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Several new market segment specialization program (MSSP) audit technique guides have been issued by the IRS. These new guides address the following industries:

* Reforestation industry

* Auto body industry and repair industry

* Industries surrounding the Port of Houston

* Gasoline retailers

* Alaskan commercial fishing industry (two guides)

* Beauty and barber shops

The reforestation industry guide advises agents to watch out for nonfilers, underreporting and unsubstantiated expenses, employment tax avoidance, offsets of independent contractor income with business expenses resulting in earned income tax credit, and return preparation by unlicensed preparers.

The auto repair guide instructs agents to focus on cash accounts, inventories, depreciable assets, liability, and owner equity accounts. The guide also advises agents how to analyze sales and understand the bookkeeping systems.

The Port of Houston guide advises agents on conducting audits of industries associated with port activities such as ship and boat building and repair, trucking, warehouses, and water transportation. The guide notes common problem areas associated with the shipping business, including shipping-related excise taxes, sourcing of income, and capital construction funds.

After advising agents how to approach a gas retailing audit, that guide provides agents with information on how the industry works. As pre-audit techniques, they are advised to gather third-party information from oil companies, compute purchases and sales, and compare to the return. The guide suggests possible sources of additional income, and instructs agents to focus on capital gains, rents and other expenses, rebates, imaging reimbursements (loosely termed loans from oil companies to change signs or improve station appearance), and a number of other specific issues. The guide also focuses on problems with gas stations located on the borders of other countries or Indian reservations.

The first Alaskan fishing guide deals with issues such as the relationship of the catchers with fish purchasers and processors and revenue flow considerations. The guide also examines the reporting requirements pertaining to catchers' employees and discusses the influence of non-U.S. interests on the U.S. fishing industry. The second fishing guide examines the fish processing and brokerage industries.

The beauty and barber shop guide helps agents deal with a cash-based business with few records. The guide advises agents to use financial status audit techniques and analyze the cash flow to determine the extent of their income probe. The guide includes a list of questions to ask during the examination.

MSSP audit guides are frequently reprinted by the major tax services and are contained on some of the tax CD-ROM discs. You may obtain a copy of any of the MSSP guides directly from the IRS by writing IRS Freedom of Information Reading Room, P.O. Box 795, Ben Franklin Station, Washington DC 20044. Requests of 100 pages or less are filled at no charge. A 15¢ per page charge applies to any excess over 100 pages. The FOI Reading Room telephone number is (202) 622-5164. *

Sources: MSSP audit guides for the industries noted.


A number of enhancements to the NYSSCPA's online service, LUCA ONLINETM, were announced at its November computer show. Topping the list is Internet e-mail. It is now possible for those signed up on LUCA to not only communicate among themselves using the LUCA messaging capability, but also to communicate to anyone with an Internet e-mail address. As a result, all readers of The CPA Journal who are on the net can communicate with the editors via LUCA. Managing editor James Craig is jcraig@lucaonline.com. Editorial assistant Michael Rosencrantz is mrosencrantz@lucaonline.com. We look forward to our readers using this medium to be in touch with us.

Other enhancements include the capability to download upgrades in the LUCA software while connected to LUCA and the ability to print the LUCA file currently being accessed.

The schedule to open LUCA to all CPA Journal readers continues on track for the spring of 1996. The full details will be made available in the Journal and through a separate mailing. *


For the past several years as part of the year-end tune-up by the editors, there has been included a table of recently issued and effective accounting and auditing pronouncements to assist in calendar year-end engagements. This year that same table is presented as the final pages of News and Views in this issue. *


By Nicholas Cammarano, Jr., CPA, and James J. Klink, CPA

John Wiley & Sons, Inc. 330 pages; hard cover $105.00.

Review by Alexander A.H. Bohtling, CPA, retired from Deloitte & Touche

Real Estate Accounting and Reporting provides a comprehensive analysis of this very unique industry by two authorities in this field.

The book provides a clear overview of the complicated real estate industry and of the specialized areas of GAAP that apply to it. The GAAP covered include FASB statements and technical bulletins, AICPA industry audit and accounting guides, AICPA statements of position, AcSEC practice bulletins, emerging issues task force consensuses, and SEC requirements.

The book consists of three parts‹accounting for real estate costs, accounting for real estate sales, and accounting for investments in real estate ventures. Covered are the various accounting aspects that are applicable to investors, developers, merchant bankers, investment bankers, contractors, syndicators, mortgage lenders, and brokers. Also included are the accounting principles that apply to residential (including condominiums) and commercial properties.

The authors also point out that virtually all real estate transactions are subject to clearance of environmental matters.

The book is in its third edition. Nicholas Cammarano, Jr., CPA, is partner in charge of Price Waterhouse LLP's real estate industry services group. James J. Kirk, CPA, is retired from Price Waterhouse LLP and a former chairman of that firm's real estate industry services group.

In your reviewer's opinion, this book provides very useful guidance to a wide range of potential readers including accounting executives in the industry and CPAs in public practice. *


The National Endowment for Financial Education, the umbrella organization for a number of divisions that offer credentials and service marks in the financial planning area (such as the certified financial planner credential) recently announced the Chartered Mutual Fund Counselor Professional Education Program, the successful completion of which will lead to the CMFCSM designation. The program is jointly sponsored by NEFE and the Investment Company Institute. Topics in the nine module, self-study format course will range from risk and return to tax issues and retirement planning. The course, according to NEFE, is designed to help a broad range of investment professionals‹registered representatives, bank representatives, financial planners, registered investment advisers, mutual fund wholesalers, and mutual-fund desk representatives‹to better understand the technical aspects of mutual funds. The cost of the course is $525. Those who successfully complete the materials, pass the proctored final exam, and sign a code of ethics and related declaration will earn the CMFC designation. *


Child star Skye Bassett, who acted in Broadway shows, two made-for-TV movies, and several TV show episodes‹all before turning 15‹earned over $28,000, $56,000, and $21,000 respectively for the years 1985 through 1987. Her parents failed to file tax returns for those years despite receipt of appropriate W-2s.

The IRS asserted civil payments for lateness and negligence against Ms. Bassett and she fought the assessments, asserting she should be excused from the penalties due to her youth and ignorance. The Tax Court noted Bassett's parents' obligation to file her income taxes and their negligence in failing to file for their daughter, but nonetheless rejected Bassett's arguments. On appeal, the court noted that the IRC sections at issue did not specify exactly whose lateness or negligence would trigger the penalties.

The Appellate Court distinguished IRS practices and court opinions that held a taxpayer's illness or incapacity would provide reasonable cause excuse from these penalties. In those cases, the court held the obligation to file was on the incapacitated individual. Here the obligation to file was on Bassett's parents, not Bassett herself, so her incapacity as a minor provided no excuse. The road to stardom can be fraught with uncaring individuals (and tax authorities, it seems). *

Source: Bassett v. Commissioner, __ F.3d __ (2nd Cir. 1995).


LEXIS-NEXIS, a provider of comprehensive online services for accountants and lawyers, in conjunction with the AICPA, recently announced a special package for small firm AICPA members. The special program, available to firms with 20 or fewer CPAs, includes access to the IRC, Treasury regulations, case law, state tax materials, and AICPA accounting literature. It will also give users the capability to search related business publications.

The special pricing offer runs through January 31, 1996. AICPA members can contact LEXIS-NEXIS at (800) 227-9597, Ex. 4300 for information on this online service. *


Karl von der Heyden was recently appointed chair of the Financial Accounting Standards Advisory Council (FASAC) to succeed E. Virgil Conway who left that position to become chairman of the New York Metropolitan Transit Authority. FASAC advises the FASB on its technical agenda and assists in setting priorities for FASB's standard setting activities. With approximately 30 members, FASAC intends to replicate the constituency that FASS serves.

Von der Heyden is retired from RJR Nabisco Holdings Corp. *


By Peter Barton, MBA, CPA, JD, and Clayton Sager, PhD, University of Wisconsin-Whitewater

In Ranciato v. Commissioner, the Second Circuit Court of Appeals vacated and remanded a Tax Court decision denying losses of a retail store because the owner lacked a profit motive. Ranciato is important because the Tax Court's opinion is the first case where a court ruled that a middle-income owner of a retail business lacked a profit motive. The Court of Appeals ruled that the Tax Court misinterpreted congressional intent regarding IRC Sec. 183, which was to disallow paper losses of wealthy individuals who deliberately pursue unprofitable activities.

IRC Sec. 183 specifies that if an activity is not engaged in for profit, deductions are generally not allowed in excess of gross receipts. Therefore, losses are disallowed. An activity is for profit if the taxpayer has "...an actual and honest, even though unreasonable or unrealistic, profit objective." The burden of proof is on the taxpayer unless the activity was profitable for three of the last five years.

To determine the taxpayer's intent, the regulations specify the following nine nonexclusive factors: 1) whether the activity is operated in a businesslike manner; 2) the expertise of the taxpayer or his or her advisors; 3) the time and effort spent by the taxpayer; 4) the expectation that the activity's assets may appreciate; 5) the taxpayer's record in other activities; 6) the taxpayer's history of income or loss in the activity; 7) the amount of any profit earned; 8) the taxpayer's financial status; and 9) elements of pleasure or recreation in the activity [Reg. Sec. 1.183-2(b)]. These factors must be applied on a case-by-case basis using "common sense and an appreciation for the overall picture..."

Anthony Ranciato opened South Sea Aquarium, Pets, and Pet Supplies in 1963. Anthony's mother worked full-time days at South Sea without compensation since the 1960s. Anthony, his wife, and children worked nights and weekends at the store. Anthony kept the books for South Sea in a "very disorganized manner." He did not calculate gross profit percentages, operating expenses, or the percentage of sales from animals verses supplies.

Profitable until 1980, South Sea has incurred losses since then. During the loss years, Anthony made minimal changes in operations and did little advertising. He financed these losses from his other employment, savings, and loans. Anthony worked full-time as an electrician or real estate agent during 1985-87. He and his wife had combined gross income of $66,942 in 1985, $33,488 in 1986, and $44,221 in 1987. The IRS audited 1985-87, when South Sea's losses were approximately $21,000-$28,000 per year and gross receipts were $30,000-$39,000 per year. The IRS disallowed these losses and assessed negligence and substantial understatement penalties.

The Tax Court ruled that Anthony did not have a profit motive from 1985-87. The court cited the following facts: He did not operate South Sea in a businesslike manner; he neither had expertise nor hired experts in the pet business; he did not adopt new methods to increase profitability; he devoted little time to South Sea; the assets were not expected to appreciate; and South Sea had years of losses. The Tax Court also sustained the penalties.

The Court of Appeals first agreed that the poor bookkeeping and the failure to change operations in spite of continuing losses were evidence that Anthony lacked a profit motive. However, the court ruled that it could not affirm because the Tax Court overemphasized Anthony's negligent business methods and did not consider the following factors:

1. Congress enacted Sec. 183 to disallow paper losses of wealthy individuals, not actual losses of middle-class wage earners, even if they are inept at operating a business;

2. Anthony's methods produced profits from 1963-80; and

3. The taxpayer's burden of proof is lighter for an activity, such as a retail store, that is typically operated for profit, not recreation. The Court of Appeals concluded that consideration of these factors "might well yield a different result."

Ranciato is important because if the Court of Appeals had affirmed, every business with losses, poor bookkeeping, and minimal changes would be vulnerable to disallowed losses. Also, it's not certain that the Tax Court will reverse its opinion. Taxpayers are advised to maintain a good accounting system and use it to make decisions. *

Source: Ranciato v. Commissioner, 52 F.3d 23 (2d Cir. April 7, 1995); vacating and remanding T.C. Memo 1993-536.


The Tax Equity and Fiscal Responsibility Tax Act of 1982, TEFRA, added special rules allowing for the consolidated examination of partnership returns. Previously, when the IRS audited a partnership, each partner could attack any assessments. To represent the partnership and its owners in a consolidated proceeding, TEFRA created the function of a Tax Matters Partner, or TMP. The TMP is the general partner designated by the partnership to serve in that role or if none, the general partner with the largest interest in the profits of the partnership.

In general, the consolidated partnership proceedings have worked well. Then along came the LLC, which ordinarily is classified as a partnership for tax purposes, but has no partners and no owners with general partner liabilities. How should the IRS conduct an audit of an LLC under the consolidated partnership proceedings? Who is the person to represent the LLC in the audit? These were open questions until the October 27 issuance of proposed regulations under IRC Sec. 6231(a)(7).

The proposed regulations treat any member-managers of an LLC as general partners and any other members as partners other than general partners. The regulations define member-managers as those who are vested with the continuing exclusive authority to make the management decisions necessary to conduct the business for which the organization was formed. Where there are no designated member-managers, all members will be treated as member-managers.

The proposed regulations also address certain technical difficulties in determining which partner has the largest profits interest in determining who is the TMP. *

Source: Notice of Proposed Rulemaking PS-34-92, Fed. Reg. __ (10/30/95), containing Prop. Reg. sections 301.6231(a)(7) -1 and -2.


The attorney-client privilege protects confidential communications pertaining to legal advice between a client and an attorney. Such communications include those between a client's attorney or a third person hired by the attorney and the client. Note that the communications must be confidential and must pertain to legal advice. Disclosure of a communication protected by the attorney-client privilege cannot be compelled in court, unless certain narrow exceptions apply.

The work-product doctrine protects documents, interviews, statements, mental impressions, and other tangible things prepared by an attorney in anticipation of trial. Litigation frequently is anticipated well in advance of the commencement of a lawsuit. "A litigant must demonstrate that the documents were created 'with a specific claim supported by concrete facts which would likely lead to [the] litigation in mind,' not merely assembled in the ordinary course of business or for other nonlitigation purposes," writes the Tax Court.

Work-product doctrine protection is broader than attorney-client privilege protection. The work-product doctrine protects items prepared by another regardless of whether the client or the attorney engages the third party. In another sense, the doctrine is weaker than the privilege because the other party can force disclosure if there is a demonstration of "a substantial need for the document in preparing [the other party's] case for trial."

The Tax Court's Bernardo decision is interesting because the court analyzed the need to disclose documents produced by the taxpayer's accountant under the requirements of both the attorney-client privilege and the work-product doctrine. The case involved the charitable donation of a sculpture called Omphalos (Greek for navel) to the Massachusetts Bay Transportation Authority. The taxpayers deducted $593,000 over the course of several years for the donation. IRS notified the taxpayers that its Art Advisory Panel would be looking at the deduction and ultimately the panel determined the sculpture was worth significantly less than claimed.

In the Tax Court litigation, the IRS sought to discover many communications between the taxpayers and their attorneys and their accountants and appraisers. None of the accountant communications were protected under the attorney-client privilege. But nearly all the same accountant communications were protected by the work-product doctrine after the point that litigation became likely. This point came when the taxpayers were notified that the Art Advisory Panel was brought into the picture. *

Source: Bernardo v. Commissioner, __ TC __, Docket No. 24694-93 (June 20, 1995).


SFAS No. 106, Employers' Accounting
for Post-Retirement Benefits Other than

SFAS No. 107, Disclosures About Fair Value of Financial Instruments of a Loan

SFAS No. 114, Accounting by Creditors for Impairment of a Loan

SFAS No. 116, Accounting for Contributions Received and Contributions Made

SFAS No. 117, Financial Statements of
Not-for-Profit Organizations

SFAS No. 118, Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures

SFAS No. 119, Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments

SFAS No. 120, Accounting and Reporting
by Mutual Life Insurance Enterprises and by Insurance Enterprises for Certain
Long-Duration Participating Contracts

SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of

SFAS No. 122, Accounting for Mortgage
Servicing Rights, an amendment of FASB Statement No. 65

SFAS No. 123, Accounting for Stock-Based Compensation

FASB Interpretation No. 40, Applicability
of Generally Accepted Accounting
Principles to Mutual Life Insurance
and Other Enterprises

FASB Interpretation No. 41, Offsetting of Amounts Related to Certain Repurchase and Reverse Repurchase Agreements

SOP 94-1, Inquiries of State Insurance

SOP 94-2, The Application of the Requirements of Accounting Research Bulletins, Opinions of the Accounting Principles Board, and Statements and Interpretations of the Financial Accounting Standards Board to Not-for-Profit Organizations


For fiscal years beginning after December 15, 1992, except for plans outside the U.S. and for
defined benefit plans of employers that: (a) are nonpublic enterprises and (b) sponsor defined
benefit post-retirement plan(s) with no more than 500 plan participants, the effective date is for
fiscal years beginning after December 15, 1994.

If total assets are greater than $150 million: years ending after December 15, 1992.

If total assets are less than $150 million: years ending after December 15, 1995.

For fiscal years beginning after December 15, 1994. Earlier application is encouraged. Previously
issued financial statements shall not be restated. Initial application shall be at the beginning of an
enterprise's fiscal year.

For years beginning after December 15, 1994 and interim periods within those fiscal years, except
for not-for-profit organizations with less than $5 million in total assets and $1 million in annual
expenses, the effective date shall be for fiscal years beginning after December 15, 1995. Earlier
application is encouraged.

For annual financial statements issued for fiscal years beginning after December 15, 1994, except for
organizations with less than $5 million in total assets and $1 million in annual expenses, the effective
date shall be for fiscal years beginning after December 15, 1995. Earlier application is encouraged.
This statement need not be applied in interim periods in the initial year of application but shall be
reclassified if reported with annual financial statements for that fiscal year. Retroactive application is required if comparative annual financial statements are presented for earlier years.

For fiscal years beginning after December 15, 1994, which is concurrent with SFAS No. 114. Earlier application is encouraged.

For fiscal years ending after December 15, 1994, except for entities with less than $150 million in total assets in the current statement of financial position, the effective date is for fiscal years ending after December 15, 1995. Earlier application is encouraged. This statement need not be applied to complete interim financial statements in the initial year of application.

For fiscal years beginning after December 15, 1995, with earlier application encouraged. Initial application shall be reported retroactively through restatement of all previously issued financial statements for comparative purposes for fiscal years beginning after December 15, 1992.

For fiscal years beginning after December 15, 1995, with earlier application encouraged.

For fiscal years beginning after December 15, 1995, with earlier application encouraged.

For calendar year 1996. Disclosure required in 1996 financial statements about 1995 stock options.

Disclosure provisions: years beginning after December 15, 1992.

Other provisions: years beginning after December 15, 1994.

For financial statements issued for periods ending after December 15, 1994. Earlier application is encouraged. Previously issued financial statements may be restated to apply the provisions of this interpretation to the date Interpretation 39 was first applied.

For audits of financial statements performed on or after December 15, 1994.

For fiscal years beginning after December 15, 1994, except for not-for-profit organizations with less than $5 million in total assets and $1 million in annual expenses, the effective date shall be for fiscal years beginning after December 15, 1995. Earlier application is permitted. For organizations that adopt FASB Statement No. 117 prior to its effective date, earlier application is encouraged.


SOP 94-3, Reporting of Related Entities
by Not-for-Profit Organizations

SOP 94-4, Reporting of Investment
Contracts Held by Health and Welfare
Benefit Plans and Defined-Contribution Pension Plans

SOP 94-5, Disclosures of Certain Matters in the Financial Statements of Insurance Enterprises

SOP 94-6, Disclosure of Certain Significant Risks and Uncertainties

SOP 95-1, Accounting for Certain
Insurance Activities of Mutual Life
Insurance Enterprises

SOP 95-2, Financial Reporting by
Nonpublic Investment Partnerships

SOP 95-3, Accounting for Certain Distribution Costs of Investment Companies

SAS No. 73, Using the Work of a Specialist

SAS No. 74, Compliance Auditing
Considerations in Audits of Governmental Entities and Recipients of Governmental Financial Assistance

SAS No. 75, Engagements to Apply Agreed-Upon Procedures to Specified Elements, Accounts, or Items of a Financial Statement

SAS No. 76, Amendments to SAS No. 72,
Letters for Underwriters and Certain
Other Requesting Parties

SSAE No. 3, Compliance Attestation

SSAE No. 4, Agreed-Upon Procedure

GASB Statement No. 24, Accounting and Financial Reporting for Certain Grants
and Other Financial Assistance

GASB Statement No. 25, Financial
Reporting for Defined Benefit Pension
Plans and Note Disclosures for Defined
Contribution Plans

GASB Statement No. 26, Financial
Reporting for Postemployment Health Care Plans Administered by Defined Benefit
Pension Plans

GASB Statement No. 27, Accounting for
Pensions by State and Local Governmental Employers

GASB Statement No. 28, Accounting
and Financial Reporting for Securities
Lending Transactions

GASB Statement No. 29, The Use of Not-for-Profit Accounting and Financial Reporting Principles by Government Entities


For fiscal years beginning after December 15, 1994, except for not-for-profit organizations with
less than $5 million in total assets and $1 million in annual expenses, the effective date shall be
for fiscal years beginning after December 15, 1995. Earlier application is permitted. For organizations
that adopt FASB Statement No. 117 prior to its effective date, earlier application is encouraged.
Comparative financial statements for earlier periods included with those for the period in which
this SOP is adopted should be restated.

For financial statements for plan years beginning after December 15, 1994, except that the
application of this SOP to investment contracts entered into before December 15, 1993, is
delayed to plan years beginning after December 15, 1995.

For annual financial statements for periods ending after December 15, 1994.

For annual financial statements for periods ending after December 15, 1995.

For fiscal years beginning after December 15, 1995.

For fiscal years beginning after December 15, 1995.

For annual financial statements for fiscal years beginning after December 15, 1995, and for interim
financial statements for periods in such years, with earlier application encouraged.

For audits of periods ending on or after December 15, 1994.

For audits of financial statements and of compliance with laws and regulations for fiscal periods
ending after December 31, 1994.

For reports dated after April 30, 1996.

For letters issued pursuant to paragraph 9 after April 30, 1996.

For engagements in which management's assertion is as of, or for a period ending, June 15, 1994, or thereafter, unless otherwise indicated.

For reports dated after April 30, 1996.

For years beginning after June 15, 1995.

For years beginning after June 15, 1996.

For years beginning after June 15, 1996.

For years beginning after June 15, 1997.

For years beginning after December 15, 1995.

Generally effective for years beginning after December 15, 1994.


Cabintaxi, Corp. was formed on November 11, 1983 with only one shareholder. Within a few days, the board voted to increase the number of shares and sell stock to four additional persons. But no shares were ever issued. While there was no written subscription agreement, there was an oral understanding that the newly subscribed shares would be paid for and, in fact, all of the shareholders paid for some or all of their stock before the S election was filed. But only the original shareholder signed the election.

The corporation incurred losses of $17,000 and $19,000 in its first two years and passed them through to the entire shareholder group. The Tax Court had held that all five shareholders were shareholders for purposes of making the S election. And the Appellate Court, though mentioning that the Tax Court's analysis was not as thorough as it would have liked, agreed. So the S election was invalid and the early losses could not be passed through to the shareholders.

To throw salt on the wounds, both courts added that the early losses were nondeductible anyway because the corporation had not entered its trade or business at the time the deductions were taken.

Proposed legislation presently before Congress would alleviate situations such as Cabintaxi's by giving the IRS authority to retroactively permit corporations to correct invalid elections. *

Sources: Cabintaxi, Corp. v. Commissioner, __ F.3d. __ (7th Cir. 1995) and H.R. 2039 and S. 758, both entitled the S Corporation Reform Act of 1995.


TenKey, Inc., developer of Tax Shop tax preparation software, is now offering accounting and tax professionals a page on the worldwide web‹enabling them to tell their story to the over 30 million browsers of the Net. TenKey provides accountants with a standard-size, full-color page to include a photo, information about their experience, practice, areas of expertise, and how those interested can contact them.

The accountants' pages are connected to TenKey's home page located at http://www.tenkey.com/. TenKey's home page also includes connections to various other pages, including one featuring tax tips and tax planning ideas, which the accountants are encouraged to contribute to (for which they are given a hypertext reference back to his or her page).

For more information, accounting and tax professionals should contact TenKey at (800) 639-1040. *


The November 1995 issue of The CPA Journal includes an article by Professors Anthony Cocco and Daniel Ivancevich, "Recognition or Footnote Disclosures of Compensatory Fixed Stock Options?" That article suggests that if a company elects to recognize compensation expense for fixed options, "an asset (prepaid compensation) is increased, along with a corresponding increase in equity (options outstanding). These increases will have an immediate impact on financial statement ratios that include assets and/or equities." The authors then discuss the impact on the debt-to-equity ratio and provide an example.

Unfortunately, the authors' analysis of the accounting required by FASB Statement No. 123 Accounting for Stock-Based Compensation, is incorrect. Paragraph 30 of Statement No. 123 states:

    The compensation cost of an award of equity instruments to employees shall be recognized over the period(s) in which the related employee services are rendered by a charge to compensation cost and a corresponding credit to equity (paid-in-capital) if the award is for future service.

The FASB exposure draft (issued in June 1993) proposed that an asset (prepaid compensation) be recognized at the date stock-based employee compensation awards are granted. However, the Board ultimately agreed with many respondents to the ED who said that future employee services (prepaid compensation) do not represent probable future benefits that are controlled by the employer at the date employee stock options are granted because employees are not obligated to render the services required to earn their options. Therefore, Statement No. 123 does not require recognition of prepaid compensation at the grant date. Rather, the cost of the related services is accrued and charged to compensation cost only in the period or periods in which the related services are received. Because prepaid compensation is not recognized at the grant date, the debt-to-equity ratio is not affected at the grant date.

On another point, the authors provide an example that illustrates the effects of recognizing and then amortizing prepaid compensation, and the last exhibit (Exhibit 3) focuses on comparative financial statements and ratios after the service period has been completed. The authors conclude that "prepaid compensation has been written off, reducing not only total assets, but also retained earnings. Thus, by extension, stockholders' equity decreases.... as well."

That extension is incorrect for the financial statements after the service period has been completed. Under the approach described by the authors, compensation expense would reduce net income, retained earnings, and therefore total stockholders' equity during the service period. However, after the service period has been completed, the cumulative decrease in retained earnings would exactly offset the cumulative increase in options outstanding. As a result, total stockholders' equity would not change because of the recognition of compensation expense for fixed options.

Under the method required by Statement No. 123, cumulative changes in retained earnings would offset cumulative changes in options outstanding, so total stockholders' equity would not be affected by the recognition of compensation expense for fixed options. *

Robert J. Swieringa, Member

Financial Accounting Standards Board

[Editor's Note: Authors Cocco and Ivancevich realize that changes in the final statement affected their article and furnished The CPA Journal with an explanation. Mr. Swieringa's letter makes such an explanation unnecessary.]

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

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