Accounting Research Tools and Strategies, 7th Edition Thomas R Weirich, Thomas C Pearson, Natalie Ta

Accounting Research Tools and Strategies, 7th Edition By Thomas R. Weirich, Thomas C. Pearson, Natalie Tatiana Churyk

Email: Richard@qwconsultancy.com

Accounting & Auditing Research: Tools and Strategies 7th Edition SOLUTIONS MANUAL Thomas R. Weirich, PhD, CPA Thomas Pearson, LL.M., J.D., CPA Natalie Churyk, PhD, CPA

CHAPTER 1 INTRODUCTION TO PROFESSIONAL RESEARCH Discussion Questions 1. Research in general involves the investigation and analysis of an issue in question. The researcher usually applies reasonable and reflective thinking to develop an answer to the issue or problem at hand. Research requires a clear definition of the problem, using professional databases to search the authoritative literature, reviewing and evaluating the data collected, drawing conclusions and communicating your rsults.

2. Accounting, auditing, or tax research involve a systematic and logical investigation of an issue or problem using the accountant’s professional judgment. Furthermore, accountants approach this problem using critical-thinking skills to obtain and document evidence underlying a conclusion relating to an issue or problem currently confronting the accountant or auditor.

3. Accounting, auditing, or tax research are necessary in order to determine the proper recording, classification, and disclosure of economic events; to determine compliance with authoritative pronouncements; or to determine the preferability of alternative accounting procedures.

4. The objective of accounting, auditing, or tax research is a systematic investigation of an issue or problem utilizing the researcher’s professional judgment to arrive at appropriate and timely conclusions regarding the issues at hand.

5. Research plays an important role within an accounting firm or department. It is critical for the accountant/auditor to be able to find and locate applicable authoritative pronouncements and to ascertain their current status. Given the number and diversity of clients served, public accounting firms constantly engage in research on a wide array of accounting, auditing, or tax issues. This 1

research process is usually conducted by the local office staff, selected local or regional "research specialists," and/or the executive office research personnel.

6. The functions of a multi-office CPA firm's Policy Committee are to evaluate significant accounting and auditing issues and establish firm-wide policies on these issues. Its Executive Subcommittee handles daily ongoing policy (i.e., lower-level) decisions for the firm as a whole.

7. Some basic questions that the researcher must address in performing, accounting, auditing, or tax research include: Do I have the knowledge to do the research?; What is authoritative literature?; Does authoritative literature address the issue?; If authoritative literature does exist, where can I find it?; If there exist more than one alternative of authoritative support, which one do I use?; If authoritative literature does not exist, what do I do?; What professional databases do I use?

8. Theoretical (pure or basic) research involves investigating questions that, while interesting, have little or no present, practical applications; while applied research involves investigating issues of immediate, practical importance.

9. Some of the characteristics that a practitioner-researcher should possess include inquisitiveness, open-mindedness, patience, thoroughness, and perseverance.

10. The “Research Navigation Guide” serves as a tool in navigating through the authoritative literature. The guide helps to focus or narrow one’s research when utilizing various databases like the FASB’s Codification System. One would first focus on a functional area like “Financial Accounting”. Once the functional area is identified then focus on the broad categorization of the topic such as “Revenue”. This is followed by focusing on the subtopic that allows for further segregation of the issue “Software Revenue”. The final step would be to focus on the section or nature of the content of the issue which is often a recognition, measurement, or disclosure issue such as “Recognition of Software Revenue”.

11. While a priori (before the fact) research refers to research before the client actually enters into the (proposed) transaction, a posteriori (after the fact) research refers to research relating to past or completed economic transactions. For planning purposes, the practitioner would rather be involved with a priori research to work with the client to develop a correct solution rather than attempting to correct a completed transaction.

12. The California court decision stresses that "well-informed" accountants are expected to master "standard research techniques" (or face severe malpractice claims).

13. The research process "adds value" to an accounting firm’s services, since today's complex business transactions and proliferation of new authoritative pronouncements mandates that the firm efficiently and effectively conduct such research for their clients.

14. Some economic consequences to the standard-setting process of performing research include the impact of such pronouncements to investors and creditors resource allocation decisions in 2

today's (competitive) capital markets, and the cost/benefit analysis of the issuance of a new standard.

15. Since the accounting and auditing literature is organized with a keyword indexing system, listing keywords in step one of the research process will aid the researcher in locating the authoritative literature in an efficient and effective manner. Failure to describe the keywords in sufficient detail can cause one to overlook important sources.

16. The five steps involved in the research process include: identifying the (research) issue, collecting the (appropriate) evidence, evaluating the results and identifying alternative solutions, developing (appropriate) conclusions, and communicating the results to the interested parties.

17. Research can support or refute a biased alternative by gathering evidence that is either unbiased or slanted toward the alternative being researched. Since the researcher should be unbiased in evaluating the various alternatives, the process often requires a (detailed and logical) analysis of complex and detailed accounting issues--thereby requiring "critical thinking" skills.

18. Problem distillation entails "refining" and "restating" the research issue from general to sufficiently specific terms, in order not to waste time investigating irrelevant items.

19. The skills tested on the CPA exam include: understanding, analysis, judgment, communication, RESEARCH, and synthesis.

20. A research memorandum should contain such attributes as selecting objective and unbiased words; a grammatically correct and well-spelled, clear statement of the issue researched; a statement of the facts; a brief and precise discussion of the issue; and a straightforward conclusion based upon supported and identified authoritative literature.

The researcher should avoid making such common errors as excessive discussion of the issues and facts, excessive citations to authoritative sources, avoidance of presenting a conclusion, and including irrelevant information.

21. Critical-thinking skills (e.g., understanding a variety of contents and circumstances and applying various accounting, auditing, and business principles to help solve the problem under review) helps the researcher effectively and efficiently gather relevant facts, synthesize and evaluate alternatives, and develop alternative solutions.

22. The SEC stressed the importance of accountants performing effective research, claiming that this CPA's deficiency constituted a lack of exercising "due professional care."

23. Although this question is raised in Chapter 1, it is not directly answered until a later chapter.

However, in Chapter 1 it briefly discusses that when authoritative literature does not exist on a specific issue, the practitioner would normally develop a theoretical solution based on logic or analogous authortitaive literature. In a later chapter we will focus on this question in detail whereby one utilizes the “FASB’s Conceptual Framework” and other authoritative literature by analogy to solve the problem.

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CHAPTER 2 CRITICAL THINKING and EFFECTIVE WRITING SKILLS FOR THE PROFESSIONAL ACCOUNTANT

Discussion Questions: 1. Critical thinking has many definitions. One definition is as follows: Critical thinking involves a process of (more deeply) understanding, evaluating, and judging the underlying issues under investigation.

2. The highest level of thinking according to Bloom’s taxonomy entails the "evaluation” of a statement (based upon definite criteria) for a given purpose.

3. In Bloom’s taxonomy, comprehension (or grasping the meaning of a statement) entails the ability of restating the item into the researcher’s own words without changing the statement's meaning--thereby entailing a higher order skill than merely paraphrasing it.

4. While critical thinking involves a process of (more deeply) understanding, evaluating and judging the underlying issues under investigation, professional skepticism entails an attitude of examining and recognizing emotional-laden, and explicit and hidden assumptions “behind” each question.

5. The qualities that lie behind rethinking include: a willingness to say that you don’t know the answer, an openness to alternatives, an interest in the ideas of others, thoughtfulness, a desire to discover what others have done and thought, an insistence on getting the best evidence, and an openness to one’s own intuition.

6. The three levels of thought by the Illinois Renewal Institute include: Recall--the lowest level, where one defines, describes, lists, recites or selects; Process--the second level, where one compares, contrasts, classifies, sorts, and analyzes; and Application--the highest level, where one evaluates, imagines, judges, and hypothesizes.

7. The AICPA’s list of effective writing characteristics include a coherent organization, conciseness, clarity, use of standard English, responsiveness to the requirements of the question, and appropriateness for the reader. The editing skills include conciseness, clarity, and the use of standard English. The composing skills include organization, responsiveness, and appropriateness.

8. Per SEC Rule # 33-7380, six principles of clear writing include using: a.

Active voice; b.

Short sentences; 4

c. d. e. f.

Everyday language; Tabular presentation of complex material; No legal jargon; and No multiple negatives.

9. Plain English writing does not mean deleting complex information. Rather, it presents documents in an orderly and clear fashion so the reader can better understand it.

10. The elements of plain English include: Know your audience; know what material information needs to be disclosed; use clear writing techniques; and design and structure the document for ease of readability.

11. The active voice uses strong, direct verbs. The subject of the sentence performs the action described by the verb. An example: “ I will respond to the client’s memo.” The passive voice is where the action is done to somebody or something by another agent. The passive voice often uses the words “be" or "been.” An example: “No one has been authorized to respond to the client’s memo.”

12. Special concerns of using e-mails include the need to develop strong writing skills as one attempts to state his or her thoughts as concisely as possible; and strong technological skills in the security of the transmission of the communication.

13. The different types of client letters include: transmittal letters that merely transmit information; status update letters that reminds the client about a situation by providing an update to the issue; action request letter requests action; and an opinion letter summarizes the situation very briefly.

14. A memo to the file documents the reasoning for one’s conclusion that might be related to a research issue. A client letter normally does not document the details of the research process.

15. A tax memo is often unique in that it usually includes the reasoning for the law or authorities used, as well as the application of the law or authorities to the client’s set of facts. The memo would include the following areas: Facts, Issues, Conclusion, and Reasoning. Chapter 7 will provide greater details as to tax issues and memoes.

Exercises: 1. The solution to this logic problem is the following: House 1 House 2 House 3

House 4

House 5

Color

Yellow

Blue

Red

White

Green

Country

America

Russia

England

Spain

Japan

5

Sport

Football

Table Tennis Hockey

Basketball

Baseball

Drink

Water

Tea

Milk

Orange Juice Coffee

Pet

Fox

Horse

Hamster

Dog

Monkey

2.

The eight elements of reasoning as to the question of when assets need to be classified as current assets are as follows: a.

Purpose—the purpose is to respond to the client’s request for information. b.

Issue—the issue is to provide a specific response to the question, "When do assets need to be classified as current assets?" c.

Information—the information for this issue would include the authoritative accounting literature. d.

Concepts—the concepts would include the concepts (definition) of an asset, and the classification between current and long-term assets. e.

Assumptions—the assumption to classify an asset as current is that it will be used up, or consumed within one year or the operating cycle, whichever is longer. f.

Interpretations or inference—the interpretation requires one to determine from the evidence whether the asset will be used up or converted into cash. g.

Implications or Consequences—If an asset is not properly classified, the analysis of the financial statements (i.e., current ratio) would be misleading. h.

Solution—An asset should be classified as a current asset when it will be converted into cash, or consumed in operations within one year or the operating cycle, whichever is longer.

3.

The eight elements of reasoning for the question of when a contingent liability should be booked are as follows: a. Purpose—the purpose is to respond to the client’s request for information. b. Issue—the issue is to provide a specific response to the question, "When should a contingent liability be recorded?" c. Information—the information for this issue would include the authoritative accounting literature. d. Concepts—the concepts would include the concepts (definition) of a contingent liability, and when to record a liability. e. Assumptions—the assumption to record a contingent liability would be that the dollar amount can be estimated and the liability is probable in occurrence. f. Interpretations or inference—the interpretation requires one to evaluate the probability of occurrence and whether the amount can be reasonably estimated. g. Implications—If a contingent liability meeting the requirements of FASB No. 5 is not recorded, then the financial statements are misstated. h. Solution—a contingent liability should be recorded if it meets the two criteria of FASB No. 5—probable and the amount can be reasonably estimated.

4. Correct punctuation: 6

a. A general ledger contains all the assets, liabilities, and owners’ equity accounts. b. The purpose of a trial balance is to prove that debits equal credits, but this does not prove that all transactions have been recorded. c. The current assets section of the balance sheet contains items such as cash, accounts receivable, and prepaid expenses; and the current liabilities section contains items such as accounts payable, notes payable, and short-term debt. d. The auditing exam was to begin at 2:00 p.m., but the professor’s car broke down, so we didn’t begin until 2:30 p.m. e. Did William ask, “ How can we finish the audit tonight because Linda said, ‘We have twenty hours of work left to do’”?

5. Examples of the sentences rewritten: a. Original sentence; For good reasons, the secretary may grant extensions of time in 30-day increments for filing of the lease and all required bonds, provided that additional extensions requests are submitted and approved before the expiration of the original 30 days or the previously granted extension. rewritten: We may extend the time you have to file the lease and required bonds. Each extension will be for a 30-day period. To get an extension, you must write us giving the reasons that you need more time. We must receive your extension request in time to approve it before your current deadline or extension expires. b. Original sentence: If the State agency finds that an individual has received a payment to which the individual was not entitled, whether or not the payment was due to the individual’s fault or misrepresentation, the individual shall be liable to repay to the State the total sum of the payment to which the individual was not entitled. rewritten: If the State agency finds that you received a payment that you weren’t entitled to, you must pay the entire sum back. c. Original sentence: Universities differ greatly in style, with some being located on out of town campuses in parkland, others having buildings scattered about parts of city centers and others being at various points between these two extremes. rewritten: Universities differ greatly in style. Some are located on out of town campuses in parkland. Others have buildings scattered about parts of city centers. Others are at various points between these two extremes.

6.

Multiple Negatives sentence rewritten: 7

Original sentence: No termination will be approved unless the administrator reviews the application and finds that it is not lacking any requisite materials.

Rewritten: Termination will be approved if the administrator finds the application to contain all requisite materials.

7.

Active Voice sentences rewritten: a. Original sentence: The fraud was reported by the employee.

Rewritten sentence: The employee reported the fraud. b. Original sentence: The book was enjoyed by me because the seven fraud investigation techniques were described so well by the author.

Rewritten sentence: I enjoyed the book because the author described the seven fraud investigation techniques so well.

8-a. By keeping $20, the bellboy changed the auditors’ rate to $270 ($250 actual + $20 stolen).

The $20 should have been subtracted from the $270 rather than added! The $300 is composed of the $250 cost, the $30 refund, and the $20 stolen.

8-b. This question involves critical thinking that will vary between students and therefore does not have a right answer. Some potential answers to the given questions include: 1) An asset “stays” as an asset as long as it generates future cash inflows to the company. Thus, an obsolete machine that continually requires much labor and other maintenance costs to keep operating could well be considered a liability— especially if cheaper technologies have arisen.

2) (Part 1) While financial statements may not report certain assets and liabilities, such as human resources (employees), or the benefits of high employee morale, the more critical question is if the presented financial statements provide useful information to decision makers: i.e., can such decision makers make more informed decisions when they use such statements than they would have if these statements were unavailable? (Part 2) Similarly, financial statements that present assets at historical costs—rather than at fair market values—should provide more meaningful information than not reporting statements that follow GAAP. Moreover, the objectivity of assets reported at historical costs usually supersedes those presented at current value.

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9-a.

3)

A liability should normally be first reported when the entity can reasonably measure the expected cash outflows associated with a financial transaction or event (and stop recognizing such liabilities when the entity can no longer meet these “reasonably measurable” criteria). For example, a firm experiencing potential environmental remediation liabilities should recognize such liabilities when it ascertains a reasonable value of the amount of such damages. SFAS No. 5 discusses this matter further.

4)

A primary advantage of using a contra-accumulated depreciation—rather than as a direct reduction to the associated fixed asset account—includes keeping better track of the original cost of the acquired asset. Disclosing both the original and accumulated (depreciation) components of a fixed asset informs the financial statement reader of what part of such assets have “expired.” Moreover, directly reducing the “used” portion of fixed assets will eventually bring such assets (i.e., at the end of their depreciable lives—unless some salvage value exists) to a ‘zero value,” while these assets actually exist.

1) The professor received his PhD from the University of Illinois, and he continued teaching there after he was finished with the program.

2) The general ledger does not balance. It must balance before we leave.

3) Did Robert say, “Can this item be classified as an asset?”

4) Susan’s investigation didn’t discover any fraud but there’s new evidence that might keep the investigation going.

5) Dear Mr. Smith,

9-b.

1) The auditor said, “We must have these work papers completed by tomorrow.”

2)When do we have to file our taxes?

3) Is the conference in Dallas or Austin, Texas?

CHAPTER 3 THE ENVIRONMENT OF ACCOUNTING RESEARCH Discussion Questions 9

1. The development of accounting standards is influenced by such environmental considerations as the requirements of federal, state, and local government, and other regulatory bodies; influence of various tax laws on the financial reporting process; practices or problems of certain specialized industries (such as the motion picture or the oil and gas industries); inconsistencies in practice; disagreements among accountants, business executives, and others as to the objectives of financial statements; and influence of professional organizations.

2. A primary reason for the establishment of accounting standards appears to be in response to the increasing needs of various financial statement users--including investors, lenders, and governmental entities; the increasing complexity of business enterprises and their underlying economic events and accounting transactions; and the increasing requests of government agencies, legislative bodies, and professional organizations to respond to this demand.

3. The FASB uses "due process" in developing its Standards, including identifying the problem or issue and considering legal or SEC pressures; deciding whether to consider the issue; establishing a task force to study the problem; having its research staff investigate the issues; issuing a discussion memo to interested parties; holding public hearings and request written comments on the issue; analyzing the results of the investigation, mail and hearings; if action is appropriate, issuing an exposure draft (a preliminary SFAS); requesting additional comments on the exposure draft and holding further public hearings; after analyzing the public response, issuing a final SFAS. 4. The FASB's conceptual framework project is a long-term project that should help describe concepts and relationships that underlie financial accounting standards and address such issues as the following: the elements of financial statements and their recognition, measurement, and display; capital maintenance; unit of measure criteria for distinguishing information to be included in financial statements from that which should be provided by other means of financial reporting; and criteria to evaluate and select accounting information (qualitative characteristics).

This project can help practitioners develop theoretical justification for resolving issues that contain no authoritative citations.

5. Statements of Financial Accounting Concepts (SFAC) are not authoritative because FASB did not use full due process in this project. Therefore, CPAs need not justify departures from their guidance.

6. Some authoritative publications of the AICPA include: ARBs and APB Opinions (and nonauthoritative Statements of Position and Issues Papers).

7. Authoritative GAAP includes items issued by the FASB (statements, interpretations, technical bulletins, staff implementations guides, SFAS 138 examples); Emerging Issues Task Force abstracts and Topic D; Derivative Implementation Group Issues; Accounting Principle Board opinions; Accounting Research Bulletins; accounting interpretations; items issued by the AICPA (Statements of Position, audit and accounting guides, practice bulletins, technical inquiry services). Non-authoritative includes items such as notable industry practice, APB statements, AICPA issue papers, FASB concept statements, international accounting standards, textbooks, journal articles and monographs.

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8. The purpose of GASB is to set financial accounting and reporting standards for the public sector as the FASB does for all private entities. The public should have an interest in governmental financial reporting because of the large value of assets managed by governmental entities. The financial community can also be affected by financial crisis in municipal units, such as the infamous crisis in New York, Cleveland, and Orange County.

9. Generally Accepted Accounting Principles (GAAP) constitutes "a technical accounting term which encompasses the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time." GAAP also changes in response to changes in the business environment, and alternative principles for similar transactions may be considered equally acceptable.

10. A critical implication of authoritative support relative to GAAP for the researcher includes that he or she should seek to find the highest available level of support. Primary authoritative support should be reviewed first; however, if no primary sources are found, the researcher would then drop down and review any available secondary support.

11. In conducting efficient research, the researcher should begin by reviewing primary sources that have the highest level of authority in the GAAP hierarchy prior to July 1, 2009 and the FASB Accounting Standards CodificationTM (The Code) subsequent to July 1, 2009..

12. Promulgated accounting standards frequently impact economic behavior, since decision makers frequently engage in certain transactions in order to "report" better financial statements.

For example, companies adopting the provisions of FASB Statement No. 96 could "transfer" part of their Deferred Tax Liability from a liability on the balance sheet to revenue on the income statement, as income tax rates fall; the reverse would occur as income tax rates rise.

13. Primary authoritative support differs from secondary authoritative support in that the former one provides sufficient authoritative support for including a particular accounting principle within GAAP. However, secondary authoritative support includes sources that support inclusion within GAAP, but individually do not constitute authoritative support.

14. The formation of the GASB caused the following two governmental organizations to be added to the list of Financial Accounting Foundation sponsors: the Government Finance Officers Association (GFOA) and the National Association of State Auditors, Treasurers, and Controllers.

15. Answers will vary. Rules-bases accounting provides specific rules or “bright-lines” for the accountant to follow while preparing financial statements. Principles based accounting does not provide these specific rules, thereby relying on professional judgment. An advantage to having rules is that there will be no question as to how to apply or interpret the standard. The disadvantage to having rules for all standards is that the volumes of literature are ever expanding and when standard setters leave anything open to interpretation, they are inundated with questions on how to apply the standard. Another disadvantage to “rules” is that not every company fits a certain mold. With that in mind, companies not fitting the rule must as for an exception or another application to be permitted.

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16. FASB is addressing the “standards overload” issue by implementing a framework that emphasizes issuing standards that focus more on objectives than detailed rules. In addition, another project aims at improving the quality of the cost-benefit analysis performed on proposed standards, reducing the costs of new standards without decreasing the benefits. Overall, the FASB’s goal is to make accounting standards that are easier to understand and apply.

Practice Exercises on Standard Setters 1. The eight elements of reasoning for this question would include: a. b. c. d. e. f.

g. h.

Purpose—the purpose is to respond to the client’s request for information.

Issue—the issue is the proper accounting for R&D according to U.S. GAAP and International Accounting Standards.

Information—the information sources one would utilize are U.S. authoritative literature (The Code) and International Accounting Standards.

Concepts—the concept would include the capitalization or expensing of R&D. Assumptions—the assumptions would be that in order to capitalize R&D there exists future economic benefits.

Interpretations or Inferences—the interpretation is that R&D costs have future economic benefit in order for Daimler to capitalize such costs. Also, one must conclude whether U.S. GAAP or International Accounting Standards are more appropriate if there exists a conflict.

Implications or consequences—if R&D costs are not properly recorded, the financial statements are considered misleading.

Solution—the solution according to US GAAP—FASB No. 2 (ASC 730)—is to expense R&D costs.

2. As of 07/1/09 the Board members were Robert H. Herz, Thomas J. Linsmeier, Leslie F. Seidman, Marc A Siegel, Lawrence W. Smith.

3. As of 07/01/09 the FASB’s three most recent issued exposure drafts were: a. Proposed FSP FAS 157-g, Estimating the Fair Value of Investments in Investment Companies That Have Calculated Net Asset Value per Share in Accordance with the AICPA Audit and Accounting Guide, Investment Companies (Issued 06/08/09) b. Proposed FSP FIN 48-d, Application Guidance for Pass-through Entities and TaxExempt Not-for-Profit Entities and Disclosure Modifications for Nonpublic Entities (Issued 05/01/09) c. Proposed FSP FAS 157-f, Measuring Liabilities under FASB Statement No. 157 (issued 05/01/09).

4. GASB Concept Statement No.1—Objectives of Financial Reporting; Concept Statement No. 2—Service Efforts and Accomplishments Reporting 5. As of 07/01/09, the GASB’s three most recently issued exposure drafts were; a.

Accounting and Financial Reporting for Chapter 9 Bankruptcies (Issued 06/26/09) 12

b.

OPEB Measurements by Agent Employers and Agent Multiple-Employer Plans (Issued 06/26/09) c.

Pension Accounting and Financial Reporting (Issued 03/31/09)

6. As of 07/01/09, the two most recently issued FASB Statements were: a. FASB St. No. 166 and FASB St. No. 167. b. The primary function of the Financial Accounting Standards Advisory Council is to advise the Board on issues related to projects on the Board’s agenda.

7. As of 07/01/09 a. The two most recently issued SEC proposed rules include: Facilitating Shareholder Director Nominations (Issued 06/10/09) and Custody of Funds or Securities of Clients by Investment Advisors (Issued 05/20/09) b. The Office of Internet Enforcement (OIE) has the following responsibilities: 1) conducts Internet investigations and prosecutions, 2) identifies areas of surveillance, 3) formulates investigation procedures, 4) performs training for the Commission staff and others, and 5) serves as a resource on Internet matters for the entire Commission.

8. As of 07/01/09 the three most recently issued comment letters from the FEI to the FASB include: As of 7/01/09, the FEI has not recently issued comment leters to the FEI. 9. As of 07/01/09 the Accounting Standards Executive Committee has issued: 1) Exposure Draft of Proposed Gaming Guide, 2) Comment letter on FASB’s Financial Statement Presentation Discussion Paper, and 3) Comment letter on the FASB’s Proposed Staff Positions (1) FSP FAS 115-A, FAS 124-a, and EITF 99-20-b, Recognition and Presentation of Other-than Temporary Impairments, and (2) FSP FAS 157-e, Determining Whether a Market is Not Active and a Transaction is Not Distressed.

10. As of 07/01/09, three upcoming conferences of the IIA include: 1) 2009 Internal Audit Solutions for Tough Times, The IIA's GRC Conference including Fraud & Technology August 24 – 26, 2009, San Diego, CA, USA 2) 2009 Midwestern Regional Conference, September 13 – 16, 2009, St. Louis, MO, USA 3) 2009 Eastern Regional Conference October 11 – 14, 2009, Philadelphia, PA, USA

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CHAPTER 4 FINANCIAL ACCOUNTING RESEARCH TOOLS

Discussion Questions 1. The advantages of commercial databases, compared to free internet sources, include the providing of a more comprehensive document retrieval system, having better search capabilities, and making an effort to seek out reliable sources of information.

2. Some tools to help in using a database include the use of connector terms, database directories, different products within the database, and the use of full text searches or citation searches.

3. The typical search process in a database entails: a. Define the specific information needed. b. Determine the sources to search. c. Develop a search inquiry using keywords and sometimes connectors and limitations. d. Select how to view the search results, such as full text or just the citations. e. Print or download the relevant documents.

4. The challenges to accounting research include the issue of finding all relevant authoritative sources, and the fact that in certain cases there are no clear cut answers to the issue or problem.

The Codification has made finding relevant source material easier. Professional judgment is required for problems that do not have apparent answers.

5. The four major topical FASB Codification topical guidance areas are: presentation, financial statement accounts, broad transactions, and industries.

6. The topical area “financial statements accounts” is further refined into subtopics: assets, liabilities, equity, revenues, and expenses.

7. Original Pronouncements can be found in “Pre-Codification Standards” located in the left naviation panel.

8. The Codification will contain essential GAAP content as listed in Figure 4-2 and for user convenience, limited SEC content.

9. Secondary sources are used to help the researcher find an answer to a problem that has no primary authoritative support. Secondary sources need to be combined with other secondary sources to help support a conclusion.

10. a. Authoritative GAAP sources are found in the Codification and can originate from the following: the FASB (statements, interpretations, technical bulletins, staff implementations guides, SFAS 138 examples); Emerging Issues Task Force abstracts and Topic D; Derivative 14

Implementation Group Issues; Accounting Principle Board opinions; Accounting Research Bulletins; accounting interpretations; items issued by the AICPA (Statements of Position, audit and accounting guides, practice bulletins, technical inquiry services). b. Non-authoritative GAAP is any item not in the Codification and includes items such as notable industry practice, APB statements, AICPA issue papers, FASB concept statements, international accounting standards, textbooks, journal articles and monographs 11. The SEC accounting authorities are different than GAAP because they follow the traditional legal hierarchy and are generally found under Title 15 of the United States Code. They are found at the SEC’s website and in legal databases such as Westlaw and LexisNexis.

12. The Codification contains limited SEC authority for user convenience. The Codification has no authority over SEC content.

13. The Next-Generation Edgar System is different from other research tools because it uses an XBRL format that and viewer that allow the researcher to extract desirable information for analysis directly from filings without having to retype. This removes human error in data extraction and retyping.

Exercises 1. Answers will vary slightly. The five research steps discussed in the chapter are: 1. define what information is needed 2. determine the sources to search 3. use appropriate search methods 4. view the results and 5. communicate the search results. 1. We know the information needed – due diligence review of a company. 2. Since that is related to auditing, use the AICPA database to locate the information. 3. perform a keyword search of “due diligence”. 4. after reviewing the results 5. communicate in a memo to the client.

2. The five research steps are 1. Define the information needed – Natalie Churyk’s suggestions for mastering the computerized CPA exam; 2 – the sources to search – the internet would be a viable option or a commercial databases such as ABI Inform or EBSCO known for locating articles; 3- key word search using the author and key words from the topic would be appropriate; 4 – results from the internet – typing in “Natalie Churyk mastering the cpa exam” resulted in 257 hits. There appears to be two articles by Natalie Churyk – Mastering the Technology, and The Computer-Based CPA Exam: Hints for Managing the Exam Technology. The first is a quick synopsis on exam pitfalls while the latter is an inclusive article on the computerized CPA exam. At this point, it may be helpful to circle back to the client to see exactly what the client is looking for (total exam, or just exam pitfalls). 5. Assuming the client is concerned with pitfalls communicate to the client in a memo the following regarding Mastering the Technology by Natalie T Churyk and Katrina L Mantzke: timing out at the front end, automatic shutdown, no going back to completed testlets, budgeting time for all testlets and simulations, the “Microsoft like” but not Microsoft software and how to use it, potential blind spots and other known exam problems.

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3. The first three subtopics within the general topic of Presentation are: 205 – Presentation of Financial Statements, 210 – Balance Sheet, and 215 – Statement of Shareholders Equity.

4. One possible search strategy to find literature on stock option gains is to highlight Broad Transactions, 815-Derivtives and Hedging, 30 - Cash Flow Hedges, 25 – Recognition.

5. Cash [Consistent with common usage, cash includes not only currency on hand but demand deposits with banks or other financial institutions. Cash also includes other kinds of accounts that have the general characteristics of demand deposits in that the customer may deposit additional funds at any time and also effectively may withdraw funds at any time without prior notice or penalty. All charges and credits to those accounts are cash receipts or payments to both the entity owning the account and the bank holding it. For example, a bank's granting of a loan by crediting the proceeds to a customer's demand deposit account is a cash payment by the bank and a cash receipt of the customer when the entry is made. [FAS 095, paragraph 7, sequence 51]] 6. Film Production Interest Costs 926-835-25-1 An entity shall account for interest costs related to the production of a film in accordance with Subtopic 835-20.

7. Rule 10b-5 discusses the issue of the “Employment of Manipulative and Deceptive Devises.”

SAB 99 provided the views of the SEC staff that exclusive reliance on certain quantitative benchmarks to assess materiality in preparing financial statements and performing audits of those financial statements is inappropriate; misstatements are not immaterial simply because they fall beneath a numerical threshold.

8. The Chief Accountant for the SEC is the principal adviser to the SEC Commission on accounting and auditing matters. The Office of the Chief Accountant also works closely with domestic and international private-sector accounting and auditing standards-setting bodies to monitor the application of accounting standards and financial disclosure requirements.

Prepare your client to handle a SEC investigation through internal reviews, self-reporting, correcting problems, and cooperating with the SEC staff.

9. The seven methods to search with SEC’s Next-Generation Edgar System include: company or fund name, ticker symbol, central index key, file number, state, country, or SIC. 10. As of 7/1/09 and example using the Next-Generation EDGAR System would be Dean Foods’ proxy statement as of 12/31/08. On the SEC website – the Next-Generation 16

Edgar System allows the user to hyperlink to the section desired whereas the report on the company website is static and one must scroll down to the section desired.

11. Student answers will vary. One example is asking students to determine which venture should consolidate Cherry Pop, if either predicated upon if Cherry Pop is a variable interest entity. Some key Codification authorities to answer the case would include: Broad Transactions – 810 Consolidation, 10 Overall, 25-1 tthrough 25-81 (recognition, initial measurement and subsequent measurement) on variable interest entities. 810-1015–Scope and Scope exceptions should be examined as well.

12. As of 7/01/09 there is one case on the ACIPA Web site, Catch Me If You Can – Version 2.

13. Use the Codification to find the guidance for: a. Prepaid advertising 340-20; 340-10-05; 210-10-45-1; 720-35-25-1 b. Negative loan amortization 978-605-25-7 (relating to real estate) EITF as would have been codified no longer exists for negative loan amortization relating to loans. c. Accelerated depreciation 360-10-35 d. Range of an estimated loss contingency 450-20-25-1; 450-20-30-1 e. Reporting period 270-10-05 f. Factoring of receivable with recourse 860-10-05-15; without recourse – 310-10-05-6 14. Use the Codification to find the guidance for: a. b. c. d. e. f.

goodwill350-20 start-up costs720-15 installment receivable 605-10-25-3 (revenue); 310-10-45-9 (receivable) subordinated debt470-10-45-s45-4 imputed interest 835-30 loss from operations Concept Statement 6

15. Use the Codification to find the guidance for archived FASB Interpretation 36: a. What does it discuss? FASB Interpretation 36 discusses the accounting for exploration costs by oil and gas producing companies. Its rationale is that an unsuccessful company will end up capitalizing the costs. b. How did you find the authority? Click on Pre-Codification standards in the left navigation panel which will link the user to the FAS website c. The authority affects the gas and oil producing industry. d. The major organizational parts of that authority are Status, Summary, Introduction, Interpretation, Effective Date and Transition, and the Appendix 16. Costs to be recognized as research and development 730-10-25-2 Five types of cost associated with R &D activities: (1) Material, Equipment, and Facilities; (2) Personnel; (3) Purchased intangible; (4) contract services; (5) Indirect costs.

17

a) The salaries of the research staff designing new products can be classified as the personnel cost related with R&D activities thus can be expensed as R&D costs. 730-1025-2 b) The commissions paid to sales staff marketing new products is a selling expense, so it does not qualify. 730-10-15-4 17. Use the master glossary for the following question. a. Master glossary “C” - An existing condition, situation, or set of circumstances involving uncertainty as to possible gain (a gain contingency) or loss (a loss contingency) to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. b. master glossary “c” c. Contingent losses will be recorded when it is probable that a liability has been incurred at the date of the financial statements and the amount of the loss can be reasonably estimated. d. 450-20-25 18. Identify the issues/subparagraphs related to post-retirement benefits: 715-60-05-1 (retirement): general, Medicare prescription drug, improvement and modernization act; settlements, curtailments, and certain termination benefits; and split-dollar life insurance arrangements.

19. Use the Master Glossary to locate disclosure requirements for post-retirement benefits other than pensions. Left click on Master Glossary in left navigation panel. Left click on the letter “P”. Scroll down to “postretirement benefits.” Hyperlink to 715-60-50, link to disclosure 715-60-50-2 This Subsection provides guidance on disclosures regarding the effect of the Medicare subsidy. This Subsection also provides guidance on the disclosures about the effects of the subsidy for an employer that sponsors a postretirement health care benefit plan that provides prescription drug coverage but for which the employer has not yet been able to determine actuarial equivalency.

715-60-50-3 In interim and annual financial statements for the first period in which an employer includes the effects of the subsidy in measuring the accumulated postretirement benefit obligation and the first period in which an employer includes the effects of the subsidy in measuring net periodic postretirement benefit cost, it shall disclose all of the following: •

a. The reduction in the accumulated postretirement benefit obligation for the subsidy related to benefits attributed to past service.

•

b. The effect of the subsidy on the measurement of net periodic postretirement benefit cost for the current period. That effect includes any amortization of the actuarial gain in (a) of this paragraph as a component of the net amortization called for by paragraphs 715-60-35-29 through 35-30, the reduction in current 18

period service cost due to the subsidy, and the resulting reduction in interest cost on the accumulated postretirement benefit obligation as a result of the subsidy.

•

c. Any other disclosures required by paragraph 715-20-50-1(r).

715-60-50-4 For purposes of the disclosures required by paragraph 715-20-50-1(a) and 715-20-50-1(f), an employer shall disclose gross benefit payments (paid and expected, respectively), including prescription drug benefits, and separately the gross amount of the subsidy receipts (received and expected, respectively).

715-60-50-5 [Paragraph not used] 715-60-50-6 Until an employer is able to determine whether benefits provided by its plan are actuarially equivalent, it shall disclose both of the following in financial statements for interim or annual periods: •

a. The existence of the Medicare Prescription Drug, Improvement, and Modernization Act

•

b. That measures of the accumulated postretirement benefit obligation or net periodic postretirement benefit cost do not reflect any amount associated with the subsidy because the employer is unable to conclude whether the benefits provided by the plan are actuarially equivalent to Medicare Part D under the Act.

20. Preferred stock has debt characteristics. a. How should an accountant account for this in the financial statement and and b. provide the reference. It should be accounted for as follows: 480-10-S99-1 The following is the text of CFRR 211: Redeemable Preferred Stock.

•

[.01 General : ASR 268: [CFRR 211, paragraph .01, sequence 1] ] [On July 27, 1979, the Commission amended Regulation S-X to modify the financial statement presentation of preferred stocks subject to mandatory redemption requirements or whose redemption is outside the control of the issuer.

The rules adopted do not impact reporting practices of registrants not having such securities outstanding. Registrants having such securities outstanding are required to present separately, in balance sheets, amounts applicable to the following three general classes of securities: (i) preferred stocks subject to mandatory redemption requirements or whose redemption is outside the control of the issuer; (ii) preferred stocks which are not redeemable or are redeemable solely at the option of the issuer; and (iii) common stocks. A general heading, "Stockholders' Equity," is not to be used and presentation of a combined total for equity securities, inclusive of redeemable preferred stocks, is prohibited. In addition, the rules require disclosure of redemption terms, five-year maturity data, and changes in redeemable preferred stocks in a separate note to the financial statements 19

captioned "Redeemable Preferred Stocks." [CFRR 211, paragraph .01, sequence 2] ] [There is a significant difference between a security with mandatory redemption requirements or whose redemption is outside the control of the issuer and conventional equity capital. The Commission believes that it is necessary to highlight the future cash obligations attached to this type of security so as to distinguish it from permanent capital. It is expected that the rules will provide more meaningful presentation of the financial obligations of those companies which finance operations through the use of such securities. [CFRR 211, paragraph .01, sequence 3] ] [The Commission noted an increase in the issuance, by registrants, of preferred stocks to finance operations, consummate mergers and acquisitions, or to restructure existing debt arrangements. Many of the preferred stock issues included terms which required the issuer to redeem the stock at a fixed or determinable price on a fixed or determinable date. Other issues required the issuer to redeem the stock at the option of the holder at the time certain prescribed conditions are met which are not necessarily within the control of the issuer, such as attainment of a specified level of earnings. [CFRR 211, paragraph .01, sequence 4] ] [The Commission believes that redeemable preferred stocks are significantly different from conventional equity capital. Such securities have characteristics similar to debt and should, in the opinion of the Commission, be distinguished from permanent capital. The Commission believes that traditional financial reporting practices do not provide the most meaningful presentation of the financial obligations attached to these types of securities and that improvement in the financial statement presentation of redeemable preferred stocks is necessary.

[CFRR 211, paragraph .01, sequence 5] ] [The rules are intended to highlight the future cash obligations attached to redeemable preferred stock through appropriate balance sheet presentation and footnote disclosure. They do not attempt to deal with the conceptual question of whether such a security is a liability. Further, the rules do not attempt to deal with the income statement treatment of payments to holders of such a security or with any related income statement matters, including accounting for its extinguishment. The Commission is cognizant of these conceptual problems in determining the appropriate accounting for and reporting of redeemable preferred stock and believes that these matters can best be addressed by the FASB. As an interim measure, the rules require that the amounts applicable to redeemable preferred stock be presented in financial statements as a separate item—and not combined with equity investments not having similar redemption requirements.

The Commission believes the presentation required by the rules will highlight the redemption obligation and the fact that amounts attributable to these securities are not part of permanent capital. [CFRR 211, paragraph .01, sequence 6] ] 20

21. a) At the SEC’s website in the “information for accountant” folder (as of 07/1/09), the SEC has issued approximately 92 Accounting and Auditing Enforcement Releases. b) Archived standard SFAS No.115 establishes the accounting standard for investment securities including required disclosures regarding the investment portfolio in their filings: (a) The accounting policy note to the financial statements should identify clearly the characteristics that must be present for the institution to carry a debt security at amortized cost, as specified in SFAS No. 115. (b) Disclose the market value of the portfolio on the face of the balance sheet. If the portfolio's fair value is less than its cost, MD&A should assess the significance of the unrealized loss relative to net worth and regulatory capital requirements. (c) Distinguish proceeds from the sales of debt securities from the proceeds from maturities in the cash flow statement or in a note thereto. Distinguish sales proceeds generated from the held-to-maturity portfolio from those from the available-for-sale portfolio. (d) MD&A should analyze and quantify the likely effects on current and future earnings and investment yields and on liquidity and capital resources of: material unrealized losses in the portfolio; material sales of securities at gains; and material shifts in average maturity. Provide a similar analysis if a material portion of fixed rate mortgages maturing beyond one year carries rates below current market. (e) If a material proportion of the portfolio consists of securities that are not traded actively in a liquid market, MD&A should disclose that proportion, describe the nature of the securities and the source of market value information, and discuss any material risks associated with the investment relative to earnings and liquidity. Provide similar disclosures if the portfolio includes instruments that are highly volatile relative to small changes in interest rates and this volatility may materially affect operating results or liquidity. (f) Trading securities and available-for-sale securities (categorized by types of investments) should be presented separately from the balance of the investment portfolio in Table II, "Investment Portfolio" of Industry Guide 3 data. One need not present Contractual maturities of investments held for sale. The average yields on investments held for sale should be based on amortized cost and footnoted.

CHAPTER 5 THE ENVIRONMENT OF INTERNATIONAL RESEARCH Discussion Questions 1. The predecessor committee to the IASB was the IASC which issued 41 International Accounting Standards.

2. Due process is a six-stage process: 21

a.

b. c.

d.

e.

f.

The IASB considers the potential agenda item’s relevance, existing accounting guidance, the possibility of increased convergence, the potential quality of any proposed standard, and the resources needed to examine the potential agenda item.

The IASB plans the research project to determine whether to work with other accounting standard setters. , Developing and publishing a discussion paper is not a mandatory stage, but the action is usually taken to obtain early feedback from constituents. Analysis is performed on the comment letters received during the usual 120-day comment period, and the results are posted to the IASB Web site.

Developing and publishing the exposure draft (ED) is mandatory and is based on IASB staff research, discussion paper comments, SAC input, working groups, and other standard-setter input. ED periods are usually 120 days or longer for major projects; if a matter is urgent, the ED period is 30 days. Once comments are received, they are summarized and posted to the IASB Web site.

The IASB then decides whether to draft an IFRS or publish a second ED. If the IFRS is drafted, the IFRIC reviews the draft before it goes to the IASB for a vote.

A version of the IFRS draft is also posted for paid subscribers. An IFRS is issued only after any outstanding issues are resolved and the IASB members have voted in favor of the standard.

The IASB and its staff periodically hold meetings with constituents with respect to implementation guidance and any unforeseen standard shortcomings. The IASC Foundation promotes educational seminars and events to ensure proper application of the IFRS.

The IASB’s Conceptual Framework (the Framework) establishes objectives and concepts for the development of accounting standards. The Board uses the Framework in the development of future standards. The Framework should also assist users and preparers/practitioners and researchers in applying and interpreting standards and financial statements. For instance, preparers and researchers may need to look to the Framework in the absence of a published standard, and auditors may want to ensure clients’ financial statements are in compliance with the IFRS to form an opinion on those statements. However, occasionally, a conflict arises between the Framework and previously issued IASs or IFRS. In conflict situations, the standards override the Framework.

4.

Although the Framework should be used to assisted users, the standers override the Framework.

3.

5.

No, the IASB cannot enforce the use of its standards. Each country or organizations of countries can enforce use of IFRS. For instance, the EU requires use of IFRS in all member states and has set up various bodies (CESR and ESC) to help with consistency.

6.

The Norwalk agreement was the first Memorandum of Understanding (MOU) between the IASB and FASB, whereby they agreed to work on both short- and long-term 22

projects removing differences (convergence) between IFRS and U.S. GAAP and to continue coordinating activities.

7.

Although each IFRSs is equal, there is a hierarchy when choosing between standards; 1. Apply specific IFRSs and consider relevant implementation guidance. If specific IFRSs do not apply, choose the relevant and reliable accounting policy from the listed sources in the following order: a. Apply other IFRSs that involve similar or related issues. b. Apply the IFRS Framework. c. Apply pronouncements of other standard-setting bodies that are consistent with the IFRS Framework.

8.

CESR provides opinions of EU and non-member states status towards compliance with IFRS.

9.

The researcher should look to the hierarchy. If an answer cannot be found within IFRS a researcher could look to pronouncements of other stand-setting bodies as long as those pronouncements are consistent with IFRS.

10.

The main goals of the IASC Foundation are to develop a single set of global, highquality standards; promote the use of those standards; consider its constituents (small to large and stable to emerging); and initiate convergence of IFRS with other national accounting standards.

11.

Funding of the Foundation and the IASB is mostly voluntary and comes from organizations as well as various countries.

12. The SEC has expressed three conditions for accepting international accounting standards for all public companies: a. IASB standards should include a core set of accounting pronouncements that constitute a comprehensive, generally accepted basis of accounting. b. IASB standards must have high quality, result in comparability and transparency, and provide for full disclosure. c. Rigorous interpretations and applications must exist for IASB standards.

Exercises 1.

As of 07/01/09, three active IASB projects relate to Financial Crisis (derecognition, credit risk, and fair value measurement).

2.

Four types of enforcement cases are; insider trading, securities fraud, market manipulation, and foreign corrupt practices act.

23

3.

4.

The working committees of the IOSCO are: the Executive Committee, the Technical Committee, the Emerging Markets Committee, and the SRO Consultative Committee.

As of 07/01/09 there are twenty-seven member states.

Using e-IFRS 1.

Enter e-IFRS, click on IFRS 1, introduction. a. IFRS 1 replaced SIC-8 First-time Application of IASs as the Primary Basis of Accounting. b. Paragraph 4 of the Introduction requires an entity to comply with all IFRS effective at the end of its first reporting period by ensuring all assets and liabilities are in conformity. If not, they cannot be recognized.

2. As of 07/01/09, seventeen IFRICs have been issued, although not all are still active.

3. Answers will vary slightly depending upon which IAS/IFRS and IFRIC/SIC are chosen. a. .IFRS 7: Objective, Scope, Classes of financial instruments and level of disclosure, significance of financial instruments for financial position and performance, Nature and Extent of Risk, Effective date, withdrawal of IAS 30, Appendices, Approval of the Board, Basis for Conclusions, and Implementation Guidance. b. IFRIC 4: References, Background, Scope, Issues, Consensus, Effective Date, Transition, Appendix, Illustrative Examples, and Basis for conclusions. c. Yes, for the most part, both standards contain information about the standard, what it covers, how to apply it, the Board approval, and why the Board came to its decision.

4. e-IFRS research a. IFRIC 13 b. SIC 15 c. IFRS 8 d. IAS 32, IFRIC 11 e. IAS41 5. Impairment test for long-lived asset a. IAS 36 b. Perused the list of standards until an “Impairment” standard was spotted. c. The accountant would take into account internal and external factors such as damage, obsolescence, adverse market conditions, and/or reduced cash flows. If the indicators are present, then the asset’s recoverable amount needs to be calculated. If the recoverable amount is less than its carrying amount, impairment has occurred.

24

6. IFRS 3 B; - Previously recognized negative goodwill—the entity shall derecognize the carrying amount of that deferred credit at the beginning of the first annual period in which this IFRS is applied with a corresponding adjustment to the opening balance of retained earnings at that date.

7. No, IFRS avoids so called “bright lines” tests.

8. IAS 11 suggests percentage of completion method for construction contracts.

9. Use the glossary: a. Contingent liability definition A possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or nonoccurrence of one or more uncertain future events not wholly within the control of the entity; or a present obligation that arises from past events but is not recognized because: it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or the amount of the obligation cannot be measured with sufficient reliability. b. IAS 37.10IFRS 3.A 10. Materiality definition a. Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. b. F.30

Chapter 6 OTHER RESEACH DATABASES AND TOOLS Discussion Questions 1. Accounting Research Manager includes accounting and auditing information, as well as SEC materials, and separate libraries for governmental and internal control sources.

2. Research for governmental accounting depends on the governmental unit as issue. A summary of governmental accounting standards for state and local governments is available at GASB’s website: www.gasb.org. Complete online research is available only if one has access to Federal Accounting Research System (FARS). The federal accounting codification is provided at the FASAB’s website: www.fasab.gov.

3. Example of the advantages of S&P’s NetAdvantage can include researching private companies or bond information.

25

4. Examples of when to use Mergent include when seeking industry comparisons, researching foreign companies, or when it’s the best available financial research database.

5. The Thomson Research database covers about 90% of the world’s stock market value and includes records for more than 17,000 active companies representing over 50 countries.

6. Use the Factiva database when looking for business and financial information.

7. Insight offered by the Business and Company Resource database includes insider buying and selling activity, consumer marketing data, corporate chronologies and histories, and emerging technology reports.

8. Hoovers Online is distinguishable from other databases which provide corporate information by seeking to provide objective information, instead of relying on what a company’s corporate staff might issue.

9. Business Source Premier is used to access periodicals, peer-reviewed journals, trade generals, general business magazines, and other reports.

ABI/Inform Global includes international professional publications, academic journals, and trade magazines.

10. The major source of information in Stat-USA is information from the U.S. Department of Commerce. Stat-USA provides current and historical data on business, international trade, and the economy.

11. Conducting international business research is assisted by going to the website GlobalEDGE. Research categories for sources of information are Multi-Country, Statistical Data Sources, Rankings, Government Resources, and Organizations.

12. Financial ratios found in LexisNexis Academic are found by selecting the business tab and then Company Dossier and search for the particular company of interest. A snapshot of the company appears, but more information, such as the financial ratios are accessible by selecting financial information on the left side of the screen. Scroll down after the presentation of the financial statements to view the ratios.

13. The general areas of Lexis-Nexis Academic are general, news, business, legal, and people.

14. LexisNexis Academic database provides only a small subset of information compared to the LexisNexis database. LexisNexis also has a less powerful search engine.

15. Westlaw is a comprehensive legal database, unlike its small subsets Westlaw Business or Campus Research.

Exercises

26

1. The FASAB’s exposure drafts as of 7/09, presented at its website include “Accounting for Federal Oil and Gas Resources, Deferral of the Effective Date of Technical Bulletin 2006-1, Recognition and Measurement of Asbestos-Related Cleanup Costs, and the Hierarchy of Generally Accepted Accounting Principles for Federal Entities, Including the Application of Standards Issued by the Financial Accounting Standards Board.”

2. Because the FASB and GASB have a common parent organization, pressure may exist for GASB to codify the sources of accounting and make the accounting source either authoritative or non-authoritative, similar to the change enacted by the FASB in 2009.

GASB issued Statement 55, The Hierarchy of Generally Accepted Accounting Principles for State and Local Governments in April 2009.

3. Companies must recognize unfunded pensions in their balance sheets,under FAS 158.

This is found in the Accounting Standards Codification at 715-20-50-1(c).

NOTE: Most accounting students can access the academic view of the FASB’s Accounting Standards Codification by going to http://aaahq.org/FASB/Access.cfm. One finds the answer either by drilling down in the Codification, an advanced key word search on unfunded pensions, or researching archieved GAAP and then using the crossreference in the Codification. Using the drill down, one selects expenses, compensation, retirement benefits, pensions. Using the advanced search in the upper right of the Codifcation’s screen search for all key words in the phrase phrase “unfunded pension,” rather than the exact phrase. Alternatively, archieved GAAP from selected FASB’s issuances is accessible through the Codification, as well as from the FASB’s website.

4. DATABASES WITH RATIO ANALYSIS include Mergent Online, Standard & Poor’s NetAdvantage, LexisNexis Academic, and Morningstar.

MICROSOFT’s RATIO ANALYSIS: Microsoft’s ROA, ROE, and ROI increased from 2006–2008, whereas its current ratio decreased.

REVIEW OF RATIO ANALYSIS: ROA indicates how effectively assets are being used to produce profit. ROE indicates how effectively the Stockholders’ Investment is being used to produce profit. ROI is annualized income expressed as a percentage of average invested capital. Current ratio is the current assets divided by current liabilities.

Microsoft Corporation

6/30/2008

6/30/2007

6/30/2006

ROA % (Net)

25.94

21.19

17.95

ROE % (Net)

52.34

39.51

28.56

ROI % (Operating)

66.58

52.03

37.34

27

MICROSOFT’s FINANCIAL SITUATION in 2008 was based on three major revenue sources: Windows, Office, and Server & Tools. Although, Microsoft’s total revenue posted a 2% growth from the prior year, the Windows business posted an 8% decline in sales. The company sought to cut annual operating costs by $1.5 billion .

5. Alexander & Baldwin’s MAJOR OPERATIONS: Transportation, Real Estate, and Agribusiness. Alexander & Baldwin is a multi-industry corporation. It is engaged in ocean freight transportation, property development and management in Hawaii and on the U.S. mainland, and producing sugar cane and coffee in Hawaii.

COMPETITORS listed will depend on the database used. Those listed in LexisNexis are APL, Crowley Maritime, and Horizon Lines. Those listed in Mergent or S&P NetAdvantage include ENSCO International Inc, Overseas Shipholding, Group, Inc, and Kirby Corp. Those listed in Hoovers: “A.P. Møller – Mærsk, APL, Castle & Cooke, Crowley Maritime, Evergreen Marine, Hanjin Shipping, Maui Land & Pineapple, Royal Vopak, Sterling Sugars, Tate & Lyle, and Trailer Bridge.”

NOTE: The competitors are not divided by major lines of business.

6. LARGEST FINANCIAL FRAUD DISCOVERED in late 2008 and early 2009) was the Ponzi scheme by Bernard Madoff.

NOTE: Students will probably have different answers for OTHER FINANCIAL FRAUDS in early 2009, such as Robert Stanford misrepresented securities as liquid.

Students often use either a Google search or an article index database, such as ABI Inform, to find the fraud. Encourage the students to search through leading professional sources, such as The Wall Street Journal.

7. FINANCIAL RATIOS in MERGENTS includes Return on Assets (ROA), Return on Equity (ROE), Return on Investment (ROI), Revenue per employee, Quick and Current Ratio, Receivable, Payable, and Inventory Turnover, and other ratios for profitability, liquidity, and other analysis.

FINANCIAL RATIOS in S&P NetAdvantage: ROA, ROE, ROI, and Current Ratio.

NetAdvantage is less extensive than Mergents in its quantity of ratios and its analysis.

8. The financial ratios on Wells Fargo for 2008 indicate that its operational assets are not effectively used to generate profit and these could result in delinquency in future years. Wells Fargo’s operational and financial indicators went bleak in 2008. Cash flow per share became negative in 2008.

Wells Fargo & Co. Profitability Ratios

12/31/2008

12/31/2007

12/31/2006

ROA % (Net)

0.28

1.52

1.76

ROE % (Net)

3.61

17.23

19.6

12/31/2008

12/31/2007

12/31/2006

Total Asset Turnover Property Plant & Equipment Turnover

0.05

0.1

0.1

6.29

10.92

10.53

Cash & Equivalents Turnover

1.28

3.36

2.91

12/31/2008 28

12/31/2007

12/31/2006

Asset Management

Per Share

Cash Flow per Share

-1.43

2.71

9.53

9. GOOGLE’s G-MAIL SYSTEM CONTROVERSY concerned PRIVACY. A unique privacy concern to Gmail is that Google could sought to profile each user by scanning a user's saved emails in order to deliver contextually relevant text ads.

Another privacy concern was that the Electronic Communications Privacy Act allows law-enforcement agencies to gain access to messages on a mail provider's system without the user’s knowledge.

ARTICLE INDEX DATABASE: Business Source Premier has the following article: Wildstrom, Stephen H.. “Google's Gmail Is Great -- But Not for Privacy.” Business Week, published on 5/3/2004.

10. IBM’s FIRST FOOTNOTE explains the significant accounting principles.

ADVANTAGES OF COMMERCIAL DATABASES: Commercial databases have the advantage over the SEC database in providing ratios and analysis. The SEC’s database provides only the raw financial statements. Convenience advantages also exist for commercial databases. For example, using the SEC’s database to search IBM related information, the researcher needs to use the complete name for IBM: “International Business Machines.” However, IBM is one of the businesses that are retrieved by commercial databases if “IBM” is the search keyword.

DISADVANTAGES OF COMMERCIAL DATABASES: They often do not provide all of the SEC filings of the company. Furthermore, most commercial databases will not provide footnotes or other non-financial information contained in the 10K filing.

11. Journal of Accountancy is the name of the major accounting journal published by the AICPA. Two recent articles in this journal as of 2009, using the keyword "derivatives” include Fick, K.F. & Rees, T.G. (2009) IFRS Requirements for Recognizing Impairment on Securities Journal of Accountancy. See www.journalofaccountancy.com/ Web/IFRSforRecognizingImpairment.

This article is about the IFRS requirements for recognizing impairment on securities are specified in International Accounting Standard no. 39: Financial Instruments: Recognition and Measurement. This standard addresses a wide range of accounting issues relevant to financial instruments, including securities, loans, derivatives and liabilities.

Rees, T.G., & Fick, K. F. (March 2009). IFRS Requirements for Recognizing Impairment on Securities.

Journal of Accountancy. at www.journalofaccountancy.com/Web/IFRSforRecognizingImpairment The article provides a very brief summary of IAS no. 39 (Financial Instruments: Recognition and Measurement) requirements.

12. Environmental liability disclosure for Chevron appeared in the description of the company’s business, legal proceedings, and Management's Discussion and Analysis of Financial Condition and Results of Operations relating to the environmental liability.

NOTE: Some students will just present the accounting for environmental liabilities. Archieved GAAP on the topic is based on SFAS No. 5, Accounting and Reporting for Loss Contingencies, SEC Staff Accounting Bulletin 92, accounting and disclosure obligations for contingent environmental liabilities.

29

Also, FIN 14, Reasonable Estimation of the Amount of a Loss, and AICPA SOP 96-1, Environmental Remediation Liabilities are relevant authorities.

13. BLACKSTONE GROUP’s STOCK PRICE DROPPED in 2008: from about $22.50 per share to about $6.50 per share. This was due to the difficult credit markets and common stock market declines in 2008. Information on Blackstone Group was more readily available than most private equity firms because the LP is publicly traded on the NYSE. NOTE: Students will probably have different answers depending on the database used.

14. WEBSITE for IRS’ Market Segment Specialization Program (MSSP) is at www.irs.treas.gov/pub/irs-mssp.

ACCOUNTING ISSUES include balance sheet reporting such as improper accruals and shareholder owned assets maintained by the business.

BUSINESS ISSUES in the automobile repair industry include are insurance company preferences, regulatory compliance issues especially air quality restrictions and hazardous waste disposal, and other issues related to health and worker safety.

15. HCA is the largest for-profit hospital operator in the United States. It operates about 170 hospitals in the US and abroad. It also runs about 100 ambulatory surgery centers outpatient rehab centers that form health care networks in many of the communities it serves. The company has facilities in about 20 states, with about three-quarters of its hospitals located in the southern US. (About 70 are in Florida and Texas.) HCA International operates six hospitals in the UK. HCA’s CORPORATE HISTORY: HCA has had several name changes, such as Columbia Hospital Corporation, Columbia Healthcare Corp, HCA-The Healthcare Co. Columbia/HCA Healthcare Corp, and HCA-Hospital Corporation of America.

DATABASES discussing HCA’s history include LexisNexis Academic; Hoover’s (company records), and Mergent Online.

LEGAL CONCERNS this company may face include those of malpractice due to the lawsuits that may arise from malpractice or other legal issues that doctors face.

16. Reliastar was acquired by ING Group NV in 2000.

The financial ratios in 2007 depends on the source used. Debt/Equity Ratio from Ing website was .095, whereas Morningstar showed .20. Thus, the debt/equity ratio listed on Ing’s website is more favorable than what is reported on Morningstar’s website.

LESSON: Check independent third party databases before making any investment decisions.

17. Yahoo’s growth rate from 2007 to 2008 declined due to several reasons. In early 2008, Microsoft offered to buyout Yahoo at $31 per share. Subsequently, Yahoo rejected that and all other offers Microsoft tendered until finally, Microsoft was not interested in the acquisition. The onset of the economic crisis in the third quarter of the 2008 calendar year brought the stock price down substantially. In addition, a goodwill impairment charge attributed to the increase in operating expenses reported in the 2008 income statement. The return of income dropped drastically from 7.15 to 0.12. Bad financial performance and change of senior officers may contribute to the decline in stock price of Yahoo.

18. AN ANALYST REPORT ON FORD MOTOR COMPANY found in Morningstar is David Whiston, CPA, CFE, publishing on 3/11/2009.

ANALYST REPORT CONTENTS: includes valuation, risk, strategy, management and stewardship, profile, growth, profitability, and financial health.

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FORD MOTRO COMPANY: In 2009, Ford worked out a new work agreement with the United Auto Workers (UAW) union that brought their cost down from $71 an hour to $55. This saved the automaker about $500 million per year. Uncertainties existed over a government bailout and the company’s high debt to equity ratio.

NOTE: Students may will have various answers to this question, depending on the database and analyst report used.

19. Stat-USA for 2007, reveals that the United States steel traded internationally was $4.25 billion. This answer is found in the State of Nation section of the Stat-USA database under the archive section where “Steel Commodity” was inserted into the search bar.

NOTE: some students will have difficulty because of the tremendous volume of reports within the Stat-USA database and changes in the datatbase. The goal is to force the students to examine the database and think about how to find such information. If you wish to guide students, encourage them to scroll down the main page to view the most requested reports.

Merely enterring terms in the search engine will not produce the desired results.

20. This question asks the students about your university’s particular library. Students should have different powerpoint presentations to explain it.

Accounting Research Tools 21. Go to www.fasab.gov to find the FASAB’s Exposure Drafts. The most recent one in early 2009 was “The Hierarchy of Generally Accepted Accounting Principles for Federal Entities, Including the Application of Standards Issued by the FASB.” 22. Accounting Trends and Techniques is found at HF5681…, Financial Reporting Trends is found at HG8525…, Audit and Accounting Manual is found at HF5667…

NOTE: If your library does not have the book, check the AICPA Library at the Univ. of Mississipi, whose catalog is accessible at the AICPA’s website. www.aicpa.org.

Government Accounting Databases 23. GASB Concept Statement No. 5 is “Service Efforts and Accomplishment Reporting.”

The Statement was created in 2008.

24. SFFAS No. 33 discusses pensions and retirement benefits. It was issued Oct. 14, 2008, as shown at the bottom of the standard. The purpose of the standard is to create a separate display of these costs in the financial statements for greater transparency.

Financial Research Databases 25. The three largest companies in the music industry are (1) Universal Music, (2) Sony BMG Music, and (3) Warner Music. The answer is not as important as discussing the search process.

NOTE: Hoover Industry Snapshots may provide a ranking of firms in that industry. One can find Hoover snapshot within LexisNexis by looking up a particular company, such as Sony Music, and getting information from the company profiles.

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26. The NAICS Code for property and casualty insurance is 524126. This is found by drilling

down on finance and insurance , after googling for NAICS codes.

General Business Databases 27. An overview of Realnetworks, Inc. previously explained the significance of its RealPlayer line of web products, as well as the number of registered users exist for the RealPlayer line of products. As with many websites, changes occur so that the requested information is no longer readily accessible.

28. Many international business resources are recommended for statistical data sources, based on the country. The student should list three of them, hopefully of interest to the student.

Legal Databases 29. Using LexisNexis, one article from the Journal of Accountancy that discuss the term money laundering in the title is “AUDITING, The CPA's Role in Fighting Money Laundering,” Abel and Gerson in 2001. A second more recent article is “THE FRAUD BEAT, Build an Antifraud Practice,” by J. Wells in March 2004.

NOTE: Several articles on this topic exist. The articles with the term in the title may provide the most relevant articles, but one should check more recent articles with slightly different names to remain current with the topic.

30. Two Accounting and Auditing Enforcement Releases that address revenue recognition are In the Matter of VICTOR HERMAN, CPA, Accounting And Auditing Enforcement Release No. 1906 October 23, 2003 and Securities and Exchange Commission v. Alexander H. Edwards, III, Accounting And Auditing Release No. 1828, issued August 5, 2003.

NOTE: Once agin the trick is making sure the drop down source box is searching in the appropriate place- in this case Accounting and Audiiting Enforcement Releases (AAER).

CHAPTER 7 TAX RESEARCH FOR COMPLIANCE AND TAX PLANNING

Discussion Questions 1. The difference between tax evasion, tax avoidance, and abusive tax avoidance is the means used to minimize one’s taxes. Tax evasion consists of illegal acts. Tax avoidance seeks to minimize taxes legally. “Abusive tax avoidance,” represents attempts to intentionally misapply the tax laws.

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2. Tax research goals depend on the type of tax research. Policy-oriented research has the objective of providing new information that will help policy-makers make appropriate tax law.

Application oriented tax research addresses existing tax law, with the objective of determining its impact on a given factual situation.

3. The basic steps of tax research include: Identify and refine the tax problem.

Locate relevant tax authorities Apply the authorities.

Arrive at a defensible solution.

Communicate the results to the taxpayer.

4. Challenges in tax research include identifying the relevant facts, identify the precise legal issues for the given set of facts, searching for relevant legal authorities, and selecting the correct legal authorities.

5. Tax compliance engagements prepare tax returns. Often these are closed-fact engagements because all the facts have already occurred. In tax planning (sometimes referred to as open-fact engagements), usually not all of the relevant facts have occurred.

6. One difference between regulations and revenue rulings is whether the authority has general or specific application. Treasury regulations interpret and clarify the statutory law. Revenue rulings apply the law to a specific set of facts. Another difference is the strength of the authority.

Treasury regulations are stronger authority than revenue rulings.

7. The term “precedent” for tax research means that the legal principle announced in a court case will apply to future cases.

8. In a non-acquiescence, the IRS will not follow a court’s decision in other cases.

9. IRB is the weekly publication by the IRS that includes revenue rulings and revenue procedures. The CB (Cumulative Bulletin) is a semi-annual publication that reorganizes these sources in accordance with the Code section interpreted.

10. The IRS generates tax forms, notices, and private letter rulings, and other documents.

11. Advise the client to go to district court if the precedent in the TAX Court is adverse to the client.

12. To find relevant cases, use the annotations part of a tax service. Annotations usually provide one sentence summaries of cases, organized by issue for a Code section.

13. AFTR and USTC reprint all tax cases, except for those from the Tax Court.

14. Besides revenue rulings and revenue procedures, three other types of documents that the IRS generate are Letter Rulings, Technical Advice Memoranda, and Treasury Decisions (regulations).

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15.

United States Supreme Court 12 regional Circuit Courts of Appeal Court of Appeals for the Federal Circuit Tax Court 94 District Courts Court of Federal Claims 16. A memo includes sections on the facts, issues, conclusion, and analysis.

17. Students will have a broad variety answers for this question on different tax websites. For instance, one website is Tax and Accounting Sites Directory which has links for tax topics, tax forms, and many other tax and accounting concerns. Another website is IRS’ website has tax forms and publications, information for different taxpayers, and tax statistics.

18. The reasoning or analysis is often divided into discussion of the law and then its application.

The law should include brief discussion of relevant Code provisions, regulations, and cases.

Each source discussed should get referenced as to how it applies to the given set of facts. Thus, the application integrates the law and the facts, instead of leaving the work to the reader’s interpretation.

Exercises 1. The following illustrates the answer as applied to Hawaii. Possibly remind students to help find the materials for your state a helpful website is http://www.taxsites.com. a. A copy of Hawaii’s state tax return is at http://www.state.hi.us/tax/2009/n11.pdf b. A copy of Publication 597—“Information on the United States–Canada Income Tax Treaty,” is on the IRS’ website is at http://www.irs.gov/pub/irs-pdf/p597.pdf. c. Examples of two proposed taxation bills in 2009 were “Recovery and Reinvestment Act of 2009” and “Renewable Energy and Job Creation Tax Act.” 2. Primary research authorities in the problem are the Internal Revenue Code, Treasury Regulations, and Tax Court decisions. Secondary sources in the problem are the tax services and tax newsletters.

3. a. Section 61 defines gross income. b. Section 166(d) defines nonbusiness debts. c. Section 1222(7) defines “net long-term capital gains.”

NOTE: Most Code sections have a letter as a subsection. However, the handful of sections currently existing thate were written before the 1954 Codification continue to lack subsections.

d. Section 121 entitled “Exclusion of gain from sale of principal residence” determines if the gain on the sale of a home is taxable.

4. Students must access a tax research database and answer the following questions; then repeat the problem on a different tax research database and compare the ease of use of the database: 34

a. A keyword search of “moving expenses” in the Regulations includes various regs, such as: Reg. sec. 1.62-1T Adjusted gross income (Last amended 1992).

Reg. sec. 1.67-1T 2-percent floor on miscellaneous itemized deductions (1988).

Reg. sec. 1.82-1. Payments for or reimbursements of expense of moving from one residence to another residence attributable to employment or self-employment. (Last amended 1978).

Reg §1.217-2 Deduction for moving expenses paid or incurred …. (Last amended HTML

1995) .

Reg §1.262-1 Personal, living, and family expenses. (Last amended 1972).

NOTE: Students find RIA Checkpoint easier for conducting tax research than LexisNexis Academic because the results in RIA Checkpoint are grouped by source (such as Regulations) and the results show the more conventional citation form used in tax.

b. When conducting a keyword search of “tuition credit” in the Internal Revenue Bulletin/Cumulative Bulletin, the exact phrase will not appear in any document. However, a search without the quotes will show the three most recent Revenue Rulings, as of mid 2009: 1) Rev. Rul. 76-167, 1976-1 CB 329.

2) Rev. Rul. 73-255, 1973-1 CB 54.

3) Rev. Rul. 71-413, 1971-2 CB 228. **RIA Checkpoint has more resources indexed to this particular topic than the LexisNexis Academic. Encourage students to double-check the relevance of their search results.

5. None of the expenses paid by Minsu’s family for his Disney Training Program, prior to his becoming a Rock Star, are deductible. They are nondeductible personal expenses. Sec. 261.

“Expenses of taking special courses or training … in seeking employment … are not deductible.”

Reg. § 1.212-1(f).

6. Section 6707(b)(1) provides a $50,000 penalty for failure to furnish information regarding reportable transactions, except tht listed transactions incur a penalty the larger of of $200,000 or 50% of the gross income derived from the services related to the listed transaction . If the omission is intentional, the penalty percentage is increased to 75%.

7. “Reportable transactions are listed transactions, confidential transactions, transactions with contractual protection, loss transactions, and transactions of interest. “ Reg § 1.6011-4(b).

8. Key issues include the following: (1) Can a cardiologist deduct the loss from the sale of his personal residence when relocating to a new business location?

(2) Is the reimbursement for the loss on selling one’s house included in gross income?

(3) Does the tax consequences for the reimbursement depend upon whether one takes a deduction?

Refine each issue more precisely by identifying in the issue the most relevant Code provision for legal research.

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9. a. IRC § 62(a)(2) addresses classifying certain trade and business deductions of employees as deductions for AGI. b. IRC § 162(e)(4) addresses the meaning of “influencing legislation.” c. IRC § 262(b) disallows personal, living, and family expenses. d. IRC § 6702(a) provides the civil penalty on frivolous income tax return.

10. The Code sections that highlight the main tax law provisions for the following topics are: a. Gift tax: Sections 2501–2524 b. Capital gains: Sec. 1(h), Sec. 1201–1298. c. Stock dividends: Sec. 243–247 d. Business energy credits: Sec. 43, Sec. 45 11. The following subchapters of the Code address the following topics: Subchapter A: Determination of Tax Liability Subchapter C: C corporations Subchapter K: Partnerships Subchapter S: S Corporations 12. Yes, it’s possible to claim a $3,000 deduction. The loan extended to the roommates is a nonbusiness debt. Sec. 166(d). When the nonbusiness debt becomes worthless, the resulting loss is considered a short-term capital loss. Capital losses are deductible by $3,000 per tax year, beyond offsetting capital gains in the taxable year.

13. “Material advisor” is defined in section 6111(b)(1)(A). A list of reportable transactions is needed. “Reportable transactions are listed transactions, confidential transactions, transactions with contractual protection, loss transactions, and transactions of interest. “ Reg § 1.6011-4(b).

14. Reg. § 1.6038A-3 provides the rules for record maintenance. IRS Form 8886 is the Reportable Transaction Disclosure Statement. Besides revenue rulings and revenue procedures, three other types of documents that the IRS generates include Private rulings, Notices, and IRS Forms.

15. a. § 101: 10 Regulations (including 3 Proposed Regulations); the last Regulation is the Prop. Reg. § 1.101-8 b. § 183: 6 Regulations (including one proposed and one reserved); the last Regulation is Reg. § 1.183-4 c. § 385: No Regulations.

Using the Code 16. A deduction for traveling expenses while away from home in the pursuit of a trade or business exists under Section 162(a)(2). This deduction includes amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances.

Section 274 has several subsections that disallow certain travel expenses. Subsection 274(c) disallows certain foreign travel expenses. Subsection 274(h) disallows certain foreign 36

convention travel expenses. Section 274(m) provides additional limitations on travel expenses.

Subsection 274(n)’s 50% limitation on the deduction for meals and entertainment, also applies to travel expenses.

Note: Disallowance provisions are in Part IX (Items Not Deductible) – Sec. 261–291. Students sometimes mistakenly identify Section 62(b)(2) as a disallowance provision, when it actually determines how much of a deduction qualifies for AGI, also known as “above the line.” Section 62(b)(2) provides that a qualified performing artist can only deduct those expenses under Section 162 only if the amount exceeds 10% of his/her AGI. 17. Section 6662(b)(2) provides a penalty for a substantial understatement of income tax. The penalty applies if any part of the required income tax is attributable to a substantial understatement, as defined in Section 6662(d). The penalty is an amount equal to 20 percent of such understatement.

18. Section 105 includes in gross income amounts received by an employee through accident or health insurance for personal injuries or sickness to the extent such amounts (1) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (2) are paid by the employer.

Using the Treasury Regulations 19. Section 183 addresses activities not engaged in for profit. Reg. § 1.183-2 interprets the term “activity not engaged in for profit” under Code section 183.

NOTE: The relevant code section which a treasury regulation interprets is found in the regulation citation as the number after the period and before the dash.

Reg. § 1.183-2 provides nine factors to consider in determining whether an activity is engaged in for profit: (1) Manner in which the taxpayer carries on the activity; (2) The expertise of the taxpayer or his advisors; (3) The time and effort expended by the taxpayer in carrying on the activity; (4) Expectation that assets used in activity may appreciate in value; (5) The success of the taxpayer in carrying on other similar or dissimilar activities; (6) The taxpayer's history of income or losses with respect to the activity; (7) The amount of occasional profits, if any, which are earned; (8) The financial status of the taxpayer; (9) Elements of personal pleasure or recreation.

20. Section 162(a) provides a deduction for trade or business expenses. Whether educational expenses qualify as trade or business expenses is clarified in Reg. § 1.162-5: “Expenditures made by an individual for education (including research undertaken as part of his educational program) which are not expenditures of a type described in paragraph (b)(2) or (3) of this section are deductible as ordinary and necessary business expenses (even though the education may lead to a degree) if the education— (1) Maintains or improves skills required by the 37

individual in his employment or other trade or business, or (2) Meets the express requirements of the individual's employer, or the requirements of applicable law or regulations, imposed as a condition to the retention by the individual of an established employment relationship, status, or rate of compensation.”

b. Sally can’t deduct the cost of the tax courses within the law degree as a trade or business expense. IRC § 162(a). An individual’s educational expenses from a program of study which will lead one to qualify in a new trade or business are nondeductible business expenses. Reg. § 1.1625(b)(3). The disallowance of the deduction applies even if the education maintains or improves skills required for employment or meets the express requirements of the individual's employer.

Earning a law degree will enable Sally to qualify for a new trade or business, regardless of whether she wants to enter that trade or business.

21. Section 6707A provides a penalty for failure to include “reportable transaction” information with the tax return. Reportable transactions include “listed transactions,” confidential transactions, transactions with contractual protection, loss transactions, and transactions of interest to the IRS. Reg. § 1.6011-4. As of 2009, the IRS in a proposed regulation also included patented transctions. Form 8918 is the material advisor disclosure statement.

Locating Cases 22. In Ballard the main issue was the Tax Court’s procedure regarding a Special Trial Court Judge’s report. The Supreme Court reversed and remanded the appellate court’s decision.

23. a. A Tax Court regular decision which discusses whether hair transplants are deductible medical expenses is Mattes v. Commissioner, 77 TC 650 (1981). b. The Tax Court held the hair transplant operation was a specific medical treatment, so the cost of the hair transplants qualified as a deductible medical expense under Sec. 213(e). c. Hair transplant is now regarded as cosmetic surgery and such cost does not qualify as a medical expense. “Medical care” does not include cosmetic surgery, unless the surgery is to correct a deformity arising from birth, an accident, or disfiguring disease. Section 213(d)(9)(A).

Using Revenue Rulings 24. Revenue Ruling 2003-25 addresses fringe benefits for non-commercial flight valuations.

The ruling was issued on 3/28/2003. This Revenue Ruling interprets Section 61.

25. Revenue Procedure 2008-20 provides guidance for material advisors to prepare and maintain lists for reportable transactions under § 6112. This revenue procedure was effective May 1, 2008. See IRS Form 8886.

Evaluating Different Sources 26. A Circuit Court of Appeals decision is precedent to taxpayers within that court’s jurisdiction.

Because the Tax Court must follow the appellate court, the taxpayer should not go to Tax Court 38

in that jurisdiction. Instead, the taxpayer must pay the amount in dispute and sue for a refund in district court. A district court’s decision from another part of the country is not precedent.

27. Advise the client that the article written by a famous tax lawyer is not a source of authority, but it may provide some perspectives for the case. A revenue ruling is issued by the IRS to provide interpretation of the tax law. However, a revenue ruling does not carry the same legal force as regulations. The IRS may revoke or modify the revenue ruling by subsequent rulings or treasury regulations.

28. A private letter ruling does not have a preferential value for a subsequent case. Whereas, a Tax Court regular decision is a precedent to subsequent cases by the Tax Court. Thus, if a Tax Court decision on point is unfavorable, the taxpayer should avoid using the Tax Court.

Conducting Tax Research and Documention 29. The following is a brief memo explaining the tax consequences of the football scholarship.

Tax File Memorandum July 30, 2004 From: Student’s Name Subject: Athletic Scholarship Facts: Best Friend received a full scholarship from the University of Colorado at Boulder for playing college football. The scholarship covered tuition, dorm room and meal costs at the university.

Issue: Whether a scholarship received for playing on a college sports team is gross income as compensation for services under sec. 61(a)(1) or excludable as a qualified scholarship under sec.

117(b)?

Conclusion: An athletic scholarship is excludable to the extent of other qualified scholarships.

Reasoning: A qualified scholarship is excluded. Sec. 117(a). The exclusion covers qualified tuition and related expenses for fees, books, supplies, and equipment. Sec. 117(b)(2). Amounts paid as compensation for services is not considered a scholarship. Reg. § 1.117-4. Athletic scholarships awarded by a university primarily to assist the recipients in pursuing their studies are excludable from the recipients' gross income. Rev. Rul. 77-263, 1977-2 CB 47. The amounts received by Best Friend for the dorm room and meals are gross income. Reg. § 1.1175(c)(1) flush language.

30. The following is a brief memo explaining the tax consequences of swapping services within the family context.

Tax File Memorandum January 30, 20XX From: YYY 39

Subject: Personal services within the family Facts: Older sister Sara agreed to tutor her younger sister in math for about a month. Older sister usually charges her clients $500 for similar services. Younger sister usually charges $100 for tax research services.

Issue: Whether services provided between siblings represents gross income as compensation for services under sec. 61(a) or are excludable as gifts under sec. 102(a)?

Conclusion: The value of the services are excludable as gifts because of the family context.

Reasoning: Except as provided, gross income includes compensation for services under section 61(a)(1). Gross income includes income realized in any form, including services. Reg. § 1.611(a). However, sec. 102(a) states that gross income does not include value of property acquired by gift. The Supreme Court defined as gift in Commissioner v. Duberstein, 363 U.S. 278 (1960), as essentially coming from true love and affection. The family context of the sisters suggests real love and affection for a gift excludable under sec. 102(a).

31. The issue before the Court of Appeals was whether Reg. § 1.882-5 is consistent with the U.S. obligations under its tax treaty with the United Kingdom. (The Bank sought a refund of $66,000,000. The citation for the prior decision was National Westminster Bank v. United States, 40 Fed. Cl. 120 (2003), 92 AFTR 2d 2003-7013.

32. a. The athletic scholarship for tuition, books, supplies, and equipment is excluded under Section 117(a). Athletic scholarships must primarily assist the student in pursuing their studies.

Rev. Rul. 77-263, 1977-2 CB 47. An athlethic scholarship covering expenses for meals creates gross income. Reimbursement of the clothing and fitness camp expenses is probably gross income but may depending on the particular facts, as to whether the clothing is football uniforms and the fitness camp is provided to all football players. b. The expenses of clothing, meals, and fitness camp are not deductible. The college football player is not yet in the trade or business of playing football.

33. Textron address tax accrual workpapers. Other topics include summons enforcement, legitimate purpose, attorney-client, tax practitioner and work-product privileges, waiver because the government was denied enforcement of IRS summons seeking corporation’s tax accrual workpapers.

Subsequent cases have cited this case. These cases include United States v. Textron Inc., 507 F. Supp. 2d 138 (D.R.I. 2007). Cases citing Tedxtron favorably include: Browning, Perry W. v.

U.S., 101 AFTR 2d 2008-1708 (DC NH 2008), Regions Financial Corp. & Subs. v. U.S., 101 AFTR 2d 2008-2184 (DC AL 2008), and Evergreen Trading, LLC v. U.S., 100 AFTR 2d 20077165 , 2007-7169, 80 Fed Cl 127 (Ct Fed Cl 2007).

34. Myrtle recognizes the $20,000 gain from transferring her gardening property. Section 108(a)(1) excludes the amount of the discharge of a qualified farmer indebtedness. Second, based on a Tax Court decision, recognize $20,000, the excess of the fair market value of the property over its basis. Third, Reg. § 108-8 states that if a debtor corporation transfers stock to a creditor in satisfaction of its indebtedness, treat such corporation as having satisfied the 40

indebtedness with an amount of money equal to the fair market value of the stock. Thus, Myrtle recognizes neither gain nor loss on the transfer of her stock.

CHAPTER 8 ASSURANCE SERVICES AND AUDITING RESEARCH

Discussion Questions 1. An assurance service engagement entails independent professionals (i.e., usually CPAs or those working for CPA firms) working to improve the quality of information, or its content for decision-makers.

2. An attest engagement entails a professional service where a practitioner is engaged to issue or issues a written communication that expresses a conclusion about the reliability of a written assertion that is the responsibility of another party. An audit would be an example of an attest engagement since the auditor is issuing a written audit report on the client’s financial statements.

3. Besides performing financial statement audits, the CPA practitioner can perform attestation, review, and prospective financial information engagements.

4. Unlike auditing standards, attestation standards add assurance to information other that historical financial statements. Attestation standards are an extension to the auditing standards.

5. The guidelines used to encompass accounting and review services consist of the AICPA’s Statements on Standards for Accounting and Review Services (SSARS).

6. Unlike auditing standards, which provide measures of the quality of performance, audit procedures refer to the steps the auditor should perform in the engagement. Furthermore, while auditing standards remain identical for all audits (e.g., maintaining the CPA’s independence), auditing procedures change, depending on the nature and type of entity under audit and the complexity of the engagement.

7. The ten GAAS serve as broad guidelines as to the quality of performance in conducting an audit, whereas the SASs serve as interpretations of GAAS. 8. The first and third General Standards of GAAS ("technical competence" and "due professional care") are important to the research process because the practitioner must first master a research methodology in order to determine if the auditor is in compliance with GAAS and the entity is following GAAP. Second, performing research properly requires the auditor to competently plan, exercise and review this process and to use due professional care in doing so.

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9. The PCAOB stands for the Public Company Accounting Oversight Board that was created by the Sarbanes/Oxley Act of 2002 to establish auditing and related attestation, quality control, ethics, and independence standards to by used by registered public accounting firms.

10. The Single Audit Act incorporates the concept of an entity-wide financial and compliance "single audit," rather than various federal agencies conducting separate financial and compliance audits. The Act requires an annual audit of any state or local government unit that has received $100,000 or more in Federal financial assistance.

11. Primary auditing guidelines in the public sector include the General Accounting Office's "Yellow Book," the Office of Management and Budget's Single Audit Act, and the AICPA’s Attestation Standards, GAAS, and applicable Audit Guides.

12. The importance of the Code of Professional Conduct is that it outlines a minimum, mandatory and enforceable level of conduct in performing audits.

13. Rules 202 and 203 of the AICPA’s Code of Professional Conduct are important to CPAs, since the provisions of this Code are applicable to all CPAs--whether they are in public practice, these two Rules apply to practitioners. Specifically, Rule 202 requires CPAs who perform auditing, review, compilation, management advisory, tax, or other professional services to comply with standards promulgated by bodies designated by Council. Rule 203 prohibits auditors from expressing an opinion that financial statements are in conformity with GAAP if the statements depart materially from accounting principles promulgated by bodies designated by AICPA Council.

14. Accounting and auditing research helps practitioners comply with Rules 202 and 203 of the AICPA’s Code of Professional Conduct as a critical means of ascertaining if management has adhered to GAAP. 15. Professional judgment plays a critical role the accountant/auditor's daily activities, since the provisions of Rule 203 allows the auditor to be associated with financial statements that depart significantly from GAAP only under "unusual circumstances." The standard requests auditors to exercise professional judgment in justifying the position that adherence to a promulgated principle would be regarded, generally by reasonable men, as producing a misleading result.

16. The authoritative auditing literature that has general applicability includes GAAS, SASs, Auditing Interpretations, AICPA Code of Professional Conduct, and the International Auditing Guidelines for non-public company audits, and the PCAOB Standards for audits of public companies.

17. Some guidelines available to help the accountant serve nonpublic clients include provision' of the U.S. Comptroller General's Standards for Audits of Governmental Organizations.

Programs. Activities, and Functions, GAO's revised Government Auditing Standards and U.S. Single Audit Act. 18. The authoritative body that exists to develop international auditing standards is the 42

International Auditing Practices Committee (IAPC).

Exercises 1.

ISA 500 (redrafted) Audit Evidence (published December, 2008).

ISA 505 (revised & redrafted) Enternal Confirmations (published December, 2008).

2.

The eight elements of reasoning include the following: a.

Purpose—the purpose is to respond to the request by the client. b.

Issue—the issue before the practitioner is what type of service engagement this is, which will direct the report to issue. c.

Information—the information to review would entail the assurance services standards, and in particular the consulting literature. d.

Concepts—the main concept to consider is the idea of the reliability of electronic commerce activities. e.

Assumptions—if the client is following proper electronic commerce practices and has implemented proper controls, it can be assumed that its activities are reliable. f.

Interpretation or Inference—since this assurance service falls under the domain of consulting services, the practitioner would follow consulting standards in conducting the review and reporting on the reliability of the activities. g.

Implications or consequences—if activities are not reliable, the practitioner will so state in the report. h.

Solution—The report by the practitioner would either state that the client’s electronic commerce activities are reliable, or not reliable, depending on his or her review.

3. AU Section 330.17-.21 explains the ue of the positive and negative confirmation forms.

4.

Section 220 of the AICPA Bylaws provides the requirements for admission to membership of the AICPA which includes: a) possession of a valid CPA certificate, b) passed the examination, and c) obtained necessary practical experience.

5-a. . SAS No. 100 (AU Section #722) Interim Financial Information provide the guidance on review interim financial information. The following is an example of a review report: Independent Accountant's Report We have reviewed the accompanying [describe the interim financial information or statements reviewed] of ABC Company and consolidated subsidiaries as of September 30, 20X1, and for the three-month and nine-month periods then ended. This (These) interim financial information (statements) is (are) the responsibility of the company's management.

We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion 43

regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modifications that should be made to the accompanying interim financial information (statements) for it (them) to be in conformity with accounting principles generally accepted in the United States of America.

[Signature] [Date] 5-b. AU Section 543 of the U.S. Auditing Standards provides information when part of the audit is conducted by other independent auditors and provides the following example of appropriate reporting by the principal auditor indicating the division of responsibility when he makes reference to the audit of the other auditor follows: Independent Auditor's Report We have audited the consolidated balance sheet of X Company and subsidiaries as of December 31, 20...., and the related consolidated statements of income and retained earnings and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the financial statements of B Company, a wholly-owned subsidiary, which statements reflect total assets and revenues constituting 20 percent and 22 percent, respectively, of the related consolidated totals. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for B Company, is based solely on the report of the other auditors.

We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.

An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit and the report of the other auditors provide a reasonable basis for our opinion.

In our opinion, based on our audit and the report of the other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of X Company as of [at] December 31, 20...., and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.

When two or more auditors in addition to the principal auditor participate in the audit, the percentages covered by the other auditors may be stated in the aggregate. [Revised, April 1998, to reflect conforming changes necessary due to the issuance of Statement on Auditing Standards Nos. 53 through 62. Revised, October 2000, to reflect conforming changes necessary due to the issuance of Statement on Auditing Standards No. 93.]

6.

As of 7/1/09, the three most recently issued auditing standards were: SAS # 116—Interim Financial Infsormation (2/09).

SAS #115—Communicating Internal Control Related Matters Identified in an Audit (10/08).

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SAS #114—the Auditor’s Communication with Those Charged With Governance.

(12/06).

7.

As of 7/1/09, the PCAOB most recent auditing standards are: Auditing Stnadrad #6—Evaluating Consistency of Financial Statements Auditing Standard #5—An Audit of Internal Control over Financial Reporting

8. Type of Engagement---Attestation Engagement Related Standard: AT Section 201- Agreed-Upon Procedures Engagement SSAE No. 10 and No. 11.

9. An adverse opinion is appropriate “when in the auditor’s judgment the financial statements taken as a whole are not presented fairly in conformity with GAAP.” Professional Standard Section: AU 508.58.

10. Additional standards applicable: Yes Appropriate standards: Statement on Standards for Consulting Services.

CHAPTER 9 REFINING THE RESEARCH PROCESS

Discussion Questions 1. The focus of accounting, auditing, and tax research includes determining appropriate alternative principles, locating relevant authorities for those alternatives, and using professional judgment in applying the authorities and principles for solving the problem.

2. The three part approach used to identify the precise problem or issue is as follows: 1) Preliminary problem identification.

2) Problem analysis.

3) Refined statement of the problem.

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3. The two ways to collect evidence are (1) a review of authorities and literature and (2) a survey of present practice.

A review of related accounting, tax, or auditing authorities and literature searches for the highest level authorities, statutory law for tax and official standard-setting bodies for accounting—generally the FASB and PCAOB or, in certain cases, the SEC, GASB, or others.

A survey of present practice is assisted by using financial research databases or using a google search to find relevant Web sites and other accounting, tax, and auditing resources..

4. Keywords are used to evaluate and collect evidence to locate relevant authorities. Sometimes a diagram can help the researcher in conducting and documenting an efficient literature search.

The researcher also can review a list of keywords identified from the statement of the problem for relevant citations, cross-references to other terms in the text, whether broader, narrower, or related terms and examine these additional terms for potential citations.

5. Students will have different answers to determine accounting alternatives. Some might suggest the importance of consulting with others in the firm, particularly those with more professional experience. Another approach is to check a survey of current practices to obtain ideas. Perhaps another answer is to brainstorm alternatives and verify their reasonableness.

6. The purpose of a research memorandum is to serve as a communication medium which delivers the conclusion of the research problem in a concise and clear way and provide the supporting reasoning and documentation needed..

7. The researcher should document the research process with the following information: a) A statement of the problem and relevant facts. b) References to legal and authoritative literature used, along with a brief explanation of the relevant parts of the authority. c) A description of alternative procedures considered and the authoritative support for each alternative. d) An explanation of why certain alternatives were discarded and why the recommended principle or procedure was selected.

8. Some basic ways of keeping current with the authoritative literature are developing a checklist, preparing some pronouncement summaries, reading of periodicals, reviewing accounting newsletter and utilizing the news information on the internet 9. Complexities in international practice include increased outsourcing of work so as to raise more questions about whether laws are enforced and professional standards are similarly applied.

10. Skills needed for the CPA Exm include knowledge, oral and written communication skills, and application skills.

Exercises 1. What the audit committee must do is explained at 17 CFR 229.306 (item 306 with Reg. S-K).

The audit committee must state whether: (1) The audit committee has reviewed and discussed the 46

audited financial statements with management; (2) The audit committee has discussed with the independent auditors the matters required to be discussed by SAS 61; (3) The audit committee has received the written disclosures and the letter from the independent accountants required by Independence Standards Board Standard No. 1, and has discussed with the independent accountant the independent accountant's independence; and (4) Based on the review and discussions above, the audit committee recommended to the Board of Directors that the audited financial statements be included in the company's Annual Report on Form 10-K, the annual report to shareholders required by Section 30(e) of the Investment Company Act of 1940 and Rule 30d-1 for the last fiscal year for filing with the Commission.

2. SEC Accounting and Auditing Enforcement Release No. 1062 discussed a case against the Sony Corp. and Sumio Sano for their violations of the periodic reporting provisions applicable to foreign issuers in the Section 13(a) of the 1934 Act and other relevant rules, and violations of industry segment financial reporting provisions in the FAS 131.

3. A tax treaty exists between the United States and Japan with respect to taxes on income. The treaty was signed at Tokyo on March 8, 1971 and took effect on July 9, 1972.

4. ASC 280-10-05-3 requires using a “management approach [to segment reporting] … based on the way that management organizes the segments within the public entity for making operating decisions and assessing performance. Segment reporting under international accounting is under IAS 14 and conveniently summarized by Deloitte at http://www.iasplus.com/standard/ias14.htm.

5. The major music production companies which compete with Sony are Universal Music Group, Warner Music, and EMI Group. Find the information by using either LexisNexis (business > company profiles > sony music) for the Hoovers Industry snapshot or a google search on the music industry, such as in Wikipedia. The answer is not as important as the student discussing the search process and delving into different databases. NOTE: This problem is repeating ch 6, problem 25.

6. NOTE; This is a good problem to have students revise after their initial efforts.

List of Relevant Authorities: 17 CFR, §210.2-01 (Regulation S-X, Rule 2-01) PCAOB Interim Standards (AU §§ 220 and 311) AAER-2859 (Aug. 5, 2008) AICPA Code of Professional Conduct Rule 101, Interpretation 101-1, and ET 92.16 Issue: Is the independence of an audit partner of a CPA firm impaired if he or she invests in a side business with a public company audit client under 17 CFR, §210.2-01 (Regulation S-X) ?

Conclusion: An auditor’s independence is impaired if he or she invests in a side business with an audit client since the audit client has the ability to exercise significant influence over the side business.

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Similarly, an auditor’s independence is impaired if he or she has a material joint closely held investment with an audit client.

Reasoning: Legal Authorities Discussed (SEC and PCAOB standards, as approved by the SEC) The SEC will not recognize an auditor as independent if the auditor cannot exercise objective and impartial judgment during an engagement. A qualified auditor must have independence from their audit clients in both fact and appearance. An auditor’s independence is considered impaired if the auditor has a material investment in an entity over which the audit client has the ability to exercise significant influence. 17 Code of Federal Regulations (CFR) §210.2-01.

An accounting firm’s independence includes its mental attitude and any covered person under AU §220.01. The auditor must be free from any obligation to or interest in the client, its management, or its owners so that the general public recognizes the auditor as independent.

PCAOB Interim Audit Standard (AU § 220.03).

The term “covered persons in the firm,” as defined in Rule 2-01(f)(11), includes not only all partners, who conduct an audit, review, or attestation engagement of an audit client, but also individuals who are capable of influencing the audit process either through their oversight of the audit itself or through their influence over the members of the audit engagement team. It also includes any other partner or principal from an `office' of the accounting firm in which the lead audit engagement partner exists. PCAOB Interim Audit Standard (AU § 311.046).

An SEC enforcement decision in Accounting and Auditing Enforcement Release (AAER) #2859 concerned independence-impairing business relationships. Ernst & Young was ordered to pay disgorgement of $2,4 million and prejudgment interest over $500,000 due to an independenceimpairing business relationship between E&Y and Mark Thompson, a member of the board of directors of three of E&Y’s audit clients. The relationship between E&Y and Thompson involved their collaboration in the creation of audio CDs called The Ernst & Young Thought Leaders Series. Two E&Y partners were ordered to cease and desist from causing any future securities violations.

Other Professional Standards Discussed (AICPA) The AICPA’s Code of Professional Conduct Rule 101 also require independence in the performance of professional services provided by its members. An auditor’s independence is considered impaired if the auditor has a material joint closely held investment with the audit client under ET-Int. §101-1(A)(3). A “joint closely held investment” is an investment in an entity or property by the member of AICPA and the client’s directors or officers, or any owner who has the ability to exercise significant influence of the client that enables them to control the entity or property. ET-INT 92.16 Application of Relevant Authorities: 48

If the audit partner of a CPA firm holds an investment in a computer side business with a member of the board of directors of a public company of an audit client, his or her independence is considered impaired. In this situation, the audit client has significant influence over the investment, therefore, the auditor is not independent. 17 CFR §210.2-01 (Reg. S-X, Rule 2-01).

Assuming that the audit partner in question does not engage in direct audit and review services, if the firm has only two audit partners, then, 17 CFR §210.2-01(f)(11), Reg. S-X, Rule 201(f)(11) classifies the second partner as a covered person, as he may perform second partner review. Hence, the audit partner may be a covered member in a two-partner registered accounting firm even though he does not engage in direct contact with the audit client.

The problem exists if the lead partner of the audit client practices in the same office as the audit partner. If the lead partner who associates with the audit client practices in the same office as the audit partner, the audit partner will be a covered member. Hence, without contrary to current assumptions, the auditor in question may be a covered person. AU § 311.046.

In addition, as a covered person (the audit partner) has a direct business relationship with director, it indicates that this direct business relationship impairs the independence of an auditor with respect to the audit client in pursuant to Reg. S-X, Rule 2-01(c)(3). (17 CFR §210.2-01).

An auditor must be free from any obligation to or interest in its owners (directors) so that the general public recognizes the auditor as independent. As the audit partner has business interest with the director of the audit client, who has the power to influence the audit client, such as by holding a seat in audit committee, the general public may perceive that this business relationship may not be, in appearance, independent. PCAOB Interim Audit Standard AU § 220.03.

The audit partner and the member of board of director’s business relationship is similar to the business relationship described in AAER #2859. If the SEC finds that the joint investment in the computer side business is independence-impairing, then the audit partner must cease and desist from causing any future securities violations and lose the right to practice as an accountant before the SEC. It is also likely that the CPA firm will have to pay disgorgement and interest charges.

Investing in a business with a board member of an audit client causes the two parties to have a joint closely held investment. AICPA Code § 101. A joint closely held investment between the audit partner and the board member of the audit client impairs the audit firm’s independence under ET-INT. 101-1(A)(3) since the audit partner’s CPA Firm is performing professional services for the board member’s company. The investment in the computer business, a material joint closely held investment with the audit client, also impairs an auditor’s independence.

As both the audit partner and the director invest in the computer business, they control the business when they engage in a joint closely held investment. ET-INT 92.16. This impairs the independence of the accounting firm as the covered member and the director held business and financial interest in the computer business.

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7. “Step 1” Identify the Problems (1) Preliminary problem identification: Should Midwest Realty recognize the future lease commitments as a loss for the current period or as period costs to be expensed in the year paid?

(2) Problem Analysis: • Midwest Realty classified the lease commitments as operating leases.

• The lease agreement was standard and no cancelable. The agreement required the lessee to make the monthly payments over 10 years and offered the lessee a five- year renewable option.

• Midwest Realty was bound by the lease agreements on all the offices.

(3) Redefined statement of the problem.

Can one recognize a contingent loss currently on the future rental commitments?

Step 2—Collect the evidence (1) Review authorities: the researcher can identify the following keywords for a literature or website search: Losses, contingent loss, contingency, lease, rental expense, commitments.

(2) Locate and review the authoritative sources and literature Keyword/ Citation Diagram Keyword Reference Descriptions Losses No relevant citations Contingencies Loss Contingencies Leases

Operating leases

Citation 450-20-05-5 450-20-55-25 840-20-50-1

Step 3—Evaluate Results and Identify Alternatives Through the examination of the documents, the following facts are identified: • Midwest Realty, Inc. has the obligation to make the lease payments on the vacant offices; • Midwest Inc. will incur a loss because it has not generated any revenue on the remaining 6 vacant offices.

• The loss is contingent upon whether Midwest company can sublease the remaining 6 offices out. The loss can be reasonably estimated and it is possible that the loss will be incurred.

Thus, based on the facts above, the amount is a contingent loss.

Step 4—Develop the Conclusion.

Recognize the loss currently on the rental commitments on the vacant offices. Since this loss is a contingent loss, disclose it in the financial statements.

Step 5—Communicate the results 50

To: Calvin Brain, Controller From: XYZ, CPAs At your request, we have reached the following matter to determine the impact on Midwest Realty. The specific issue reached concerns whether a loss can be recognized currently on the rental commitments on the vacant offices.

A loss contingency should be accrued by a charge to income if (1) it is probable that a loss has been incurred and (2) the amount of the loss can be reasonable estimated.

Midwest Realty, Inc. has an enforceable obligation to make the lease payments on the vacant offices, and has not generated any revenues by the cost incurred. We can reasonably estimated that the remaining six vacant offices could be subleased. The authoritative literature supports that the accrual of a loss for the vacant lease offices and the amount of the loss will be the minimum estimate of the potential loss.

CHAPTER 10 FRAUD AND OTHER INVESTIGATIVE TECHNIQUES

Discussion Questions 1. Four examples of fraud engagements could include: a.

Locating evidence of vendor kickbacks. b.

Locating hidden assets. c.

Providing assistance to the audit team in investigating a potential fraud. d.

Consulting as to implementation of fraud prevention, deterrence, and detection programs.

2. Forensic accounting, also commonly referred to as “litigation support,” generally means the use of accounting in a court of law.

3. Simply defined, fraud is an intentional deception. Black’s Law Dictionary defines fraud as: “A generic term, embracing all multifarious means which human ingenuity can devise, and which are resorted to by one individual to get advantage over another by false suggestions or by suppression of truth, it includes all surprise, trickery, cunning, dissembling, and any unfair way by which another is cheated.”

Four examples would include; Mangement fraud, Employee fraud, vendor fraud, and insurance fraud.

4. Three components of the fraud triangle include: 51

a. b. c.

Perceived pressure.

Perceived opportunity.

Rationalization.

Knowledge of the three elements provides the practitioner with an understanding of the different approaches that may be taken in the investigation.

5.A red flag, or risk factor, is a characteristic that provides a motivation or opportunity for fraud to occur, or an indication that fraud may have occurred.

6. Management fraud, or fraudulent financial reporting, refers to actions whereby management attempts to inflate reported earnings or other assets in order to deceive outsiders. Employee fraud, or misappropriation of assets, refers to illegal acts perpetrated by employees of a company.

7. Risk factors associated with management fraud include: a. b. c.

Management’s characteristics and influence over the control environment.

Industry conditions.

Operating characteristics and financial stability.

Risk factors associated with employee fraud include: a.

Susceptibility of assets to misappropriation. b.

Controls.

8. The basic steps of a fraud examination include: a.

Identify the issue/ plan the investigation. b.

Gather the evidence/the investigation phase. c.

Evaluate the evidence. d.

Report findings to management/ legal counsel.

9. Two examples of a business/due diligence investigation include: a.

Verifying information about an entity before entering into a joint venture. b.

A background check on new corporate officer.

10. Three computerized tools utilized by the fraud examiner include: a.

Data mining software. b.

Public databases. c.

Internet.

11. Data mining software, an outgrowth of expert systems, models a database for the purpose of determining patterns and relationships among the data. Whereas public databases are various public accessible databases that contain information of different types such as lawsuits, bankruptcies, tax liens, and property transactions. Many of these databases are useful in a fraud examination/investigation.

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Exercises 1. Answers will vary depending upon the type of search conducted.

2. Answers will vary depending upon the name of the company researched.

3. Answers will vary depending the various types of fraud identified.

4. Answers will vary as the student explains the factors in the Madoff Ponzi scheme.

5. Answer will vary depending on the Enforcement Release accessed.

6. a) Three qualifications for becoming a CFE in the U.S. include: Be an associate member; meet minimum academic and professional requirements; and be of high moral character. b) Three items in the ACFE’s library include: the EthicsLine, FraudInfo Newsletter, and Fraud Prevention Resources.

7. Answers will vary depending on site selected.

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Student Cases with Solutions to accompany Accounting & Auditing Research: Tools & Strategies (7th edition) NOTE: In addition to the in-chapter and end-of-chapter exercises which serve as short cases you will find the following short cases arranged by course title that can also be utilized as short cases that require the student to access the authoritative literature to address the issue presented in the case. Other excellent sources of longer and more detailed cases include the Deloitte Trueblood cases (www.deloitte.com/more/DTF/cases_subj.htm), as well as the AICPA cases (www.aicpa.org).

A topical listing of the cases is presented with the case and solution following the listing.

Topical Index of Student Cases INTERMEDIATE ACCOUNTING Cases Case 1: Reporting acquisition and repayment transactions in the Statement of Cash Flows Case 2: Recording a forfeited payment Case 3: Revenue and expense recognition associated extended warranties Case 4: Accounting for “due on demand” note payable Case 5: Purchase of a controlling interest with a greenmail premium Case 6: Revenue recognition in the construction industry Case 7: Accrual and measurement of interest payments Case 8: Recognition of an asset transfer when title has not yet been received Case 9: Capitalization of interest and property taxes on a construction project Case 10: Deferred compensation and life insurance policy recognition Case 11: Reporting earnings per share balances for subsidiary companies Case 12: Deferment of lease payments Case 13: Disclosure of prior period adjustments in the statement of cash flows Case 14: Measurement and recording of payments for sick days

Case 15: Comparative cash flow statements Case 16: Social security benefits as assets Case 17: Recording a stock dividend as a stock split Case 18: Gain on a nonmonetary exchange

ADVANCED ACCOUNTING Cases Case 1: Reporting of letters of guarantee notes payable Case 2: Factors affecting minority interest control Case 3: Profits and losses in the investment in foreign currencies Case 4: Amortization of foreign currency transaction gains and losses Case 5: Reflection of expensed computer programs on consolidated financial statements Case 6: Classification of a proposed financial instrument as a hedge Case 7: Disclosure of proceeds and payments from cash flow hedging activities Case 8: Proper valuation of a “guaranteed” business combination

GOVERNMENT AND NOT-FOR-PROFIT ACCOUNTING Cases Case 1: Recognition restricted or non-restricted assets that are promised but not received Case 2: Affect of “permanent” reductions in the value of “promised” assets Case 3: Disclosure and classification on a company’s Statement of cash Flows Case 4: Disclosure of potential interest rate swings and commercial paper by a city Case 5: Capital and operating leases between related parties Case 6: Elimination of profits on intercompany sales Case 7: Reporting of funds and potential obligations on bonds issued for third parties Case 8: Disclosure of payments made to agents or brokers Case 9: Accrual of vacation time of unestablished employees

AUDITING Cases Case 1: Communication with predecessor auditors Case 2: Scope limitations Case 3: Outside services for inventory counts Case 4: Supplementary disclosures Case 5: Restating prior years’ financial statements Case 6: Independence in a review or compilation engagement Case 7: Qualified report and account classification Case 8: Re-issuance of financial statements Case 9: Communication with audit committees Case 10: Accounting for assets held for sale

TAX Cases Case 1: When should gross income be accrued?

Case 2: Stock purchased by an employee Case 3: Income sourcing- international Case 4: Business deductions Case 5: Deduction for foreign travel Case 6: Contingent liabilities INTERMEDIATE ACCOUNTING Cases Case 1: Mead Motors purchases an automobile for its new car inventory from Generous Motors, which finances this transaction through its financial subsidiary, Generous Motors Credit Company (GMCC). Mead pays no funds to Generous Motors or GMCC until it sells the automobile. Mead must then repay the balance of the loan plus interest to GMCC. How should Mead report the acquisition and repayment transactions in its Statement of Cash Flows?

Case 1 Solution: Problem Identification: How should a company report, if at all, cash and non-cash transactions owed to an entity’s financial subsidiary?

Keywords: Cash flows; financ* subsidiaries; operating income.

Conclusion: Per ASC 230-10-50-5), Mead should exclude transactions that involve no cash payments or receipts. However, per 230-10-45-17, it should record cash payments to GMCC for repayments of principle (and interest thereon) due to suppliers or their subsidiaries as operating cash (out) flows.

Case 2: Narda Corporation agreed to sell all of its capital stock to Effie Corporation for three monthly payments of $200,000. After Effie made the first required payment, it ceased making other payments. The stock subscription agreement states that Effie, thus, forfeits its payments and is entitled to no other future consideration. How should Narda record the $200,000 forfeited payment?

Case 2 Solution: Problem Identification: How should a company account for forfeited stock subscriptions? Moreover, do such payments constitute operating or other income?

Keywords: Stock Subscription; operating income; additional paid-in capital; owners’ equity; net income; operating income.

Conclusion: Per 505-10-25-2, capital transactions that incur no future corporate obligations should be excluded from calculating net or operating income. Thus, the forfeited cash should become part of additional paid-in capital about any required disclosures for such transactions.

Case 3: Lowland Appliance Stores offers customers purchasing its appliances separately priced (extended) warranties. Lowland services these extended warranties. Its customers can receive no refunds for not using these warranties, and, of course, Lowland must honor these contracts—regardless of any future costs in doing so. It also “tracks” the profits and losses these types of warranties generate by appliance category—in order to help maintain a competitive price and costing structures. How should Lowland recognize the revenues and expenses of such extended warranties?

Case 3 Solution: Problem Identification: How should a company recognize revenues and expenses associated with separately priced, extended warranties? Such contracts generally are (potential) loss contingencies.

Keywords: Loss contingency; non-refundable

Conclusion: Per 605-20-25-3, such extended warranties constitute “product maintenance contracts,” where Lowland agrees to perform certain agreed-upon services to these products for a specific time period. As such, it should recognize revenue on a straightline basis over the contract period, unless sufficient historical evidence indicates a superior alternative method of doing so. Lowland should also “match” any related costs in the same time period as the associated revenues. Moreover, Lowland should recognize a loss on such contracts that have an expected net cumulative loss over the remaining contract periods. Further information on this topic also appears in 450-20-05-3 and 46010-25-5; FASB Concepts Statement No. 5, pars. 83 and 84; and FASB Concepts Statement No. 6, par.197.

Case 4: As of January 1, the Lohse Company owes the First Arbor Bank $350,000 which is due on December 31. Since Lohse seems unable to repay the note, the bank agreed that Lohse can “settle” this balance by agreeing to make four, annual installments on each of the next four years, provided that it adds a “due on demand” clause to the note.

Specifically, the lender will “do its best” not to call the note “provided that no adverse significant shift in operations occurs." However, First Arbor Bank has the sole discretion to ascertain if these adverse conditions arose, and then to call the note due immediately.

How should Lohse account for this above situation?

Case 4 Solution: Problem Identification: How should a company account for notes payable containing a “due on demand clause” and both a short- and long-term schedule of payments due?

Keywords: Due on Demand; Notes Payable; Classification of Obligations; Installments.

Conclusion: Per 470-10-45-9 and 10, notes that are “due on demand” should be considered as a current liability However, if Lohse expected to refinance this note on a long-term basis (and a reasonable basis to demonstrate such refinancing existed), it would then reclassify the note as a long-term liability.

Case 5: On January 1, the Chin Company agreed to purchase all of Jack Jackson’s interest in the company for $30 per share. Jack, who owns 15%—and a controlling interest of Chin—previously threatened to engage in a hostile takeover attempt of Chin.

For the last two years, Chin’s stock traded from about $12-23—reaching $23 on December 31 of last year. How should Chin record this transaction?

Case 5 Solution: Problem Identification: Do “greenmail” payments constitute treasury stock transactions? Should Chin assign any “premium” to acquiring Jackson’s controlling interest in the Company, and, if so, how much should it assign to the “greenmail” premium?

Keywords: Treasury Stock; Greenmail; Capital Stock; Capital Transactions.

Conclusion: Per 505-30-25-3, companies often pay “premiums” (and can even receive “discounts”) to acquire large (potentially controlling) blocks of stocks in the open market.

An entity offering a higher purchase price than the open market price should allocate some portion to the unstated rights or privileges and give separate accounting recognition.

Case 6: Bo Broker Company charges a fee for bringing together the Acme Construction Company and the First Bank Company. The parties agree that Bo earns her fee when Acme and First “agree” to the terms of the construction mortgage. However, Bo can receive four types of documents to “settle” this matter: (a) a non-interest bearing, unsecured “negotiable” note in payment of the fees earned, which is payable over the time period of the related construction mortgage; (b) a non-negotiable note payable over the same time period as in case (a); (c) a commitment letter, not contingent upon the “future event” of the borrower receiving certain construction draws; or (d) a commitment letter, where the fees would be paid only if the borrower actually receives the draws for the construction from the lender. Bo asks the accountant when to recognize revenues under each of these four scenarios.

Case 6 Solution: Problem Identification: What circumstances must exist for an entity to recognize income—especially regarding the issue of when it can “control” the events leading to recognizing revenue?

Keywords: Revenue recognition; construction industry; commitment letter; contingency.

Conclusion: Per 450-20-25-3 Bo should recognize the revenues for each of the four cases as follows: (a) for the negotiable note, recognize income at the earlier of when services are performed and billed or when receiving consideration for the proceeds of the note; (b) same as “(a),” except that early consideration is not feasible; (c) for the commitment letter, recognize revenues upon receipt of this “outside” commitment letter which shows the completion of the earnings process; and (d) defer recognizing revenues until both outside parties fulfill their contract obligations.

Case 7: James Olds buys a four-year, $1,000,000 certificate of deposit from the Second National Bank. James will receive 5% interest in year 1; 5.5% in year 2; 6% in year three; and 6.5% interest in year 4. If James “redeems” this certificate before the maturity date, he would receive a cumulative 4.5% annual rate of interest of 4.5%. The Bank has ascertained that less than one percent of its depositors redeem their certificates before the maturity date. The bank asks its accountant how to accrue and measure such interest payment obligations.

Case 7 Solution: Problem Identification: Should the Bank recognize the future interest costs by: (1) accruing interest @ 5% for the first year, 5.5% for the second year, 6% for the third year, and 6.5% for the third year, plus appropriate compounding factors—and debit interest

expense and credit interest payable for these bonds? Or, instead, should the Bank determine the total interest that James is slated to receive at the end of the term of the bond, and accrue a pro rata share of this amount for each month of the four-year term of the bond?

Keywords: Bond amortization and discount; contingent liability; interest expense.

Conclusion: Per 450-20-25-1 and 3, since only a remote possibility of early withdrawals exists, the Bank should use the above, monthly pro rata approach to recognize the interest due to James.

Case 8: On January 1, year 1, Melvin Corporation promises to “unconditionally” transfer a building that cost $100,000 (appraised recently at $300,000) to the Vivian Company on January 1, year 2 for a boat she bought for $250,000. As of December 31, year 2, Melvin still has not transferred title to the building, although it received title to the boat. How should Vivian and Melvin record these transactions?

Case 8 Solution: Problem Identification: At what value should Vivian and Melvin recognize like and/or non-like kind exchanges? Should the parties recognize this transaction before Vivian receives title to the building?

Keywords: Like-kind exchanges, nonmonetary transactions; barter transactions; contributions recognition; revenue recognition.

Conclusion: Per the provisions of 845-10-30-1, for “different” types of assets exchanged, both parties should recognize the acquired assets at their fair market value(s).

Since Vivian’s transaction seem more recent and objective than Melvin’s, the $250,000 value seems more appropriate. 958-605-25-8, a donee receiving an unconditional promise to receive an asset should recognize it as a receivable (until it is received). Thus, Vivian should recognize the $250,000 receivable, unless reasonable, contrary evidence arises that she should recognize some “allowance for uncollectibles” for the possibility of not receiving it.

Case 9: Herb Construction Company is building a hotel for speculative purposes. That is, the Company has not yet found a buyer for the hotel, but expects to do so within a few months. Herb, who expects to spend about another two years to complete construction of the hotel, asks his accountant if interest and property taxes associated with this construction site should be capitalized or expensed. At what rate of interest should Herb use, if any, to capitalize any interest costs?

Case 9 Solution: Problem Identification: Should property taxes and interest during construction of a hotel be capitalized or expensed? What rate of interest should be used to capitalize any interest costs? Does the fact that no present buyer for the project does not exists affects he results derived?

Keywords: Property taxes; interest: capitalization; construction.

Conclusion: Per 720-30-45-3, property taxes paid for property under development for use or sale can be capitalized but is usually treated as a period expense. Assets constructed for sale are considered qualifying assets for interest capitalization per 83520-15-5. Per 835-20-30-3 through 30-4, Herb should use a rate of interest that can be “directly” associated with the project under construction. Or a weighted average of rates applicable to other debt that Herb has incurred (even if it were associated with other projects).

Case 10: In order to help induce Jill Gregory to remain as president of the Reed Company, in 2000 it promises to pay her (or her estate) $200,000 per year for the next 15 years—even if she leaves the company or dies. Reed wants to properly record this transaction as deferred compensation, but is unsure of how many years it should use to amortize this cost. Moreover, Reed also purchased a “whole life” life insurance policy for Jill, naming the company as the sole beneficiary. Reed wants to ascertain if it can offset the cash surrender value of the policy against the above deferred compensation liability.

Case 10 Solution: Problem Identification: How many years should be used to amortize deferred compensation? Can a company offset the cash surrender value of the policy against deferred compensation liability?

Keywords: Deferred compensation; purchase life insurance.

Conclusion: Per the provisions of 710-10-25-9, the future payments should be amortized over the 15 remaining years of the contract. Moreover, per 325-30-35-1 through 35-6, Reed should report changes in the cash surrender values of life insurance policies as offsets to insurance expense costs—not as reductions in deferred compensation.

Case 11: The Bootsie Holding Company has sales exceeding $10 billion and each of its three, wholly-owned subsidiaries has sales exceeding $2 billion. Three years ago, the subsidiaries had “complex” capital structures—until Bootsie acquired them. Bootsie’s annual report shows its consolidated income and individual income statement accounts of each subsidiary company. Should Bootsie also report separate earnings-per-share balances for the three subsidiary companies?

Case 11 Solution: Problem Identification: Should wholly owned subsidiaries report separate earnings per share balances?

Keywords: Earnings per share; earnings per share: applicability.

Conclusion: Per 260-10-15-2, companies whose securities are traded publicly (or soon expect to do so) should disclose such earnings per share data. However, wholly owned subsidiaries need not do so (since no separate market for their securities exists).

Case 12: Leila Company began an operating lease arrangement with Debco Industries, which was slated to begin on January 1, at monthly lease payments of $10,000.

However, Debco’s negligence prevented Leila from moving in on time—since it failed to clean up the place adequately enough to earn a Certificate of Occupancy from the township. Thus, on January 1, Leila spent $5,000 for leasehold improvements, which enabled her to obtain the needed Certificate of Occupancy on April 1. In any event, Leila paid Debco all the required $30,000 lease payments and has decided not to pursue legal action for the “un-ready” building. However, can Leila defer the $30,000 January-March lease payments over the remaining 33 months of the lease contract?

Case 12 Solution: Problem Identification: Can a lessee defer portions of an operating lease payment for conditions beyond its control? I.e., do the periods of an operating lease begin when the payments are made or when the lessee takes operating control of the asset?

Keywords: Operating lease; leasehold improvement; capitalization of interest (or other) costs Conclusion: 840-20-25-2 states that lessees should consider rent inducements or rent “holidays” as part of the operating term of a lease. i.e., the physical period that rental property is available for use for the lessee serves as a better indicator of the amortization period of the rental contract than any payment period. Next, 840-30-25-3 states that lessees should account for scheduled rate increases over the time that the lessee takes possession of or controls the property. 835-20-15-2 also considers the time needed to get property ready for its “intended use” as the prime criteria to ascertain the capitalization period. Thus, Leila should amortize the $30,000 over the remaining 33 months of the lease.

Case 13: After the Julie Company issued its previous years’ financial statements, it noticed that it incorrectly calculated depreciation expense and, thus, disclosed this fact as a prior period adjustment in its current years’ financial statements. (This difference also did not affect any cash balances, since Julie maintained an operating loss for both periods.) However, Julie did not issue comparative financial statements in the current year. Julie now wonders how to disclose this prior period adjustment in its current year’s Statement of Cash Flows.

Case 13 Solution: Problem Identification: How should a company disclose prior period adjustments in its Statements of Cash Flows?

Keywords: Prior period adjustments; retained earnings; Statement of Cash Flows.

Conclusion: Per 250-10-50-9, Julie should disclose the effect of a prior period adjustment (for a single period’s financial statement) as an adjustment in the opening balance in retained earnings—plus make adequate footnote disclosures of the reasons for and effect of the adjustment. Moreover, per 230-10-50-3, Julie should also disclose information about investing and financing activities that did not result in cash receipts for the current period. Thus, Julie should also disclose the differences in the account balances of the two consecutive balance sheets both in the statement of cash flows and in an appropriate footnote.

Case 14: The Heather Company’s fiscal year ends on June 30. Its employees (with at least three months of experience) are entitled to 12 paid sick days annually for each calendar year beginning on January 1. An employee not taking his/her earned sick days would receive payment thereon on December 31 of that year. How should Heather record and measure such a liability as of June 30th?

Case 14 Solution: Problem Identification: Should Heather recognize any liability for the above potential contingency, and, if so, how should it measure and record it?

Keywords: Contingency; compensated absence; matching concept.

Conclusion: Per 710-10-25-1, if : (a) the employees have worked the required time periods to earn the compensated sick pay; (b) these rights are vested; (c) payment of compensation is probable; and (d) the amount can be reasonably estimated, the liability exists. These conclusions follow “reasonable” and “probable” criteria of SFAS No. 5, pars. 5 and 22, which also require measuring the past “history” of employees using these benefits (e.g., also consider employee turnover). In this above, relatively simple example, an employee who used four days of vacation would be “entitled” to eight more—i.e., the balance that Heather must accrue. However, if, the employer plan were based upon an accrual concept, it would pro rate the untaken days for the remainder of year.

Case 15: Alex Corporation is planning this year to present comparative income statements but only the current year’s balance sheet. James Johnston, president of Alex Corporation requests your advice as to whether comparative cash flow statements for both the current and prior periods are necessary considering only the current year’s balance sheet is presented. Are there any authoritative pronouncements that address this issue that you could present to Mr. Johnston?

Case 15 Solution: Problem Identification: The issue is whether comparative cash flow statements are necessary when comparative income statements are presented, but only a single year balance sheet is also presented.

Key Words: comparative statements, cash flow statements

Conclusion: 230-10-15-3 states that a business enterprise that reports both financial position and results of operations shall also provide a statement of cash flows for each period for which results of operations are provided. Therefore, comparative cash flow statements need also be presented.

Case 16: A new client for your firm is Sam Jones who is preparing personal financial statements for a bank loan. Mr. Jones is attempting to list his social security benefits to be received based on his future life expectancy as an asset on his financial statements.

Mr. Jones states that such benefits meet the definition of an asset. Would you agree to allow the social security benefits to be listed as an asset?

Case 16: Solution Problem identification: The issue is whether social security benefits to be received based on one’s future life expectancy should be considered an asset on personal financial statements.

Key Words: assets, personal financial statements Conclusion: 274-10-35-11 states that nonforfeitable rights to receive future sums must meet certain criteria to qualify as an asset. One criteria states that the rights must not be contingent on the individual’s life expectancy or the occurrence of a particular event, such as disability or death. Since social security benefits are contingent on one’s life expectancy, such benefits do not qualify to be listed as assets on one’s personal financial statements.

Case 17: Albright Inc. has recently issued a 10% stock dividend to its existing stockholders. As a result of the issuance of the stock dividend the market price of the stock declined 25%. Albright has requested your assistance as to treating this stock dividend as a stock split. Would this be acceptable under GAAP? Case 17: Solution Problem identification: The issue for this case is whether a 10% stock dividend that reduces the market price of the stock can be accounted for as a stock split.

Key Words: Stock dividends, stock splits Conclusion: 505-20-25-1 through 25-3 state that to treat the 10% stock dividend as a stock split, Albright would need to demonstrate that the additional shares issued is large enough to materially influence the unit market price of the stock.

Case 18: Horizons Inc. has agreed to sell an investment in a subsidiary that has been accounted for on the equity method of accounting to a minority stockholder in exchange for the stockholder’s share in Horizons. Since the fair value of the investment exceeds its book value, Horizons CEO is considering recognizing a gain on the exchange. However,

the new CFO at Horizons is recommending to the board of directors that the excess from the exchange be accounted as a credit to equity. Horizons turns to you for advice!

Case 18: Solution Problem identification: The problem under review in this case is whether a gain on a nonmonetary exchange can be recorded.

Key Words: Nonmonetary exchange, nonmonetary asset, or nonreciprocal transfer Conclusion: 845-10-30-1 states that a transfer of a nonmonetary asset is a nonreciprocal transfer and should be recorded at the fair value of the asset transferred, and that a gain or loss should be recognized on the disposition of the asset.

ADVANCED ACCOUNTING Cases Case 1: Rosie Corporation has 70% of the outstanding voting stock of Smith Corporation and 10% of the voting stock of Tommy Corporation. Smith also just spent $10,000 to acquire 20% of Tommy’s voting stock. Smith has issued irrevocable letters of credit to guarantee Tommy’s notes payable. In the current year, Tommy lost $100,000. How should the parties report the above arrangements in its consolidated financial statements?

Case 1 Solution: Problem Identification: How should guarantees among related (but not fully owned) parties be disclosed in both their consolidated and separate financial statements?

Keywords: Control; consolidated financial statements; related party transactions; gain and loss contingencies.

Conclusion: First, Smith’s share of Tommy’s net losses (20% of $100,000 = $20,000) exceeds its cost basis of Tommy ($10,000). Per 430-30-25-1, entities should normally not recognize gain contingencies. Thus, the guarantee should not be recognized in Rosie’s or Tommy’s financial statements—other than through disclosures in the footnotes. Similarly, per 810-10-45-7, in the unusual case in which losses applicable to the minority interest in a subsidiary exceed the minority interest in the equity capital, such excess should be charged against the majority interest. Per 810-10-45-21, losses excess, and any further losses, shall be attributed to those interests even if that attribution results in a deficit noncontrolling interest balance.

Case 2: Joe Brock owns 10,000 of the 60,000 outstanding shares of Big Corporation; Leslie Ross own 20,000 shares; Mark Jones and his twin brother Sam each own 5,000 shares; and about 300 other shareholders own the remaining 20,000 shares—with no one other shareholder owning more than 1,000 shares. According to the provisions of SFAS 94, since Leslie owns half of the outstanding shares, he, in general, “controls” Big

Corporation and, thus, should consolidate his interest with that of the corporation.

However, Joe Brock is unhappy with Mark’s management decisions and plans to “challenge” his authority. What factors arise in considering if a minority investor can maintain such control or even prevent others from exercising such control?

Case 2 Solution: Problem Identification: Can corporate control rest with others besides the majority owner? What factors should we examine to make such a determination? Should we separately analyze situations where the minority shareholder seeks actual control, or (merely) wishes to “veto” another party (e.g., majority shareholder) from exercising this control?

Keywords: Consolidated financial statements; consolidation (of majority owned subsidiaries); contingencies; related parties; accounting changes.

Conclusion: Per 810-10-25-1 through 25-14, deciding if a minority shareholder can “overcome” the presumption that the majority shareholder maintains this control depends on many facts and judgments. First, can the minority shareholder participate, veto, or cause certain operating ordinary operating (e.g., which bank to hold corporate assets) (i.e., which it calls protective rights) and long-term (e.g., who sets top management’s salary and which tender offer to acquire the company to accept) (i.e., which it calls participating rights) management decisions to occur. Other factors include restating prior year’s financial statements if control passes to the minority shareholder; and does the minority shareholder control technology or customers of crucial interest to the company.

Case 3: The Treasury Department of Drof Motors invests “excess” funds daily (e.g., in foreign currencies). It, thus, earns profits and losses, which are included in the company’s consolidated financial statements. Should Drof consider its Treasury operations as a (distinct) segment in preparing its external financial statements?

Case 3 Solution: Problem Identification: Should corporate divisions that generate revenues and expenses qualify as an operating segment for financial statement purposes?

Keywords: Segment; operating division.

Conclusion: Per 280-10-50-1 all operating segments can be reported separately if they meet the guidelines: it generates revenues and expenses that a corporate decision-maker reviews, and has discrete financial information available. However, management should also believe that such additional information can contribute to outside readers and users better understanding the enterprises operations.

Case 4: The Builtwell Construction Company is building a hospital for a third party. As such it borrows substantial funds from a foreign bank and repays the required interest costs as scheduled. Builtwell also incurs some foreign currency truncation gains and losses on these transactions. Builtwell properly amortizes the interest costs over the life

of the construction project, but would now also like to amortize the associated foreign currency transaction gains and losses as well. Can Builtwell amortize such costs?

Case 4 Solution: Problem Identification: Should a construction company amortize or expense the gains and losses of foreign currency transaction gains and losses expended while a building was under construction?

Keywords: Foreign currency translation; capitalization (of interest costs).

Conclusion: Although Builtwell apparently correctly amortized interest costs during construction—per the provisions of 835, it can not amortize such foreign currency transaction gains and losses. Per 830-20-35-1, increases or decreases in expected functional currency cash flows become foreign currency transaction gains or losses, i.e., “period costs.”

Case 5: Tony Computer Services Corporation trades 50% of its common stock for the rights to certain computer programs of the Janet Corporation. Janet previously expensed such costs of developing these computer programs. Tony concurrently sold the other 50% interest in its stock to the Jeannette Company for $1,000,000. Tony later acquired another the rights to the Udder Computer Company’s computer programs in exchange for stock valued at $1,500,000. Tony, thus, debited Investments in Subsidiaries and credited Earnings for $1.5 million to reflect this latest transaction. How should Tony’s consolidated financial statement reflect the value of the expensed computer programs?

Case 5 Solution: Problem Identification: Should Tony recognize the “value” of the acquired computer programs, or should these results be consolidated, i.e., eliminated?

Keywords: Equity method of accounting; inter-company gains and losses.

Conclusion: Per 810-10-45-18, for fiscal years after December 15, 2008, complete elimination of intercompany income and loss is consistent with consolidated financial statements. The elimination of the intercompany income or loss may be allocated equally between the parent and the non-controlling interest. Moreover, Tony should ascertain that the $1.5 million stated value of the stock issued for the Udder Company is appropriate, e.g., by using “market valuation models” to test such valuations.

Case 6: The Rich Company seeks to limit its potential exposure from future variableinterest debt by engaging in a cash flow hedge. Thus, it seeks to acquire a financial instrument that varies in price “in opposition” to Rick’s expected payments on this debt instrument. However, it is unsure of the effectiveness of this hedging instrument—since it is unsure of the expected “timing” of such transactions. Can Rich classify this proposed financial instrument as a cash flow (or other) hedge?

Case 6 Solution:

Problem Identification: How much detail must a company have about proposed hedging activities in order to categorize them as such?

Keywords: Hedging; interest rate swaps; financial instruments.

Conclusion: 815-20-25-1 lists the criteria whereas 815-20-25-2 through 25-132 list specifics to fulfill 25-1. 815-20-25-1 requires that at the inception of the hedge the company must document the risk being hedged and how it will assess the effectiveness of the hedging instrument. Thus, if the Company can not document the time period the forecasted transaction that it wants to hedge is expected to occur, and the nature of the associated asset or liability involved, the transaction does not qualify as a hedge under GAAP. Case 7: Merrill Corporation engages in a valid cash flow hedge where it minimizes the risk from variable interest rated debt by promising to issue dividend payments from both its own portfolio and its portfolio of “outside” marketable securities. Since interest payments normally are classified on the Statement of Cash Flows as Operating Activities; payments of dividends from “outside” investments are classified as Investing Activities; and dividend payments from its own stock are financing activities, where should Merrill disclose the cash flows from the above transactions?

Case 7 Solution: Problem Identification: Where in the Statement of Cash Flows should Merrill disclose proceeds and payments from cash flow hedging activities?

Keywords: Hedging; cash flow hedging; statement of cash flow.

Conclusion: Per 230-10-45-27, cash flows from derivative instruments accounted for as fair value or cash flow hedges may be classified in the same category as cash flows from the (associated) item being hedged—provided that such an accounting policy is disclosed and the instrument does not include an other significant financing element at inception in which case it should be classified as a financing transaction. Thus, the cash flows should be categorized into the operating, investing, and financing categories—provided adequate disclosures are made.

Case 8: On January 1, year 1, the Allen Company issues 100,000 shares of its stock (which is valued at $10 per share) to acquire the Natie Company. The purchase agreement also states that Allen will pay $200,000 in year two if Natie has net income of at least $400,000 in year 2. There is a 50% chance Natie will meet or exceed $400,000 of net income in year 2. How should Allen recognize this transaction?

Case 8 Solution: Problem Identification: This “contingent” value of additional payment during a proposed business combination asks the researcher to obtain a proper “value” for the proposed transaction.

Keywords: Business combination; measurement date; contingent payment.

Conclusion: Per 805-30-25-5, the acquirer shall recognize the contingent consideration and the acquisition at the fair value = (100,000 shares * $10) + (0.5 *$200,000) =$1,100,000 (not considering time value of money) GOVERNMENT AND NOT-FOR-PROFIT ACCOUNTING Cases CASE 1: On January 1, the Hawaii Cancer Institute has received a promise from the Obama Foundation to receive a building that the Foundation recently appraised at $200,000.

However, the building cost only $125,000. The Cancer Institute promised to keep the building “permanently restricted,” i.e., never to sell it and to use it only for its work in helping cancer patients. As of the end of the Cancer Institute’s fiscal year (December 31), no title to the building was received by the Institute. How should the Institute record this transaction?

CASE 1 SOLUTION: Problem Identification: Should a not-for-profit organization recognize assets that contributors promised, but have not yet delivered? If recognition is required, what must the organization report?

Keywords: Not-for-profit, Restricted, Contributions.

Conclusion: Recognize unconditional promises to receive gifts at their fair market value. ASC 958-605-30-2. Thus, the Cancer Institute should recognize $200,000. Report the gift or contribution as permanently restricted support. ASC 958-605-45-4. Upon receipt of the building, the Cancer Institute may need to adjust the valuation of the contribution, based on how the initial fair market value appraisal was made. ASC 958310-55-4. For example, if the valuation to the Foundation was based on the amount of future cash flows from the building, the Cancer Institute must make an adjustment when it receives the contributed building.

CASE 2: On January 1, the Hawaii Cancer Institute has received a promise from the Obama Foundation to receive a building that the Foundation recently appraised at $200,000—but cost it only $125,000. The Institute promised to keep the building “permanently restricted,” i.e., never to sell it and to use it only for its work in helping cancer patients.

After not receiving title by December 30, the Institute inquired as to the status of the promised building. The Foundation stated that water damage to the building (from last year’s flood) has permanently reduced the carrying value of the building to $100,000.

The Foundation had initially hoped to set up a fund drive to help “clean up” the building.

However, both parties have agreed that as of December 31, this fund drive would not materialize and the date to receive the building would remain unknown. How should the Institute now record the promised gift?

CASE 2 SOLUTION: Problem Identification: Whether “permanent” reductions in the value of “promised” assets affect the not-for-profit entity’s valuation of “promised” assets?

Keywords: Restricted contributions, valuation allowances (for doubtful accounts).

Conclusion: The Institute should reduce its valuation for the decline in the value of the contributed receivable. ASC 958-310-55-4. After receipt the valuation may change because of the nature of the amount or prior fair market value if based on present value.

If the Institute decides that it does not want the building any longer (since it does not wish to spend $100,000 fixing it up), it may decide to reserve and write off the entire balance. Alternatively, if the Foundation removes the permanent restriction upon donation, the Institute can place the asset as an investment—which it can later sell to generate funds for other purposes.

CASE 3: On January 1, the Old Town Heart Association received a $1,000,000 endowment from the Chamber family. Under terms of the gift, the Association must permanently restrict the endowment—but may spend up to half of the interest earned on the gift or half of all profits earned from selling such investments for operating purposes. The Association immediately invested the gift proceeds in some “blue chip” stocks. Afterwards, the Association spent half of the $50,000 dividends earned from the Chamber portfolio for operating purposes. Where in the Statement of Cash Flows (i.e., operating, investing, or financing activities) should the Association report these transactions?

CASE 3 SOLUTION: Problem Identification: In which parts of a Statement of Cash Flows should a not-forprofit Association disclose and classify its activities?

Keywords: Statement of Cash Flows; not-for-profit organization; restricted funds.

Conclusion: The Association should generate a statement of Cash Flows. ASC 958-23005-2. The Association generated operating funds by decreasing the cash invested in assets restricted for endowment purposes. Thus, the Association should record as investing activities the difference between cash used to purchase investments and cash received upon their sale.

CASE 4: On April 15, the City of Old Putz invests its “available” excess cash with an investment broker. The investment broker then purchases 90-day commercial paper from a set of “blue chip” companies. On June 30, the last day of the City’s fiscal year, the City planned to “roll over” the commercial paper when they mature. However, interest rates fell dramatically in late June resulting in a lower value for the “maturing” commercial paper.

More importantly, the City now expects to receive a much lower return on its investment after reinvestment. Should the City make any disclosures or adjustments regarding these transactions?

CASE 4 SOLUTION: Problem Identification: Should a City disclose potential interest rate swings affecting bond values? Should the City remeasure and disclose the value of the maturing commercial paper? If so, what disclosures seem necessary?

Keywords: Not-for-profit, Investments, interest-earning investments.

Conclusion: Entities need not report the effect of changing market values of short-term money market investments in high quality commercial paper. GAS 31, ¶ 22. As such no further disclosures regarding this matter seem necessary. However, the City may wish to report both the amount of funds invested in such securities and its plans to “roll over” these investments.

CASE 5: Mount Pleasant Epilepsy Association is a not-for-profit agency. Joseph Howard is the Chair of its Voluntary Board of Directors. He is also the owner of Howard Insurance Company. The Association rents its facilities from Howard Insurance Company. The Company charges the Association $10 per square foot of space per month. This amount is considerably below the City’s average “market” rate of $14 for similar office space. The rental rates have not changed during the five years that the Association has occupied its present location. However, no formal agreement for this rental situation exists. Joseph has “hinted” that “one day” the Company may ask the Association to significantly increase its rental payments or move to another location. What disclosures, if any, should the Association make regarding this situation?

CASE 5 SOLUTION: Problem Identification: Does a related party situation exist between an Association and the chair of its voluntary Board of Directors? Does a capital or operating lease exist for the Association’s rental relationship? What disclosures, if any, should the Association make regarding the lease?

Keywords: Related party transactions, lease, operating lease, capital lease, disclosure.

Conclusion: The Mount Pleasant Epilepsy Association has a potential related party arrangement through the Chair of its Board of Directors. The Association should thus disclose this information—even though the lease terms seem quite favorable. ASC 85010-50-3. However, since the Association engages in a month-to-month lease (i.e., its noncancelable terms are less than one year), per, it need only disclose the terms of the lease.

ASC 958-20-60-15 (expected, but not in the exposure draft version).

CASE 6: The Oakland County Hospital performs lots of work for Medicare and Medicaid patients.

This results in both reimbursement of certain operating costs and some profit.

“Transfers” among related subsidiaries within the Hospital also contain some Medicare and Medicaid “profits.” For example, the pharmacy, nursing and anesthesiology subsidiaries often all participate in a Medicare and Medicaid surgical operation. When the Hospital prepares consolidated financial statements, it asks you whether the Hospital should “eliminate” gains on such transactions—especially if others consider such transactions as dealings with “regulated affiliates.”

CASE 6 SOLUTION: Problem Identification: Should a Hospital eliminate profits on intercompany sales and assets among “controlled” groups that participate in Medicare and Medicaid reimbursement policies?

Keywords: Consolidated financial statements; regulation; affiliates.

Conclusion: A Hospital should not eliminate sales to “regulated affiliates” if the sales price is reasonable, and through the rate-making process, future revenues are expected to equal the sales price from the regulated affiliate’s use of the products or services. ASC 980-810-45-1. Since the Hospital could receive profits on reimbursements on intercompany sales, its financial statements should not eliminate the intercompany profits. ASC 980-10-15-2.

Medicare and Medicaid are excluded because they are contractual-type arrangements between the provider and the government agency responsible to pay for the services provided. ASC 980-10-15-7. Thus, the Hospital should eliminate these inter-entity gains and losses from its consolidated statements—but could report them in the individual group members’ separate financial statements.

CASE 7: Some community leaders in St. Paul, MN desire a major league baseball team to relocate there. They want to build a domed stadium to attract such a team. After asking the City to help finance it, the City agreed to issue Stadium Bonds for this capital purpose. These bonds would not become part of the City’s consolidated financing, reporting entity. Also, the City would neither “guarantee” nor warrant the repayments of any proceeds. The City has asked how to account for these proposed transactions.

CASE 7 SOLUTION: Problem Identification: How should the City report on the bonds issued for third parties?

Keywords: Debt transactions, debt obligations, third party bonds.

Conclusion: Although the stadium bonds are conduit bonds which bear the City’s name, the City has no obligation for such debt beyond the resources provided in a related lease or loan with the third party. GASI 2 (Interpretation 2). The City should merely disclose a general description of the debt transactions, aggregate the amount of all debt obligations outstanding at the balance sheet date, and clearly indicate that the City has no obligation for the debt beyond the resources provided by the bonds.

CASE 8: The City of James has $10 million of 10% bonds payable in its financial statements. These bonds contain a call provision. The Agent Company told the City that it will help find parties to call back the old bond and refinance the bonds with 7% interest payments. The new bonds will not change the original redemption dates from the old bonds. However, Agent Company demands a $100,000 service charge for its role in these transactions. While the City Council recognizes the benefits of the proposed services, the City is unsure how to disclose such payments when the transactions are completed. Thus, City asks its accountants for guidance.

CASE 8 SOLUTION: Problem Identification: Should a City disclose payments made to agents or brokers who help them refinance its debt?

Keywords: Refunding of debt; debt defeasance.

Conclusion: The City must disclose the “old” and “new” cash flows generated by such refinancing and the resulting net savings (i.e., economic gain or loss). GAS 11, ¶ 7.

However, requires making additional disclosures regarding additional payments to escrow agents. GAS 11, ¶ 22 (Appendix A). Thus, the City should disclose any payment made to the Agent Company.

CASE 9: The City of Mall uses a June 30th year-end. On March 1, the City hired Frank Sears as its City Manager at an annual salary of $100,000. Frank—like all other employees—earns 12 vacation days per year for the first 10 years with the City.

Thereafter, he earns 18 vacation days per year.

Employees who leave the City receive payment for all vested, unused vacation days.

However, all employees must work for at least six months before they can take any vacation days. The City believes that Frank will be an excellent employee and assumes

that he will work past the required six months. Should the City accrue vacation time for the City Manager?

CASE 9 SOLUTION: Problem Identification: Should the City accrue vacation time for an employee who has not yet vested the necessary time to earn vacation time?

Keywords: Compensated absences, Vacation pay, and vesting.

Conclusion: Frank’s continued employment with the City is beyond the City’s control.

Some employees leave before vesting their vacation time. Thus, the City should not accrue vacation benefits. GAS 16, ¶ 7. After six months, to better match the vacation accrual expense, make a prior-period adjustment in the current period. This adjustment is made even if this amount is immaterial.

AUDITING Cases Case 1: In year 1, Joe Josephs, CPA, reviewed Lander Company’s financial statements.

However, in year 2, the Lander Company hired Tom Holstrum, CPA, to audit its financial statements. Should Tom meet with Joe, and would Joe be considered as a predecessor auditor?

Case 1 Solution: Problem Identification: Is a CPA who reviewed prior period financial statements considered as a predecessor auditor?

Keywords: Review, predecessor auditor.

Conclusion: SAS No.84 (AU Section 315) does require CPAs to meet with the predecessor auditors. However, Footnote 3 of this authoritative pronouncement states that CPAs performing compilations and reviews are not predecessor auditors.

Nonetheless, Tom may still wish to meet with him to discuss “problem” encountered during this review engagement.

Case 2: In Tom Holstrum’s audit of the Lander Company, Tom seeks to obtain an attorney representation letter regarding any, undisclosed potential corporate liabilities.

John Engle, the Lander Company General Council responded to this letter by citing American Bar Association (ABA) language that emphasizes attorney-client privilege regarding such unasserted claims. E.g., the letter uses such phrases as “it would be inappropriate for this firm to respond to such general inquiries” and “we can not comment upon the adequacy of the company’s listing, if any, of unasserted possible

claims or assessments.” Do such responses constitute limitations in the scope of the audit?

Case 2 Solution: Problem Identification: Do attorneys’ citing ABA language about the adequacy or inadequacy of client legal representations impairs the scope of the CPA’s audit services?

Keywords: Legal liability, unasserted claims; attorney representation letter.

Conclusion: According to the AICPA’s Interpretation of AU Section 337 (AU Section 9337.31), such responses are not limitations to the auditor’s scope of engagement.

Moreover, the ABA has advised attorneys that, under certain circumstances, attorneys should inform the CPAs of certain, pending litigation that could impair the “reasonableness” of the presented financial statements.

Case 3: Mary Howard, CPA, has long audited the Wheat City Grain Company’s financial statements. Much of Wheat City’s assets consist of wheat stored in three of its grain elevators, and the Company maintains perpetual inventory records of the quantity of wheat stored there. Concurrently, on a surprise basis, at different times each month, state grain inspectors also “count” the quantity of wheat found in these elevators—and have found no material differences in the perpetual records for the five years that they have performed this function. To save both time and audit fees, Mary wants to rely on the state inspectors’ counts instead of her making independent counts thereof. Can Mary do this?

Case 3 Solution: Problem Identification: Can a CPA rely on an objective, independent third party (i.e., part of a government agency) to substitute required generally accepted auditing procedures (i.e., observing the counting of the client’s inventory)?

Keywords: Reliance on specialists; inventory observation; outside inventory-taking firm; independence.

Conclusion: First, the concept of independence requires the CPA not to subordinate his or her judgment to an outside party. Next, SAS No. 73, pars. 8 and 12 (AU Section 336, pars. 8 &12), require auditors to both review the qualifications and independence of the specialist—and to make appropriate tests of the data the specialist provided.

Furthermore, SAS No. 58, pars. 5-6 (AU Section 508, pars. 5 & 6) allow the CPA to rely heavily on such reports—along as it does not substitute for the CPA’s own work.

Case 4: Aaron Jones, CPA, is auditing the current year’s financial statements of Low Company, a publicly traded company. Aaron notices some major fluctuations in Low’s fourth quarter of the previous year’s financial statement balances. He is aware that security holders of publicly traded company stock that does not separately report fourth quarter results often “impute” such results by subtracting data based on third quarter interim balances from the year-end balances. Thus, companies should report such

significant events as disposals of segments and other unusual items for that quarter as a note to the annual financial statements. Aaron notices that Low makes such disclosures, but is unsure if his firm should audit these additional, supplementary disclosures.

Case 4 Solution: Problem Identification: Is it mandated that the CPA audit supplementary fourth quarter disclosures of publicly traded companies? What other steps should the CPA perform in this regard?

Keywords: Association with the financial statements; interim reporting; auditor independence.

Conclusion: AU Section 9504, pars. 4 & 5 (an Interpretation of AU Section 504, Association With Financial Statements) states that auditors have no obligation to audit fourth quarter data, unless he or she was engaged to do so. However, the auditor should ascertain that management makes this separate disclosure, in which case the auditor can ask management if it wants him or her to audit or review it. In most cases, the auditor would state that such information was “unaudited” or “not covered by the auditor’s report”. Moreover, if management refuses to make such a disclosure, this “exception” is not material enough to warrant the auditor modifying his or hr “unqualified” opinion.

Case 5: Joe Josephs, CPA, issued an unqualified audit opinion for the Johnson Company’s previous year’s financial statements, which used a modified accrual basis of accounting, which is considered as an other comprehensive base of accounting (OCBOA). In the current year, Johnson switched to (normal, full) accrual system, and wants to show comparative financial statements for the two years. Should Joe require the restatement of the prior year’s financial statements using this new basis of accounting, and what disclosures, if any, should be made to the financial statements and Joe’s audit report?

Case 5 Solution: Problem Identification: Does a change in the basis of accounting warrant a restatement of the prior year’s financial statements, changes in the current year’s footnotes, or modifications to the auditor’s report?

Keywords: Auditor report; consistency; other comprehensive basis of accounting; Conclusion: SAS No. 58, par. 16 (AU Section 508.16), states that the auditor’s report should alert financial statement readers about any lack in consistency of presented financial reports. Moreover, SAS 62, footnote 35 (AU Section 623, footnote 35) states that a change from OCBOA to GAAP is not a change in consistency warranting a departure from an unqualified opinion. Thus, Joe should (merely) disclose this change as an explanatory paragraph to his audit report, while the Johnson Company should restate its previous financial statements under the new basis of accounting. It should also disclose the effects of this change in accounting principle on last year’s balances in its financial statements and footnotes

Case 6: Hugo Crossman, CPA, issued a review statement for the CUNY Company for last year and a compiled statement for them in the current year. During the current year, Hugo purchased some CUNY securities, which made him lose his independence—a fact noted in his CPA compilation report. Now, the CUNY Company management wants Hugo to issue comparative two year financial statements (last year and this year). Can Hugo re-issue his review report now that he is no longer independent of the CUNY Company?

Case 6 Solution: Problem Identification: Does a subsequent lack of CPA independence impair his or her ability to re-issue prior year’s financial statements when independence was not an issue?

Keywords: Independence; compilation; review; comparative financial statements Conclusion: SSARS 2, par. 8 states that a continuing accountant who performs a “lower” level of service in a subsequent period can re-issue the prior report. The accountant should, include a separate paragraph attached to his or her latest report that indicates this new, lack of independence and indicate that he or she performed no “update” procedures since last issuing the review report.

Case 7: Joseph Josephs, CPA is auditing the Elder Company’s current year’s annual financial statements and notices that the Company has violated the 2.1 to 1.0 current ratio requirements as part of its debt agreement with the Sunshine Bank. The company’s current ratio is 1.85 to 1. Elder’s management believes (strongly) that it will improve their current ratio during the 90-day grace period. Nonetheless, the bank has the “right” to call in the entire $2 million loan. However, Joseph is not so sure and must issue his report before this grace period expires. Should Joseph qualify his opinion or demand that Elder re-classify this loan as a short-term liability, in light of the above circumstances?

Case 7 Solution: Problem Identification: Does this present violation warrant re-classifying the loan from a long- to a short-term liability? Should Lander make any additional footnote disclosures? Should Joseph modify his audit report accordingly?

Keywords: Callable debt; audit reports (qualified or adverse); contingencies.

Conclusion: Per the FASB Codification 470-10-45-11, Elder needs to receive a waiver from the creditor or develop other evidence that the bank will not call this loan. These circumstances do not appear to be an uncertainty (per the provisions of SAS 58), since they do not involve matters to be resolved at a later date. Thus, if Joseph disagrees with Elder’s decision, he should issue a qualified (“except for”) or adverse audit opinion.

Case 8: During Joseph Josephs’, CPA, audit of the Belton Company’s prior year’s financial statements, he notices that sales and profits have fallen dramatically from their previous year highs. His subsequent (January 20, current year) discussion with John Land and Jill Her (equal 50% shareholders of the Company) indicate that John recognizes

that he spent much less time in the previous year with the business than he did in prior years. He agreed to refund $100,000 of his $1 million previous year’s compensation immediately, and John and Jill agreed that he would receive his original $1 million compensation in future years (as long as he re-dedicated his efforts on behalf of the company). Joseph then reduced the Belton Company’s previous year’s salary expense for the $100,000 refund, since the parties attributed these transactions to previous year’s events. He then issued the audited financial statements on March 2, of the current year.

However, on May 2, of the current year, the Sunshine bank called him and asked him to attribute the $100,000 to the current year’s events (since it was paid then) and to recall and re-issue the financial statements. Should Joseph require the recall and re-issuance of the previous year’s financial statements?

Case 8 Solution: Problem Identification: Was John’s $100,000 refund of “over-compensation” a prior year or current year event? If it were a current year event, should the parties recall and re-issue the prior year’s financial statements?

Keywords: Audit reports; subsequent events; matching principle.

Conclusion: Per AU Section 560, a “Type I” subsequent event provides additional information that occurred on the entity’s balance sheet date, and a “Type II” subsequent event consists of information arising past the balance sheet date. Type I events can be ignored in the current period or placed as a footnote to the financial statements. AU Section 561 states that auditors subsequently becoming aware of significant Type I subsequent events may need to recall and re-issue previously issued reports. Assuming that the $100,000 was material, the issue becomes if the refund was made due to prior year or current year events. Given the evidence presented, the parties made the decision in the current year based upon the prior year’s facts and transactions—and used “good faith” to do so. Thus, no adjustments seem necessary.

Case 9: Joseph Josephs is completing his audit of the Bolton Company’s current year’s financial statements and reads in SAS 114 (AU Section 380) that he should communicate his results with members of Bolton’s audit committee. But, despite many requests for many years, Bolton has established no such committee—primarily since it has only two stockholders. What should Joseph do now?

Case 9 Solution: Problem Identification: Does the lack of an (independent or other type of) audit committee impair Joseph from completing the audit?

Keywords: Audit committee; communications with those charged with governance; Conclusion: The provisions of SAS 114 (AU Section 380) are only applicable to entities that have established bodies charged with corporate governance. Since Bolton does not have a corporate governance body, Joseph need (and can) not report to such a committee.

This fact will not impair him from completing the audit. However, Joseph may well

suggest (again) that Bolton establish such a committee (e.g., as part of his letter of reportable conditions) Case 10: You are auditing the financial statements of Air Service Inc., an airplane wholesaler that purchases various types of corporate jets for sale to different companies or individuals. Prior to the sale of an airplane, Air Service utilizes the jet for charter service. In reviewing the financial statements, you noticed that Air Service reports these jets before selling them as part of fixed assets and depreciates such planes. The engagement partner questions such accounting and requests that you research this issue as to the proper treatment for these jets used in the chartering service.

Case 10 Solution: Problem Identification: The issue in this case is how the planes used in the chartering business should be accounted for—either as inventory or fixed assets which should be depreciated.

Keywords: Inventory, assets held for sale.

Conclusion: Per the FASB Codification the “definition of inventory” one would conclude that the primary use of the jets would determine their treatment in Air Service’s financial statements. Since the jets are held primarily for sale, and the chartering is only a temporary use, the jets should be listed as inventory (current asset) and should not be depreciated.

TAX – Cases Instructions: In writing a tax memo begin the discussion of the law with at least one paragraph on the relevant Code language. Pinpoint the location of the relevant language in the Code as precisely as possible. Then add a paragraph(s) on any relevant Treasury Regulation. Then describe any relevant cases or Revenue Rulings. Write clearly and concisely so that the tax memo is normally limited to three pages.

Write a memo identifying the legal ISSUE(s), conclusion, list of relevant authorities, discussion of the law, and the application of the law. Use these subheadings, as it is not enough to describe the law. For each CASE discuss and apply at least one relevant CASE or revenue ruling. The most important aspects of the memo are the ISSUE statement(s) and the application of the law to the problem facts. The application should integrate reference to every source of law previously discussed. Do not just answer the question asked in the problem.

CASE 1. When Gross Income is Accrued (Basic) Taxpayer is a securities firm which uses the accrual method of accounting.

Taxpayer executes stock trades and performs settlement functions. Settlement

functions include recording the sale and confirming it with the customer. Trades made on December 28, 20X5, until the end of the month are not settled until January of 20X6. Taxpayer made $1,000,000 of net commissions from these trades in late December. Since the security is not credited to the customer’s account until settlement date, taxpayer wants to declare the income on the settlement dates in 20X6. Taxpayer does not receive the money until January 20X6. Advise the taxpayer.

ISSUE: Whether an accrual basis securities firm has gross income under sec. 451(a) on the trading date or the next year on the settlement date when all the work is performed, payment is due, and money received?

CASE 1 SOLUTION: CONCLUSION: The trading date is the date for $1,000,000 of gross income from the net commissions on the securities because all the events have occurred then which fixes the right to receive the income.

DISCUSSION OF THE LAW: Gross income under section 61(a)(1) includes commissions. Gross income is included in taxable year received, unless the method of accounting is properly accounted for in a different period. Section 451(a). The accrual method generates income when all the events have occurred which fixes the right to receive such income and amount is determinable with reasonable accuracy. Reg. § 1.451-1(a).

Taxpayer was a securities company declaring income from trades on the settlement date. The Tax Court held that sales contract on the trading date was a condition precedent that fixed the Taxpayer’s right to receive the income. The settlement functions were conditions subsequent, so that the settlement was irrelevant to the determination of gross income.

– Charles Schwab Corp v. Commissioner, 107 TC 282 (1996).

APPLICATION OF THE LAW: Taxpayer has $1,000,0000 of gross income under section 61(a)(1) for the net commissions. This gross income is included in taxable year 20X5 because it is accounted for under the accrual method of accounting. Sec. 451(a). The accrual method generates income for the taxpayer when the trading has occurred, because at that time all the events have occurred which fixes the right to receive such income and amount of commissions is determined with reasonable accuracy. Reg. §1.451-1(a). As in Charles Schwab Corp v. Commissioner, 107 TC 282 (1996), taxpayer’s settlement functions were conditions subsequent, so that the settlement date is irrelevant to the determination of gross income.

CASE 2. Business Deductions? (Basic) For the past two years, Minsu, a Korean American, has worked as a high school physical education teacher. He is also a body-builder and a part-time graduate student in educational technology at State University. In preparing for a masters thesis he has decided to participate in Arnold’s World Body-building training program and analyzing advanced technology used to help students absorb physical education. Arnold’s training program has a regular faculty, curriculum, an enrolled body of students, and advanced technology in its gym equipment.

Minsu earned $4,000 during the fall 20X5 as a body-builder by coming in second in the state contest. Minsu paid $3,000 in spring 20X5 for his masters’ degree tuition at State University for one class on advanced computer technology and another $5,000 to participate at Arnold’s. How much can Minsu deduct? Minsu knows about relevant educational tax credits and want you to focus just on the deductions.

CASE 2 SOLUTION: CONCLUSION: Minsu may not deduct the cost of his graduate degree or the body-building training program since Minsu is not yet in the trade or business when the expense arose. Minsu’s father may not deduct any expenses, since they are not his business expenses.

DISCUSSION OF THE LAW: Section 162(a) allows a deduction for all ordinary and necessary expenses incurred in carrying on a trade or business. Educational expenses are never deductible if the education is part of taxpayer’s study program that will lead to qualifying for a new trade or business, Reg. § 1.162-5(b)(3), or if the study is required in order to meet the minimum educational requirements for qualification in the job. Reg. § 1.162-5(b)(2). If the education passes these two tests then the educational expense must either (1) maintain or improve existing skills required in the individual's trade or business or (2) meet the express requirements of the employer to retain his or her employment status. Reg. § 1.162-5(a).

For an employee, a change of duties does not constitute a new trade or business if the new duties involve the same general type of work as performed at the individual's present employment. Although additional education may qualify a taxpayer for a position with new duties, the education does not qualify her for a new trade or business if the new duties are in the similar type of work. Reg. § 1.162-5(b)(3).

Taxpayer had graduate educational expenses in educational psychology as part of a college's adult education program. The education was part of a degree program that led to employment as a high school guidance counselor. The Tax Court held

that these educational expenses were deductible business expenses in Schwerm v.

Commissioner, T.C. Memo 1986-16. The Tax Court agreed that the taxpayer was in the trade or business of teaching and found that the graduate education did not qualify the taxpayer for a new trade or business. Although the degree qualified the taxpayer for high school counseling, the court distinguished the result as merely a change of duties involving the same general work of teaching and related duties. A master's degree was not required to meet the minimum educational requirements for the job. The education in educational psychology helped the taxpayer maintain her job skills in education.

The Tax Court denied a deduction of a masters degree in social work for a teacher of learning-disabled students, reasoning that it qualified her for a new trade or business of entering social work fields. Reisinger v. Commissioner, 71 T.C. 568 (1979).

Deductions attributable to a hobby are deductible only to the extent that the gross income derived from such activity exceeds the deductions that would be allowable under the tax law without regard to whether the activity is engaged in for profit. Sec. 183(b)(1). Activities not engaged for in profit are defined with nine criteria in Reg. § 1.183-2. Hobby expenses are subject to the 2% floor on miscellaneous items deductions under sec. 67(b). Personal living expenses are not deductible under sec. 262(a).

APPLICATION OF THE LAW: Minsu’s educational expenses are not deductible if the education is part of a study program that will lead to qualifying for a new trade or business, Reg. § 1.1625(b)(3). The fact that the education helps Minsu maintain or improve existing skills required in the individual's trade or business is not enough. Reg. § 1.1625(a).

Minsu’s earning a masters degree in a related but slightly different field is similar to the taxpayer who was a teacher of learning-disabled students and earning a masters degree in social work. v. Commissioner, 71 T.C. 568 (1979). Applying the rationale in Reisinger, Minsu’s educational technology program could qualify him for a new trade or business in technology related careers.

Although Minsu might argue that he will have a mere change in duties after earning a masters degree, similar to a masters in counseling and guidance for a teacher under Schwerm v. Commissioner, T.C. Memo 1986-16. However, Schwerm appears distinguishable because of the threshold test that it could qualify Minsu for a new trade or business.

Arnold’s training program was an activity that appears more as one not engaged for in a trade or business, applying the factors of a hobby under Reg. §1.183-2.

Thus, Minsu deductions attributable to the hobby of body-building are deductible

only to the extent that the gross income derived from such activity exceeds the deductions that would be allowable under the tax law without regard to whether the activity is engaged in for profit. Sec. 183(b)(1). Although gym costs are normally nondeductible personal living expenses under sec. 262(a), Minsu should be able to deduct $4,000 of the costs (subject to the limitations of sec. 67(b), equal to the $4,000 earnings from the body-building contest.

CASE 3. Stock purchased by an employee (Intermediate) Sally became an employee of DotGismo, Inc., a privately held firm. On December 15, 20X3, Sally was allowed to buy 20,000 shares of DotGismo stock for $40,000 dollars. When Sally bought the stock, each share was worth $2. DotGismo retained the right to repurchase each share for $2 original purchase price if Sally leaves DotGismo at any time during the next two years for any reason. DotGismo stock increased to $5 per share in December 15, 20X5, when the two year restriction ended. Sally sold the stock on January 18, 20X6 for $9 per share, after the announcement of a new patent for DotGismo. Advise Sally roughly how much tax she must pay and for what year(s). Assume Sally is in the 35% tax bracket for ordinary income and 15% for long term capital gains.

CASE 3 SOLUTION: CONCLUSION: Any failure to make a section 83(b) election creates gross income from the restricted stock when the restriction lapsed in 20X5. The gain included in gross income is ordinary income measured by the FMV less the purchase cost basis.

DISCUSSION OF THE LAW: Gross income includes compensation for services under section 61(a)(1) and gains from the sale of property under sec. 61(a)(3). Property having a substantial risk of forfeiture which is transferred in connection with the performance of services is gross income. The income is measured by its fair market value upon the removal of the substantial risk of forfeiture, less any price paid for the stock. § 83(a).

Thus, property received in connection with the performance of services is not taxed under § 83(a) until the property has substantially vested. Reg. § 1.831(a)(1). Substantial risk of forfeiture is defined as rights to full enjoyment of such property which are conditioned upon future performance of services. § 83(c)(1).

The holding period for stock having a substantial risk of forfeiture begins when the restriction is lifted. § 83(h).

An election exists to include in gross income in the year of transfer. § 83(b)(1).

The gross income is the excess of the fair market value over the amount paid for the property. Make the election not later than 30 days after the transfer. § 83(b)(2).

An employer made a stock option plan available for key employees. The U.S. Supreme Court held that a purchase from employer for stock options is compensation for services, since it is not a gift. Commissioner v. LoBue, 351 U.S. 243 (1956).

Employee purchased employer’s restricted stock when the amount paid for the stock equaled its full fair market value. The Tax Court held that section 83 applies to all restricted stock that is transferred for services. Unless taxpayer elected at time of purchase to include income difference between purchase price and fair market value, taxpayer must recognize ordinary income for any appreciation in value. Alves v. Commissioner, 734 F.2d 478 (9th Cir. 1984).

APPLICATION OF THE LAW: Sally has gross income from compensation for services. § 61(a)(1). Sally’s purchase of Gismo stock is transfer of property in connection with the performance of services, because the stock was not widely available for purchase.

Commissioner v. LoBue, 351 U.S. 243 (1956). Sally’s stock had a substantial risk of forfeiture under section 83(c)(1) because the employer could buy it back.

Assuming that Sally did not make a section 83(b) election when she purchased her employer’s stock, Sally has income in 20X5 when the rights in her stock were substantially vested under Reg. 1.83-1(a)(1). In 20X5, Sally’s gross income is $60,000. This is measured by its fair market value upon the removal of the substantial risk of forfeiture, less the price paid for the stock (20,000 shares having a $5 per share FMV less $2 per share paid for the stock). § 83(a). Sally must recognize ordinary income for the $60,000 appreciation in value. Alves v.

Commissioner, 734 F.2d 478 (9th Cir. 1984).

In 20X6 when Sally sells the stock her gross income is $80,000 (20,000 shares times [$9 per share FMV less $5 per share basis ($2 cost + $3 prior gain recognized). The $80,000 is short term capital gain since the holding period for Sally’s stock starts when the restriction lapsed. § 83(f). Sally pays $28,000 of tax in 20X6 (plus the $21,000 of tax in 20X5).

However, if Sally made a Section 83(b)(1) election to include in gross income in the year of transfer, then gross income is the excess of the fair market value over the amount paid for the property, which was -0-. Sally must have made the election not later than 30 days after the transfer. § 83(b)(2). So she does not have additional income until 20X6, when she sells the stock. § 61(a)(3). The $140,000 gross income (20,000 shares times [$9 per share selling price less $2 basis]) is long term capital gain. Sally pays about 21,000 of taxes. (15% LTCG rate).

CASE 4. Deduction for Foreign Travel (Intermediate) Sylvia is a professor in business at the University of Hawaii. She went on sabbatical for an academic year to take courses in Chinese at National Taiwan

University in Taipei, Taiwan, to expand her knowledge of international business and to conduct research. On weekends and during the three week winter break Sylvia went sight-seeing by herself around the island, but one time gave a lecture in Tainan, Taiwan. Sylvia has documented her expenses and saved her receipts.

Advise Sylvia.

CASE 4 SOLUTION: CONCLUSION: Sylvia’s foreign travel expenses are generally deductible, because she is doing more than mere travel for educational purposes. However, disallow the extra traveling expenses around the island of Taiwan during the winter break and on weekends when she did not have a lecture to present.

DISCUSSION OF THE LAW: Section 162(a)(2) allows a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including traveling expenses while away from home in the pursuit of a trade or business.

If travel expenses are incurred for both business and other purposes, the travel expenses are deductible only if the travel is primarily related to the taxpayer's trade or business. Reg. § 1.162-2(b)(1).

Section 274(c)(1) requires an allocation for foreign travel pursuant to the regulations. The exception under sec. 274(c)(1)(B) is if the time not attributable to the trade or business outside the U.S. is less than 25% of the total time on business. Reg. § 1.274-4(d)(2) requires a daily allocation for calculating nonbusiness activity constituting 25% of travel time. Travel expenses are deemed entirely allocable to business activity, if the individual incurring the expenses does not have substantial control over the arrangements of the trip. Reg. § 1-274-4(f)(5)(i).

No deduction is allowed for travel as a form of education. Sec. 274(l)(2).

A teacher’s extension course travel to Southeast Asia was not disallowed because the courses included lectures by university professors, tours of related sights, and significant reading assignment. Ann Jorgensen, RIA TCMemo ¶ 2000-138 (9th Cir. 2000).

Section 274(d)(1) requires substantiation for the travel expense by adequate records or sufficient evidence provides various disallowance provisions on travel. Business meals are deductible by only 50% of the cost. Sec. 274(n).

APPLICATION OF THE LAW: Sylvia’s travel was more than just disallowed education expenses under Sec. 274(l)(2). Similar to a teacher’s deductible extension course travel to

Southeast courses Ann Jorgensen, RIA TCMemo ¶ 2000-138 (9th Cir. 2000), Sylvia’s classes at National Taiwan University would include lectures by university professors and significant reading assignment.

A business purpose for Sylvia’s course work is established by integrating some of her new knowledge into her activities of teaching and researching international business. Since Sylvia has travel expenses are incurred for both business and other purposes, the travel expenses are deductible only if the travel is primarily related to the taxpayer's trade or business. Reg. § 1.162-2(b)(1).

Section 162(a)(2) allows a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including traveling expenses while away from home in the pursuit of a trade or business.

Sylvia need not allocate the foreign travel expenses under section 274(c)(1) because the exception under sec. 274(c)(1)(B) applies that the time that she spent not attributable to the trade or business outside the U.S. is less than 25% of the total time on business. Thus, reg. § 1.274-4(d)(2) is not applicable.

Instead, the business travel expenses while Sylvia’s classes are in session are deemed entirely allocable to business activity, because Sylvia not have substantial control over the arrangements of the trip under Reg. § 1.2744(f)(5)(i).

Sylvia’s records should overcome the Section 274(d)(1) substantiation requirements. Sylvia can deduct her travel, lodging and 50% of the business meals. Sec. 274(n).

CASE 5. Income Sourcing – International Tax (Advanced) Hidetoshi was a world-renowned rock star from NewCountry. Sony-USA Records contracted with Hidetoshi to produce records. Sony-USA Records retained all intellectual property rights in the recordings. The contract granted Hidetoshi payments or “royalties” based upon future sales of recordings. Hidetoshi paid taxes on the payments in NewCountry as royalties. The U.S.-NewCountry treaty exempts royalties from tax in the U.S. However, NewCountry tax treaty, did not define royalties or compensation for personal services. The IRS has told Hidetoshi, his contract with Sony-USA generates personal service income in the United States. Advise Hidetoshi.

CASE 5 SOLUTION: CONCLUSION: A recording contract generates personal service income if taxpayer has no intellectual property right, so income exists.

DISCUSSION OF THE LAW: In the United States personal service income is sourced according to the location in which the services were performed. Services performed in the U.S. are U.S. source income. Sec. 861(a)(3). The “commercial traveler” exception is foreignsource income if the recipient is a NRA who is in the U.S. for 90 days or less during the tax year, the compensation does not exceed $3,000 for the services performed in the U.S., and the services performed are not effectively connected with a U.S. trade or business. Sec. 863(a)(3).

Royalties from tangible property located outside the U.S. are foreign source income. Sec. 862(a)(4). The location of royalties attributable to the use of intangible property (customer based-intangibles) is sourced according to the country in which the property producing the income is used. Rev. Rul. 72-232, 1972-1 C.B. 276.

In Ingram v. Bowers, 57 F.2d 65 (CA-2, 1932), the ISSUE was whether income received from master records cut by taxpayer’s deceased spouse was royalty income or personal service income. The master records were used in foreign countries (thus royalty income would be foreign source), while the records had been cut in the U.S. (thus personal service income would be U.S. source). The Second Circuit Court of Appeals determined that it was personal service income.

The IRS determined that broadcast rights in a foreign country of a live boxing match held in the U.S. were a license, rather than a sale. This resulted in the income being characterized as foreign-source royalty income since the rights were for use in a foreign country. Rev. Rul. 84-78, 1984-1 C.B. 173.

A record company contracted with Foreign Taxpayer to produce recordings. The company retained all intellectual property rights in the recordings. The contract granted Taxpayer “royalties” based upon future sales of the recordings. The applicable tax treaty, did not define royalties or compensation for personal services. The Tax Court in Boulez v. Commissioner, 83 T.C. 584 (1984), decided the contract was intended as a contract for personal services. Although the payments were based on future sales, existence of a property right of the taxpayer is fundamental for the purpose of determining whether royalty income exists.

Under applicable (US) intellectual property law, Taxpayer owned no intellectual property rights that he could license; the recordings were works for hire and therefore earned income from personal services. Because taxpayer performed his services in the U.S., his income was U.S. source and taxable in the U.S. APPLICATION OF THE LAW: Hidetoshi’s contract is probably service income based on the cases and distinguishing revenue ruling.

Similar to Ingram v. Bowers, 57 F.2d 65 (2d Cir., 1932), the ISSUE is whether income received from master records was royalty income or personal service

income. In both cases, while the master records were used in foreign countries, while the records were produced in the U.S. Thus, the same conclusion arises that the income generated is personal service income.

Hidetoshi’s case is factually similar to Boulez v. Commissioner, 83 T.C. 584 (1984). In both cases, a record company contracted with Foreign Taxpayer to produce recordings. The record company retained all intellectual property rights in the recordings. Because Hidetoshi owned no intellectual property rights, no royalty payment existed, instead the recordings were compensation for services.

Given that Hidetoshi performed his services in the U.S., his income was U.S. source. Sec. 861(a)(3).

Hidetoshi’s case is distinguishable from the facts in Rev. Rul. 84-78, 1984-1 C.B. 173, because no license or intellectual property was produced for Hidetoshi.

Thus, the characterization of the income is different. Hidetoshi does not qualify for the “commercial traveler” exception when the compensation exceeds $3,000 for the services performed in the U.S. Sec. 863(a)(3). Since Hidetoshi’s income is not royalties, so Sec. 862(a)(4) and Rev. Rul. 72-232, 1972-1 C.B. 276, are not applicable.

CASE 6. Contingent liabilities in a Section 351 transfer (Advanced) Xco is an accrual basis taxpayer with multiple lines of businesses. One business is a gas station. The land underneath the gas station did not appear contaminated when Xco purchased it. However, the land now has potential soil and groundwater problems (environmental liabilities). Xco engaged in a section 351 tax free exchange transferring the gas station to a new subsidiary Sco in exchange for the stock of Sco and the assumption of the environmental liabilities. Before the transfer, Xco did not take any environmental remediation efforts to clean up the land’s soil and groundwater problems. How is the basis of Xco’s land determined?

CASE 6 SOLUTION: CONCLUSION: No gain is recognized from the contingent liabilities, however, they can affect shareholder’s basis in the stock under sec. 358(h).

DISCUSSION OF THE LAW: Sec. 351(a) provides for tax free exchanges of property contributed to a corporation when the transferors receive 80% or more of the corporation’s stock.

However, gain is recognized if either other property or money, known as boot, is involved in the transaction. Sec. 351(b).

Liabilities included in the transferred property are generally not considered as boot. Sec. 357(a). However, gain is recognized on liabilities transferred if the

liabilities exceed the adjusted basis sec. 357(c)(1) or represent bad purpose liabilities for tax avoidance purposes. Sec. 357(b) The basis of the property received is determined under sec. 358(a)(1) as a carryover basis of the property exchanged, decreased by boot received, and increased by gain recognized. However, for purposes of sec. 358 basis, the liabilities assumed are treated as boot received. Sec. 358(d)(1).

Contingent environmental liabilities were removed under § 357(c)(1), because they have neither created a deduction nor effected basis. Rev. Rul. 95-74. Thus, contingent liabilities assumed, would not trigger gain to the extent such liabilities exceeded the adjusted basis of property contributed under § 357(c)(1).

Contingent liability is included in the definition of liability for purposes of determining whether basis exceeds the fair market value, so that a reduction in basis should occur. § 358(h)(3). Section 358(h) is aimed at contingent-liabilities tax shelters; so that § 358(h) reduces the basis of stock received by the amount of liabilities assumed but not below its FMV. However, sec. 358(h) does not apply if either the entire trade or business or substantially all of its assets are contributed. Sec. 358(h)(2).

APPLICATION OF THE LAW: Xco contributed property to a corporation under Sec. 351(a) for a tax free exchange for receiving Sco’s stock. Xco’s liabilities included in the transferred property are generally not considered as boot, Sec. 357(a), so no gain is recognized under sec. 351(b). However, if Xco’s liabilities exceed its adjusted basis, gain is recognized on liabilities transferred under sec. 357(c)(1). No facts on Xco indicate that the contingent liabilities represent bad purpose liabilities for tax avoidance purposes. Sec. 357(b) The basis of the property received by Xco is determined under sec. 358(a)(1) as a carryover basis of the property exchanged, decreased by boot received, and increased by gain recognized. However, for purposes of Xco’s sec. 358 basis, the liabilities assumed are treated as boot received. Sec. 358(d)(1).

An exception exists for contingent liabilities which Rev Rul 95-74, removed from section 357(c)(1), because they had not given rise to a deduction nor effected basis. So, Xco’s contingent liabilities assumed by Sco, would not trigger gain to the extent such liabilities exceeded Xco’s adjusted basis of property contributed under sec. 357(c)(1).

Xco’s contingent liabilities under Sec. 358(h)(3), are used to determine whether basis exceeds the fair market value, so that a reduction in basis should occur.

However, sec. 358(h) does not apply if either the entire trade or business or substantially all of its assets are contributed. Sec. 358(h)(2).