new standard or rule.

• PCAOB holds multiple public meetings/roundtable discussion (sometimes also before issuing the concept release) to review and discuss comment letters after the comment period has closed.

• PCAOB analyzes comment letters and proposes a new standard/rule or modification to an existing one.

• PCAOB opens comment period on proposed rule and analyzes comments

• PCAOB obtains SEC’s approval of new or modified rule and if approved, issues the new standard/rule.

Students could also explore the PCAOB’s website for detailed information on the standard setting process.

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5. Do you think the current pass/fail model of the auditor’s opinion report needs to be changed? Please explain your answer.

Suggested Solution

Answers will vary.

6. Discuss the pros and cons of the proposed ARM? Do you think it should become a rule? Please explain your answer.

Suggested Solution

This answer will vary but most students may include the following as pros and cons:

PROS:

• Increase transparency

• Investors learn more from the auditor about critical matters and other information

• Improve audit quality as auditors will pay closer attention to findings

• Increase auditor responsibilities

CONS:

• Cost to implement

• Little or no added value as financial statement disclosures contain the same information

• Unsophisticated users may misinterpret the information presented

• Possible increase in auditor litigation

• Longer time to issue the audit report

• Increase auditor responsibilities

7. Exhibit 3 provides a sample of the Proposed Auditor’s Report. What other (or additional) changes to the current auditor’s opinion report, not proposed in the concept release, would you suggest?

Suggested Solution

Answers will vary.

8. The proposed ARM suggests three main categories of change: Critical Audit Matters, New Basic Elements, and Expanded Responsibilities for “other information.” Discuss the basic elements of each category.

Suggested Solution

Critical Audit Matters

• Identify critical audit matters

• Communicate, in the audit report, critical audit matters or that none were identified

• Describe in the audit report the considerations that led the auditor to determine that the matter was a critical audit matter

• Refer to the accounts and disclosures that relate to the critical audit matter, when applicable

• Document process of determining critical matters with sufficient detail to support the conclusions reached

Additional disclosures

• Provide additional wording that the auditor is independent in accordance with federal securities laws and PCAOB standards

• Disclose the auditor's length of tenure with the audit client in the audit report

• Adjust wording in audit report to reflect that the auditor is responsible for detecting material fraud whether due to error or fraud

• Clarify in the audit report that the footnotes are an integral part of the financial statements

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Responsibility for ‘other information’

• Evaluate (rather than merely read and consider) “other information” reported in filings containing the audited financial statements

• Add a new paragraph to the standard auditor report describing the level of auditor’s responsibility for other information

• Report any material misstatement or inconsistencies between audited financial statements and other information

Endnotes

1 While many groups have considered and recommended changes to the standard auditor's report in an effort to enhance the auditor's overall communication to financial statement users, the only change made over the last 70 years were (1) the addition of a paragraph explaining the scope of the audit, (2) the adoption of Auditing Standard No. 1, References in Auditors' Reports to the Standards of the Public Company Accounting Oversight Board, and (3) adoption of Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.

2 Non-public entities follow auditing reporting standards issued by the Auditing Standards Board (ASB) of the American Institute of Certified Public Accountants (AIPCA).

3 In April 2014, the CPA Journal published an article titled, The PCAOB’s Proposed New Audit Report by Weirich and Reinstein. This paper differs from that article as it provides an in-depth overview of the history of the auditor’s reporting model and offers insight into the PCAOB’s standard setting process. Weirich and Reinstein (2014) offer a brief general summary of the proposed new model and historical events. Our paper also includes teaching notes, learning objectives and implementation guidance for instructors wishing to use this paper in the classroom.

4 Congress enacted the Sarbanes Oxley Act of 2002 (SOX) which created the Public Company Accounting Oversight Board (PCAOB) to oversee public company auditors and ultimately restore public confidence in the U.S. capital markets.

5 AS No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements supersedes Auditing Standard No. 2 effective for fiscal years ending on or after November 15, 2007

6 However, if separate reports are used, the standards require audit firms to reference the nature of audit opinion issued on the other audit in an additional paragraph on the audit opinion report (for example, in a 4th paragraph of the FS standard audit report, the auditor will note the opinion issued on the ICFR audit and vice versa).

75The PCAOB's Proposed Changes to the Auditor Reporting Model:

An In-depth Overview for the Classroom and Beyond

7 An adverse opinion is issued if the auditor reports one or more material weaknesses in internal controls.

8 The Commission on Auditor's Responsibilities (CAR) was an independent commission formed by the American Institute of Certified Public Accountants (AICPA). Its members represented a broad constituency including practitioners, regulators, former regulators, attorneys, and investors.

9 The Standing Advisory Group (SAG) was convened by the Public Company Oversight Board (PCAOB) to advise the PCAOB on the development of auditing and related professional practice standards. The SAG includes auditors, investors, public company executives, academics, and others. The SAG meets two or three times a year and is chaired by the Board's Chief Auditor and Director of Professional Standards.

10 The meetings were held on February 16, 2005 and October 5-6, 2005.

11 PCAOB Release No. 2013-005, PCAOB Rulemaking Docket Matter No. 034: The auditor’s report on an audit of financial statements when the auditor expresses an unqualified opinion; the auditor’s responsibilities regarding other information in certain documents containing audited financial statements and the related auditor’s report; and related amendments to PCAOB standards. The comment period was initially closed on December 11, 2013 but later reopened with the new closing date of May 2, 2014.

12 Interested readers may refer to PCAOB Release No. 2013-005 for more information on the reasons for this decision.

13 Twenty-four (24) of the comment letters were received between the close of the first (December 11, 2013) and the second (May 2, 2014) comment periods. All letters are published on the PCAOB website. Six letters were received subsequent to the reopening of comment period. These additional comments were not yet analyzed by the PCAOB staff at the time this paper was written.

14 Adapted from the PCAOB’s Proposed Auditing Standards (Release No. 2013-005) with changes in bold

15 The term ‘issuer’ as used by the PCAOB denotes an entity trading on U.S. stock exchanges; and thus is required to be audited by a registered firm subject to PCAOB oversight, inspection, and enforcement actions.

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Executive Summary

The Information Technology (IT) field has a habit of using buzzwords. “Cloud Computing” is one of these terms. Some companies are embracing the Cloud with enthusiasm, others are planning to use it, yet some have not heard about it.

By 2020, 40 percent of digital information is expected to be created in the cloud, delivered to the cloud, or stored and manipulated in the cloud.1 Clearly, the Cloud is here to stay.

As seen during the last four decades, access to the latest technologies may be disruptive when they are not understood clearly. Just like any other new technology, cloud computing will impact many functional areas in a business enterprise.

Before 2011, Cloud computing had been considered as a special case of outsourced IT operations by the American Institute of Certified Public Accountants (AICPA). In a typical outsourcing, the service user entity engaged a service organization to perform some of the business processes or functions on its behalf.

As a large scale version of outsourcing, Cloud Computing will create new challenges and complications for management and auditors. After the replacement of Statement on Auditing Standards (SAS) 70 with Statement on Standards for Attestation Engagements (SSAE) 16 (similar to the International Standard on Assurance Engagements (ISAE) 3402), most Cloud Service Providers will provide assurances to the Cloud Service Users within the framework of attestation standards instead of auditing standards.

Outsourcing presents some challenges in itself, and cloud computing further complicates those challenges. The new framework allows three different deployment models in the form of Service Organization Controls (SOC), SOC 1, SOC 2, and SOC 3. It is crucial that cloud service providers and cloud service users and their auditors should carefully consider alternative SOC deployment models. The right SOC deployment model for the Cloud is SOC 2 or SOC 3. Unfortunately, many cloud providers are opting out for SOC 12 leaving little room for the development of SOC 2 reports.

The Concept of Cloud Computing

The IT industry has a habit of using buzzwords. “Cloud computing” is no exception. As seen

Cloud Computing and the Cloud Service User’s AuditorI. Hilmi Elifoglu, The Peter J. Tobin College of Business, St. John’s University, New Yorkelifogli@stjohns.edu

Yildiz Guzey, Beykent University, Turkeyyguzey@beykent.edu.tr

Ozlem Tasseven, Dogus University, Turkeyotasseven@dogus.edu.tr

An earlier version of this paper was presented at Global Business Research Symposium, Katowice, Poland, May 28-30, 2014.

77

during the last four decades, access to the latest technologies can be disruptive when it is not understood clearly.

The National Institute of Standards and Technology (NIST)3 defines Cloud computing as:

. . . a model for enabling ubiquitous, convenient, on-demand network access to a shared pool of configurable computing resources (e.g., networks, servers, storage, applications, and services) that can be rapidly provisioned and released with minimal management effort or service provider interaction.

Cloud computing is defined, therefore, as a product of the convergence of the Internet technologies with virtualization, and IT standardization. In this environment, the most common characteristics are:

• Broad-band access and location independence: Computing resource can be reached via the Internet from any computer (a thick or a thin client) using a standard browser with 24/7 availability. Typically, the service user has no idea about the location of the server or data, such as country or state.

• Pay as you use for a measured service: The use of Cloud computing entails low or no upfront capital cost and low ongoing operational cost. Most subscribers see only the variable cost of Cloud computing. You pay only for what you use. The success of Cloud computing depends on the metering capability at some level of abstraction appropriate to the type of service. For instance, the usage of CPU time, or data size in mega bytes could be the basis for measuring the usage. The resources are easily scaled and can be automatically adjusted to meet demand without any human intervention. For applications with peak periods, the Cloud computing provides

an ideal CPU capacity. The infrastructure can be easily resized and right sized, depending upon need.

• Full customer self-service: Customers can subscribe, manage, and terminate services themselves without any human intervention.

• Resource Pooling: In a multi-tenant model, the service provider’s resources are pooled to serve multiple consumers simultaneously. Different physical and virtual resources are dynamically assigned and reassigned according to consumer demand.

The Cloud computing can be provided with three service delivery models and four deployment models.

Cloud Computing standards and related regulations are still evolving.

Service Delivery Models:

Cloud computing services are delivered in three distinct formats: SaaS (Software as a Service), PaaS (Platform as a Service), and IaaS (Infrastructure as a Service).

Typical SaaS provides online processing or data storage capacity. Application resides on the provider’s computers with very little customization. User organizations do not maintain technical staff as evidenced in Salesforce.com, Oracle on demand, Myerp.com and Facebook.

The PaaS structure provides a platform and tools for developing and hosting other applications, such as database services. Users obtain an easy access to programming languages and tools offered by the provider. The users still maintain a portion of their own technical staff to write their own code.

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The IaaS provider maintains infrastructure in the form of servers, operating systems, networks, storage devices and databases. This model is highly virtualized and requires minimal configurations for customization as evidenced at Amazon EC2, Rackspace, and Mozy.com

Deployment Models:

The Cloud may be deployed as private or public. When dedicated to a single enterprise, it is known as “Private Cloud.” Enterprises using private clouds will continue to incur capital expenditures, depreciated over time.

When resources are shared with other enterprises, they are known as “Public Cloud.” From the subscriber’s point of view, the Public Cloud is owned and managed by a third party. By avoiding the initial investments in hardware and software, the Public Cloud minimizes cash out-flow for the user organization. In the Public Cloud alternative, the user organization no longer has direct control over its own data, even though the user organization still remains responsible for compliance with all applicable laws and regulations. Examples include Amazon’s Elastic Cloud (EC2), Sales Force, and Gmail.

Currently, many assurances in the Cloud computing sector, including Google, are in the form of Type II – SOC 2 reports.

In some Cloud deployment models, the public and private Cloud infrastructure is combined. In Hybrid Cloud deployment models, the Private Cloud is allowed to access Public Cloud during the peak periods when the private infrastructure cannot answer the computing requirements (called Cloud Bursting). In a Community Cloud deployment model, several organizations with similar missions, objectives, security requirements, and compliance needs share the same Cloud Computing infrastructure.

Standard Setters for the Cloud Computing

The Cloud Computing standards and related regulations are still evolving. The following are the most prominent regulators and standard setters in this field.

• CSA (Cloud Security Alliance): Non-profit consortium to promote the use of best practices for providing security assurance and education on the use of Cloud Computing4

• ENISA (European Network and Information Security Agency): ENISA works with European Union countries on Cloud Computing security issues5

• ISACA (Information System Audit and Control Association): A global organization for information governance, control, security and audit professionals6

• NIST (National Institute of Standards and Technology): NIST tries to facilitate the development of standards for better collaboration in the information technology field7

• FedRAMP: The Federal Risk and Authorization Management Program is a government-wide program that provides a standardized approach to security assessment, authorization, and continuous monitoring for Cloud products and services8

Cloud Computing and Auditing

Before 2011, Cloud computing had been considered as a special case of outsourced IT operations by the American Institute of Certified Public Accountants (AICPA). In a typical outsourcing, the service user entity engaged a service organization to perform some of the business processes or functions on its behalf. However, transferring out of services does not change the accountability of the service user. The accountability remains with the service user, and the auditor of the service

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user needs assurances about the controls at the service provider.9

Since its release in 1992, Statement on Auditing Standards No.70 (SAS-70) provided the necessary guidance to CPAs who audit the financial statements in outsourcing environments.10 The original purpose of the SAS 70 was a report to be used between the auditors of service users and service providers. SAS 70 has been assumed to provide enough guidance for CPAs reporting on internal controls at service organizations. However, the compliance requirements of the Sarbanes-Oxley Act and the Public Company Accounting Oversight Board’s (PCAOB) Auditing Standard (AS5) led to a wider use of SAS 70 at the global level. Many service users started requiring more evidence on the design and operation of controls from the service providers to ensure that the user entity’s control requirements have been met.

Even though the principal goal of the SAS 70 was the reliability of the financial statements, SAS 70-like control reports have become increasingly widespread in the United States and around the world to meet the requirements of various regulatory agencies and governmental entities.11 Some of the SAS 70 audits cover issues like logical and physical access to information, organizational controls, application development and maintenance controls, data processing controls and business continuity controls.

Since most of the SAS 70-like reports went beyond the traditional financial statement audits and addressed issues traditionally related to the Trust Services principles of the AICPA12, in 2011, the Auditing Standards Board (ASB) replaced SAS 70 with a new attestation standard13, SSAE 16, Reporting on Controls at a Service Organization, to deal with some of the Cloud computing-specific issues. The new standard, also in accordance with the

ISAE 3402 of the International Auditing and Assurance Standards Board (IAASB),14 allows the employment of three Service Organization Control (SOC) reports: SOC 1, SOC 2, and SOC 3 in Type I and Type II formats. For practical purposes, because of close cooperation between the two organizations, there are insignificant differences between SSAE 16 and ISAE 3402.

Auditors for the user organization must be able to assure the integrity and availability of any company data residing in the Public Cloud.

Type I and Type II Reports:

Under SSAE 16, just like SAS 70, the service auditor can issue either Type I or Type II reports.15 A Type I Report includes management’s description of a service organization’s system and the suitability of the design of controls at a given moment in time. A Type I report does not deal with the effectiveness of the controls. On the other hand, the Type II report deals with the design and operating effectiveness of controls for a time period, such as a year or quarter. Because of its scope, the Type II report is usually preferred.

Under SAS 70, it was the auditors who reported directly on the controls. This was a communication between the auditors involved. The management of the service provider was not required to attest to anything. Under SSAE 16, the management of the service provider is required to prepare a written assertion attesting to the fair presentation and design of controls.

SOC 1, SOC 2 and SOC 3 Reports:

Under SSAE 16, the auditor’s task is essentially to issue a report, called: Service Organization Control (SOC) on the design and description

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of controls that may be relevant to the user entities’ needs. The SOC reports may be in three distinct forms: SOC 1, SOC 2, and SOC 3. Each one of these reports may be combined with Type I or Type II reports.

1. SOC 1 Reports: The SOC 1 Report is prepared in accordance with AT 801 by an independent service auditor. SOC 1 reports require a detailed description of the service organization’s controls that are likely to be relevant to a user entity’s internal control over financial reporting (ICFR) system along with a written assertion by management.16 SOC 1 framework places greater emphasis on the ICFR component for service organization than SAS 70. The SOC 1 report requires that the risks related to the financial reporting processes are adequately addressed. Service organizations, such as payroll processing and medical claim processing, which initiate and process a business process from beginning to the end, are the best candidates for SOC 1 reports.

2. SOC 2 Reports: The SOC 2 and SOC 3 reports, based on AT Section 101, Attestation Engagement, go beyond the financial reporting assurances of SOC 1 reports. The SOC 2 reports are designed to deal with issues uniquely related to ever expanding computer based service entities, such as data centers and Cloud computing. For instance, an entity providing on-line admission services for a university has to provide assurances to the service user (university) on the privacy and confidentiality of personal information collected. In this instance, there is no direct link to the financial statements (i.e. ICFR). The SOC 2 reports, issued by the service organization’s auditor, provide assurances

about Security,17 Availability,18 Processing Integrity,19 Confidentiality20 and Privacy21 to the users of the service. In a Type II-SOC 2 report, a description of the service auditor’s tests of controls and the results of the tests will be reported. For instance, in a Type II-SOC 2 report that addresses the privacy concerns, a description of the service auditor’s tests on privacy or security and the results of those tests should be listed.

In the event of a contract termination…the Cloud computing service provider must wipe out the user data permanently. The following are the principal components of a Type II SOC 2 report for a typical service provider:22

• Description of the service organization’s system by the management of the service provider.

• Written assertion by the service provider’s management on security, availability, processing integrity, confidentiality and privacy controls are fairly presented and suitably designed and operating effectively.

• Service auditor’s opinion of the fairness of the description of service organization’s system, the suitability of the design of the controls to achieve specified control objectives, and in a Type II report, the operating effectiveness of those controls.

• In a Type II report, a description of the service auditor’s tests of the controls with their results will be added.

3. SOC 3 Reports: SOC 2 reports can be distributed to any user entity. The SOC 2 report is not distributed to other users, such as sub-vendors, without the permission of service organization. On the other hand,

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an SOC 3 report is a general-use report and can be freely distributed. In contrast to SOC 1 and SOC 2 where there is a Type I option, a SOC 3 report is performed as a Type II only. A SOC 3 report provides only the auditor's report on whether the system achieved the trust services criteria.23 There is no description of tests and results or opinion on the description of the system SOC 3 report. Typically, the entity will be allowed to place a seal on their website upon successful completion.

Questions for Auditor of a Cloud Computing User

As stated above, the SOC 2 report focuses on non-financial controls as they relate to confidentiality, integrity, and availability. On the other hand, the SOC 1 focuses on financial reporting controls.

During the first year of the implementation of SSAE 16, some Cloud computing providers have opted for SOC 1 in place of SOC 2. There was a noticeable hesitation in the issuance of an SOC 2 report in the Cloud computing sector, as seen in the example of Google’s app engine. When a well-known Cloud computing provider like Google provided assurances in a technically-incorrect SOC 1 framework, there were doubts about the implementation of the SOC reports. Currently, many assurances in the Cloud computing sector, including Google, are in the form of Type II – SOC 2 reports.24

Regardless of the reporting framework, and because of the complicated nature of Cloud computing service delivery and deployment combinations, the auditor in a Cloud computing environment should go beyond the traditional service level agreements (SLA).

The following are some of the Cloud computing specific questions that should be addressed by the Cloud Computing user’s auditors:

• International Dimension and Privacy: Since the Public Computing Cloud has no national borders, the corporate data may reside in other countries with different rules and regulations about the organizational data. The privacy rules of one country do not apply uniformly across the globe. How can the Cloud computing user ensure compliance with laws prohibiting data from being stored in certain countries? How can the privacy of the organizational data be assured in another country?

• Security Breaches: One of the most common concerns in the digital world is security breaches. How will the Cloud computing provider identify, respond to, correct, and disclose data or other security incidents that negatively affect the user company and its customers? What are the user organization’s audit rights for data loss or data breach?

• Privacy and Encryption: Who can access the user data when it is at rest or in transit on a provider platform? What type and level of encryption is employed while the data is in transit or at rest? Who controls the encryption key? What is the location of the encryption key? What types of controls or procedures are in place to restrict privileged users within the Cloud computing environment from viewing or modifying the sensitive data stored in the provider’s infrastructure?

• Audit Rights, Integrity and Availability: To remain in compliance with Section 404 of the Sarbanes Oxley Act, the auditors for the user organization must be able to assure the integrity and availability of any company data residing in the Public Cloud. What are the audit rights (or forensic privileges) for the user organization? What rights does the user organization have in case of forensic investigations? In a multi-

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tenant environment, what measures are employed by the provider to segregate the client’s data from the data of other clients? In a multi-tenancy case, how does the provider secure the media access control (MAC), and the IP addresses from the other users? Recovery time objective and back up frequency should be consistent with the enterprise security policy.

• Exit Strategy: It may not be frequent, but some Cloud providers will go out of business as the competition intensifies in the industry. Moving from one Cloud computing provider to another will be close to impossible because of compatibility-related issues in data, program and operating system differences. In the event of a contract termination, the disclosure of programs and data on the Cloud computing servers may create opportunities to attack the user. Therefore, the Cloud computing service provider must wipe out the user data permanently.

Below is an additional list of other factors the Cloud computing user and its auditor should consider for an exit strategy should the service provider fail to deliver on its SLA because of

• changes in price

• changes in ownership

• bankruptcy

• soured relationships

• data security or privacy breaches

• fall behind its competitors

• prolonged outages

Conclusion

As a new form of outsourcing, Cloud computing is here to stay because of the

economic advantages it provides to the user. However, there are significant risks associated in the audit of Cloud computing. Most of those risks are related to the hardware, software, and infrastructure of Cloud computing. From a financial reporting point of view, a Type II SOC 1 report would be considered sufficient for many outsourcing engagements based on the assumption of independence of the computer system from the financial information.

The same cannot be said for Cloud computing because of its dependency on the computer technology. In a Cloud computing arrangement, the risks associated with the computer technology are an integral part of the financial reporting risks. The server, the operating system, the programs, and the data are not visible to the auditor of the Cloud computing user. Any failure in the Cloud computing hardware and software will lead to a financial reporting problem. In Cloud computing, it is impossible to think of a computer risk independent of the financial reporting risk.

…there are significant risks associated in the audit of Cloud computing

Therefore, an assurance Cloud computing system as a whole is needed. For this purpose, a Type II SOC 2 report for Cloud computing provides the highest level of assurances for confidentiality, integrity, and availability. As the popularity of Cloud computing increases, more Type II SOC 2 reports are expected.

Endnotes

1 http://idcdocserv.com/1414

2 http://www.ssae16.org/white-papers/soc-1-vs-soc-2.html

3 National Institute of Standards and Technology

Special Publication 800-145 (January 2011)

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4 www.cloudsecurityalliance.org

5 www.enisa.europa.eu

6 www.isaca.org

7 www.nist.gov

8 http://www.gsa.gov/portal/category/102371

9 Listed below are a sample of industries and

business sectors that have undergone SAS 70

reporting: Credit Card Processing Platforms,

Internet Service Providers (ISP), Web Design

and Development, Web Hosting, Social Media,

Data Centers, Medical Billing, Print and Mail

Delivery, Online Fulfillment, Rebate Processing,

Transportation Services, Payroll Services.

10 An entity’s internal control and the impact a

service organization may have on the entity’s

control environment has been an important issue

for AICPA - e.g., SAS 44 (December 1982) “Special

Purpose Reports on Internal Control at Service

Organizations”, and SAS 94 (May 2001) “The

Effect of Information Technology on the Auditor’s

Consideration of Internal Control in Financial

Statement Audit.”

11 Over the years, user organizations started

requesting “SAS 70-Like” reports that address

more than just their financial reporting controls.

For instance, a service user organization in the

health sector would like to assess the provider

organization’s ability to comply with the U.S. Health

Insurance and Accountability Act (HIPAA). Clearly,

this compliance-related request is not directly

related to the financial reporting.

12 Trust Services principles and criteria are issued

by AICPA and the Canadian Institute of Chartered

accounts (CICA). Typical Trust Services’ engagement

deal with security, availability, processing integrity,

confidentiality or privacy concerns. http://www.

aicpa.org/interestareas/informationtechnology/

resources/trustservices/pages/default.aspx

13 In an attestation engagement, the CPA reports on

the reliability of information or an assertion made

by another party.

14 http://www.ifac.org/auditing-assurance. From

a practical point of view, there are no significant

differences in both attestation standards.

15 http://www.aicpa.org/Research/Standards/

AuditAttest/DownloadableDocuments/AT-00801.pdf

16 The written assertion was not required by SAS 70.

17 Security – The system is protected against

unauthorized access (both physical and logical).

18 Availability – The system is available for operation

and use as committed or agreed upon.

19 Processing Integrity – System processing is

complete, accurate, timely, and authorized.

20 Confidentiality – Information designated as

confidential is protected as committed or agreed

upon.

21 Privacy – Personal information is collected, used,

retained, disclosed, and/or destroyed in accordance

with established standards.

22 http://www.cloudlock.com/blog/cloudlock-

completes-soc-2-type-2-certification-elevating-the-

standard-for-securing-information-in-the-cloud

23 SOC 3 reports can be issued on one or multiple

Trust Services principles, which are security,

availability, processing integrity, confidentiality, and

privacy.

24 http://aws.amazon.com/compliance/soc-faqs/

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Abstract

Academic institutions and programs face challenges in a higher-education environment that is confronted by overcapacity and increased competition, rising costs, a declining population of prospective traditional students, and a difficult job market for graduates. Educational institutions and individual academic units must respond to the new “higher education reality” to remain competitive, relevant, and viable, especially given the emergence of massive-open online courses (MOOCs). Based upon input from participants at American Accounting Association (AAA) meetings, we suggest how metropolitan and regionally-focused accounting programs can maintain their enrollments, or even thrive. These results should be of interest to administrators of accounting and non-accounting programs [who can adapt some of these results]; to faculty members [who depend upon high enrollments to maintain their positions]; and to alumni [who want to see their Alma maters do well].

Introduction

Higher education faces major challenges that soon will impact many academic institutions and programs. These environmental

challenges include declining numbers of traditional high school graduates starting college, more students attending college part-time, decreased financial resources, high student loan debt, and poor job prospects for many college graduates (e.g., see Pathways Commission Report, 2012). Emerging for-profit universities and on-line programs have led to an over-capacity situation with intense competition for students among different types of institutions offering similar degree programs.

Massive open online courses [MOOCs] also will soon allow vast amounts of students to take courses from such prestigious programs as Harvard, MIT and Wharton (Due, 2013), often for a small fraction of the cost of traditional programs (Kessler, 2013). Such prestigious schools as the University of Michigan, University of Virginia and Northwestern University have recently started MOOC MBA programs (Zlomek, 2013). Belkin (2013) notes that “top ranked” Georgia Tech has recently extended the MOOC program to a full on-line Masters in Engineering program, lowering total tuition from $44,000 to $6,600 and more than doubling its prior enrollments.

The objective of this paper is to examine some changes affecting the environment of higher

Strategic Planning for Metropolitan and Regionally-Focused Accounting ProgramsAlan Reinstein, Wayne State University, Michigana.reinstein@wayne.edu Mark Higgins, University of Rhode Island, Kingston, Rhode IslandMarkhiggins@uri.edu

James E. Rebele, Robert Morris University, Moon Township, Pennsylvaniarebele@rmu.edu

85

education in general, and of metropolitan and regionally-focused accounting programs in specific. We provide methods for administrators, faculty, students, alumni and other friends to enable such programs to survive and thrive as they face ever-increasing competitive challenges. Nance-Nash (2012) stresses that in 2011 students borrowed $117 billion to pay for college, averaging $26,000 per undergraduate student, many of whom are so underemployed or unemployed that repaying such debts seems unlikely.

This, coupled with budget shortfalls, such as the California State University’s projected $750 million shortfall, could impair the continuation of federal loans or loan guarantees—and of overall student enrollment. Finley (2013) adds that the recent increase of federal aid to college students is unsustainable, growing from $231 million in 1964 to $105 billion today, while student grants rose from $6.4 billion in 1981 to $49 billion today—all added to $1 trillion of federal student loan balances.

The Pathways Commission (2012) … urged professors and practitioners to work together to meet challenges facing academic accounting programs

Many prospective students and their parents now question the value of a college degree, balancing the high cost of a college education with potential unemployment or underemployment after graduation. Available data show that over half of recent college graduates are either still looking for employment or employed in positions not requiring college degrees (Weisman, 2012). Stories about recent college graduates working as baristas, car rental agents, or retail clerks illustrate that attending and graduating from college may no longer be a sure path, or even the best path, to a satisfying career and

financial independence and security.

Many Metropolitan and Regionally-Focused (MRF) and other programs also face increased faculty costs. Leslie (2008) found that while the number of accounting faculty at baccalaureate degree programs fell by more than 19 percent from 1994-2004, the average age of their accounting faculty was 57, implying that half of current accounting faculty are eligible to retire within the next ten years. More recently, the American Accounting Association [AAA] (Eigelbach, 2013) found 284 open positions for accounting professors’ positions, and predicted 574 accounting faculty retirements within five years, more than one for each of the 546 schools surveyed. Since U.S. institutions historically graduate fewer than 150 accounting Ph.D.s annually (Hasselback, 2013), many programs will face expensive costs to replace retiring doctoral-qualified accounting faculty and to maintain AACSB doctoral faculty standards.

Students and parents increasingly demand “return on investment” information from academic institutions, and so universities and individual programs must document that financial and time commitments will derive solid job opportunities with acceptable financial compensation. Gone are the days of “input-first” educational models, which allowed schools to focus mostly on achieving recruiting goals to fill a class and meet budget needs. Today, students’ and parents’ decisions focus on the educational process and post-graduation results. Academic institutions must do the same.

How universities and academic programs respond to this new educational reality will largely determine their future relevance and viability. Academic institutions and accounting programs must understand and evaluate their environments and then plan curricula, courses, and related activities to best prepare students

Strategic Planning for Metropolitan and Regionally-Focused Accounting Programs

86

for careers in a highly competitive job market. Going beyond a “one-size-fits-all” solution, different types of institutions and programs must develop responses to the unique characteristics of their environments.

Metropolitan or regionally-focused (MRF) accounting education programs are characterized as located in or near urban areas, and they focus on strategic issues facing their areas. Their students mostly come from this urban area or region, and want to stay in this location upon graduation. (Non-accounting programs can also adapt many of these ideas.)

Many MRF institutions have religious affiliations (e.g., St. Louis University, St. John’s University and DePaul University) or differ from many large state programs whose students come from broad geographical areas and are often located in more rural areas.

MRF programs often have a higher proportion of part-time, adult, minority, and commuting students than do larger state institutions. Some exceptions to this classification and characterization exist; e.g., large state institutions such as Georgia State, Temple, and Wayne State are located in urban areas. But MRF accounting programs have enough unique characteristics to warrant separate strategic planning consideration and discussion.

Nationally, accounting graduates are in high demand

Universities, such as the University of Wisconsin and Northern Arizona University, will soon offer college degrees without requiring class time (Porter, 2013)—granting credit and degrees based on knowledge demonstrated through successful completion of examinations and not on course attendance. Also, some universities place Executive MBA or other business programs far from their campuses in order to compete with MRF programs

(e.g., Michigan State University, Binghamton University and Baylor University), offering Executive MBA programs in Troy (near Detroit), New York City and Dallas, respectively.

Our next section reviews the primary literature on strategic planning in accounting education. We then identify key elements of the MRF higher-education environment, and discuss some resultant implications for strategic planning. We also present input from roundtable sessions on strategic planning for MRF programs, held at several AAA meetings. Strategic advantages for MRF programs provide opportunities to attract, educate, and place students, which we highlight in Figure 1.

Strategic Planning in Accounting Literature

Accounting education has long adapted strategic planning initiatives to, for example, revise curricula, courses, and pedagogy in response to prior calls for change to meet new or increasing practice demands (e.g., Arthur Andersen et al., 1989; AECC, 1990; Albrecht and Sack, 2000). Several articles suggest how to assess the higher education environment and how accounting programs should conduct strategic planning exercises. For example, Rebele (2002) identified some important components of the higher education environment and discussed how accounting programs should respond to changes in their environments. Nelson et al. (1998) provided a strategic-planning template that includes studying markets and competition, developing a strategy, designing a product, and implementing change.

Using KPMG’s Business Measurement Process, Barsky et al. (2003) found that school missions, preferences in learning styles, and appeal of student extracurricular activities affect accounting enrollments. They suggest that accounting departments partner with complementary academic disciplines (e.g., finance and information systems) to

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prepare graduates for the complex business environment, use their best faculty to teach introductory accounting classes, and improve their advising practices.

Billiot et al. (2004) found that inadequately prepared (especially in math) high school seniors reduced the pool of college freshmen eligible to successfully complete undergraduate accounting degrees. Frecka and Nichols (2004) suggested that programs should emphasize AICPA-defined functional competencies, such as leadership; project management; industry, global, and legal perspectives of business competencies. Reckers (1996) stressed that accounting programs must recognize basic market factors (e.g., identify our customers and their product characteristics), and basic

production factors (e.g., which teaching methods most effectively and efficiently provide value to our students in immediate job placement, in life-long learning and in career success).

Much of the strategic planning literature for accounting education assumes that all accounting education programs would benefit from a “one-size-fits-all” solution to a perceived common problem. But accounting education programs often differ, sometimes significantly, in mission, size, student backgrounds, faculty qualifications, resources, geographic location, and placement of graduates. Wal-Mart and Nordstrom’s do not face the same strategic issues, nor do they pursue similar strategies simply because

Strategic Planning for Metropolitan and Regionally-Focused Accounting Programs

• Highlight advantages of such locations• Develop non-degree programs• Have high-level practitioners teach niche classes• Increase internship opportunities with nearby CPA firms and

companies• Encourage joint student-faculty projects to solve local “real

world” problems. • Engage advisory board on an on-going basis

• Part-time employment opportunities in urban location • Offer graduate and certificate programs• Access to entertainment, cultural and sporting events• Proactively approach perceived safety issue

• Faculty internship opportunities• Emphasize the ability to collaborate with practitioners on research

projects and articles • Joint research seminars with nearby accounting programs

ADVANTAGES OF AN

URBAN LOCATION

RECRUITING

STUDENTS

FACULTY

DEVELOPMENT

Figure 1: Areas for Metropolitan and Regionally-Focused Development

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both are retail stores. Differences in business environments and type of retailer present some distinct strategic issues that require unique or tailored responses. Similarly, accounting education programs, which often differ greatly, should identify and pursue strategies given their individual external and internal environments.

Universities and individual academic programs must act competitively to attract new students.

The Pathways Commission (2012) “was structured to involve accounting educators and active practitioners, as well as regulators, administrators, and other stakeholders through an innovative ‘supply chain’ approach to gathering data and considering issues.” (Black 2013 p. 601). It examined key changes affecting accounting education, including the need to revise accounting curricula regularly in light of fast-paced business changes, budget constraints that threaten to make the cost of education prohibitive, and the need for training in specialized areas to meet the profession’s demands. The Commission identified barriers and related solutions to change, and urged professors and practitioners to work together to meet challenges facing academic accounting programs, which become critical in our competitive environment.

Environments for MRF Accounting Programs

Similar to any business organization, external and internal environments affect accounting education programs. A program’s external environment encompasses conditions outside its university, including economic and higher education factors in its region. Accounting programs reside within universities and, most often, within schools of business. Programs are therefore also affected by factors outside the

department level, but within the educational institution. A program’s internal environment would also include factors related to its own department, such as faculty qualifications. Some major components of an accounting program’s external and internal environments are identified and discussed in the following sections.

External Environment:

Value-driven prospective college students and their parents often focus on the placement of an academic department’s graduates. While regional differences in employment exist, nationally, accounting graduates are in high demand (AICPA, 2011). Accounting programs should publicize this employment advantage, especially when students and parents consider what happens after college at least as much as they consider what happens at college.

Given higher education’s overcapacity problem, universities and individual academic programs must act competitively to attract new students. Many urban areas have a fairly high concentration of colleges and universities, with almost all offering accounting and other business majors. Metropolitan and Regionally-Focused programs face added competition from for-profit institutions (e.g., Strayer University, DeVry, and the University of Phoenix), which generally rent space rather than maintain expensive campuses. On-line programs and MOOC are also available to students from any geographic area, which are especially attractive to those who currently work or have limited time available to attend school full-time. It is unclear exactly how on-line programs affect MRF institutions, but they nonetheless present themselves as significant competition.

Changing student demographics present new challenges and opportunities for MRF accounting programs. The declining

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populations of high-school graduates planning to attend college often leads academic institutions to meet enrollment goals by appealing to nontraditional student populations. Future student populations will thus probably include more international students, as well as older students who are attending college part-time. This is actually to MRF accounting programs’ advantage, given their location and history of serving non-traditional students.

Internal Environment:

Similar to external environmental conditions, accounting programs cannot control internal environmental conditions. As part of an overall campus community, departments rarely control overall strategies, resource allocations or budgets, accreditations, faculty hiring, and other decisions that often constrain a program’s ability to plan strategically. University and school level decisions can be made without faculty or accounting program administrators’ input, although the consequences of these decisions will affect the accounting program.

This limited ability to control their internal environments raises the question as to whether accounting programs can plan strategically. That is, without control over decisions and resources, can programs set their own direction and take steps to strengthen student recruiting, the educational process, and placement of graduates? Feedback from AAA meeting roundtable participants presented in the next section shows that there are many things that MRF accounting programs can do to become more competitive.

Changing student demographics present new challenges and opportunities for MRF accounting programs.

AAA Roundtable Sessions

A co-author of this article received a 2008 AAA financial grant to conduct roundtables at seven regional and one national AAA meetings to generate ideas for how to strengthen MRF accounting programs. Each panel included four to five accounting academicians and practitioners from regional and national CPA firms, who facilitated discussion and encouraged audience participation to generate ideas for strengthening MRF accounting programs.

The co-author sent letters inviting MRF accounting program department chairs or their representative to participate in the roundtables. Invitees were told that the sessions sought to exchange ideas on how to help MRF programs thrive. More than 30 individuals participated in each roundtable session, generating about 300 meeting participants, overall.

Participant Comments:

The panel leader recorded and transcribed the roundtable session comments and sent them to the panelists to check for their accuracy and to solicit further input. Some general themes emerged in the participants’ responses, and the following classification was used to interpret the comments: (1) advantages of physical location, (2) recruiting students, and (3) faculty development. The following sections present individual and summary comments for the three classifications. In some cases, relevant articles from the accounting education literature are identified to aid readers in pursuing roundtable participants’ suggestions.

Physical Location:

MRF accounting programs often enjoy the key advantage of a physical proximity near the business community, including employers, potential employers for graduates, and alumni.

Strategic Planning for Metropolitan and Regionally-Focused Accounting Programs

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Roundtable participants identified some ways for MRF programs to capitalize on this advantage:

• Being located near firms and companies offers many opportunities for current students to complete internships, either during the academic year or over the summer break. Internship employers include corporations, varying sized CPA firms, and government agencies. Most MRF students are from the geographic area near the school, so moving to complete an internship may not be necessary.

• Geographic location was also perceived as providing graduates from MRF accounting programs with an advantage in the job market. Part of this comes from networking opportunities MRF students have during their academic careers and from internships offered by local firms and companies.

• MRF programs could hire high-level accounting practitioners and corporate and not-for-profit leaders as part-time faculty, bringing relevant technical expertise and experience to their students, especially for such niche courses as State and Local Taxation and Advanced Internal Auditing. Practitioners are available locally and could be used as part-time faculty by many programs. Using practitioner part-time faculty members should strengthen ties between MRF programs and the CPA firms and other entities. This can help buttress the ties between academe and practice—a key Pathways Commission recommendation, as well provide access for internships and professional positions to qualified students. While AACSB accreditation standards might limit this opportunity for some MRF programs, since such standards are “mission-driven,” MRF programs should make such practitioner interaction a key part of their missions.

• MRF departments could develop and offer non-degree programs in, for example, tax crimes, forensic accounting, and international financial transactions—which high-level, experienced accountants can often help to staff. Since MRF accounting programs are often located near major medical centers, providing courses or programs on health care accounting could be effective.

• Course projects at MRF programs might involve practitioners to mentor students or to evaluate students’ final “real world” projects. Projects might also focus on specific issues local firms or companies face, providing students with real-world, practical perspectives to their education. Since many MRF students attend class part-time and have outside commitments that impair getting together for group meetings, such programs should offer dedicated space for group meetings in the evening and provide technology, at low or no cost, to help interact electronically.

MRF accounting programs often enjoy the key advantage of a physical proximity near the business community

• While many accounting programs have advisory boards made up of alumni and other stakeholders, MRF programs’ close proximity to board members enhances interaction with faculty and administrators, plus board member involvement with students. Schwartz and Fogg (1985) discuss how an urban accounting program (Temple University) used its location to attract advisory board members, noting that rotating board membership can accommodate various interests and provide fresh perspectives on the complex problems urban accounting programs face.

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• Greater interaction between MRF program faculty and accounting practitioners was viewed as being advantageous for fundraising; specifically, funding for faculty research projects having a practical orientation.

• Overall, being located near the business community was viewed as giving MRF accounting programs an advantage in providing students with a practice-oriented education. Interaction with accounting professionals was perceived as helping to produce graduates who are more business savvy and who could contribute immediately to client services.

Recruiting Students:

Participants identified several factors that MRF program administrators and admissions counselors should stress when recruiting prospective students, including:

• The availability of part-time employment, which is critical because many students who attend MRF universities fund their education, in part, by working while going to school. MRF accounting programs should emphasize to potential employers that their students are highly motivated and capable of juggling many tasks (school and work) and pressures simultaneously.

• Promote the excitement of living in an urban environment and having access to entertainment, sports, and cultural events.

• Counter the perception that urban schools might have safety issues by emphasizing an institution’s efforts to ensure student safety. Many MRF programs can provide data to document the safety of their campuses. Current students can also address this issue with prospective students and their parents. Addressing the safety concern in a proactive and positive manner can help alleviate the

misperception that some might have about safety so that students and parents can view MRF universities as a great place to pursue an education and to interact with a diverse group of students.

• Host an annual Community College Day where programs invite students from area community colleges to spend a day on campus. Prospective transfer students can meet faculty, current students, alumni, and advisory board members, and learn about the university and accounting program. Follow-up communication with prospective transfer students inviting them to matriculate is important for successful recruitment. Reinstein and Garr (1995) present ideas for implementing an effective program to recruit community college students to MRF accounting programs. Similarly, Law et al. (2009) describe a student-practitioner program for current and prospective students to learn about accounting as a career.

• MRF accounting programs should offer graduate courses to attract alumni from more rural accounting programs who work in urban areas after graduation. Many of these students cannot afford to attend their undergraduate institution’s graduate program full-time, and look for part-time, evening programs near their work location to complete their education. Flexible course schedules were viewed as being important for attracting graduate students.

• MRF accounting programs are well positioned to offer certificates in accounting for students wanting to meet the 150-hour certification requirement and for those wishing to focus in such specialized areas as taxation and internal auditing. Such programs are attractive to students who possess non-accounting

Strategic Planning for Metropolitan and Regionally-Focused Accounting Programs

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or non-business undergraduate degrees. Flexibility in offering courses, either in the evening or on-line, is important for success in recruiting students to certificate programs.

Faculty Development:

Roundtable participants identified several advantages for MRF programs related to faculty development, including:

• Faculty internships being available for MRF faculty. More regular interaction with local accounting practitioners and not having to move to complete a faculty internship were viewed as advantages for MRF faculty.

• Collaborating with accounting practitioners will likely enhance MRF programs conducting applied, or practice-oriented, research—especially for faculty who were not recent Ph.D. program graduates and who still needed to maintain “academically-qualified” status for accreditation purposes.

• MRF faculty might have better access to practitioners who would participate as subjects in research projects.

• Given the number of accounting programs in most urban areas, nearby MRF programs could conduct joint research seminars. Programs could share the cost of conducting seminars, and interaction with other MRF faculty would provide opportunities to get feedback on research ideas or manuscripts, and to collaborate with faculty from other schools. MRF accounting programs in the Boston area have run a successful research seminar for years.

Implications for Non-Accounting Administrators

Non-accounting administrators can apply many of the above suggestions, including

coordinating their efforts with accounting faculty, e.g., emphasize to parents, students and recruiters about the (1) closeness of school’s physical location to the students’ homes; and (2) propensity for many qualified graduates to remain near campus upon graduation. They should also recruit junior college faculty members to teach courses, in order to strengthen relationships between MRF programs and those who could “feed” them future students. In addition, they should develop innovative business degree and non-degree programs (e.g., to benefit physicians, attorneys, nurses and architects), as well as recruit quality community college graduates and establish effective advisory councils. Moreover, accounting and non-accounting faculty should work closely to develop common strategies to thrive or even survive in this growingly competitive environment.

Flexible course schedules were viewed as being important for attracting graduate students.

All accounting and non-accounting business faculty should help recruit and retain quality students, both for the need to educate and place the brightest students possible, and to minimize the risk of layoffs if enrollment numbers decline. Business faculty generally earn substantially higher salaries than their liberal arts and other non-business colleagues, making college presidents and provosts (who often are liberal arts majors) more likely to retain, say, two English professors rather than one business professor when state funding and tuition dollars shrink significantly. Such faculty should thus help maintain enrollments by, for example, (1) meeting with potential students and their families; (2) becoming active in accounting and other business organizations to develop contacts to help competent students obtain internships and professional positions; and (3) participating in community college,

93Strategic Planning for Metropolitan and Regionally-Focused Accounting Programs

advisory council and other events with key stakeholders.

Summary and Conclusion

Universities today face major challenges, such as overcapacity and increased competition from traditional and non-traditional educational institutions; emerging technologies (e.g., MOOCs and other on-line courses); changing student populations and demographics; high cost of a college education; increasing and more expensive student loan debt; and a difficult employment market that is causing questions about the value of a college education. Accounting and other business education programs are not insulated from these challenges, although the relatively robust job market for accounting graduates makes the major attractive to more prospective students and their parents. Such programs must, though, plan strategically to respond to challenges in higher education and to remain relevant and viable.

We examined MRF accounting education programs, identifying some of their key strategic advantages, and suggest how non-accounting MRF programs can apply many of these ideas. AAA meeting roundtable participants’ suggestions generally related to a program’s external environment. They noted that location near major business centers provide students with an engaged, real-world education, interaction with accounting and business professionals, fundraising, and faculty development, which are all strategic advantages for metropolitan and regionally-focused accounting programs. Programs that pursue even some of the suggestions from roundtable participants will be better able to strengthen their student populations, the education that students receive, and the placement of program graduates.

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