Field of Study: Accounting Equity compensation is a way to align the incentives of investors and executives. In economics, this is called a principal-agent problem; any time you need to get something done, you ask someone else (employee) to work on your behalf (shareholder investor). In the “modern” stage of equity compensation, companies look to design appropriate ways to pay their employees using a combination of stock and a wide universe of equity instruments. But is this the only reason to pay in equity, besides alignment of incentives? Josh Schaeffer, director of Valuation and HR Advisory Practice at EquityMethods, starts our segment by addressing that very question.

Field of Study: Accounting

On June 16, 2016 the FASB issued Accounting Standards Update No. 2016-13, Financial Instruments – Credit Losses (Topic 326). The new guidance requires organiza-tions to measure all expected credit losses for financial instruments held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. It affects organizations that hold financial assets and net investments in leases that are not accounted for at fair value, and amongst other areas on the balance sheet, also affects loans and debt. ASC-326 is certainly a very complex standard. Chris Brown, senior managing director, Forensic & Litigation Consulting at FTI Consulting, discusses in detail the accounting standard and the reasons that drove FASB to issue it.

Field of Study: Business Law

In August 2020, the Securities and Exchange Commission (SEC) issued its long-awaited amendments to Regulation S-K, the regulation which contains the detailed disclosure requirements, including a new requirement that public companies need to disclose information about “human capital resources.” Boards often focus on key areas of a business and how to drive it forward, but have not been tasked with direct oversight of human capital management, as it has been historically viewed as management’s responsibility. Gillian Emmett Moldowan, partner in the Compensation, Governance and ERISA group at Shearman & Sterling, discusses human capital management and how it fits into the broader framework of ESG.

Field of Study: Taxes In the beginning of 2021, Congress was busy working on the American Rescue Plan Act (ARPA), a $1.9 trillion bill known as Stimulus 3.0. The bill was signed into law on March 11, 2021. It is the third Economic Impact Payment to eligible individuals as well as small businesses. At the same time the IRS was working, and still is, on several tax provision extensions and keeps issuing new guidance. Barbara Weltman, president of Big Ideas for Small Business, begins our discussion with ARPA and then continues with an update on various program extensions and their tax impact. Barbara also talks about income and losses from business activities, discharge of indebtedness, FSAs for 2021 and expense deductibility under CAA, and more.

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1. Structuring Equity Compensation

2. Current Expected Credit Losses – What You Need to Know

3. Human Capital, Management Oversight & Disclosure – Is Your Board Ready?

4. ARPA, Tax Program Extensions, Deductibility Under CAA, and More

CPA REPORT SUBSCRIBER GUIDE

APRIL 2021 Summary Page i [p. 1]

CPE Requirements iii [pp. 3–5]

Segment One 1–1 [pp. 7–39]

Segment Two 2–1 [pp. 41 –74]

Segment Three 3–1 [pp. 75–106]

Segment Four 4–1 [pp. 107–134]

Sememt Five 5–1 [pp. 135–167]

Evaluation Form A–1 [pp. 169–170]

Index B–1 [pp. 171–175]

Group Live Attendance Form C–1 [p.177]

68]

CPA Report is a product of www.kaplanfinancial.com

Note: CPA Report now includes one Government/Not-for-Profit segment.

Information regarding COVID-19 changes rapidly; further updates will be in upcoming segments.

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Field of Study: Accounting – Governmental For the first time in FAF’s history, new GASB and FASB chairs started their terms at the same time. On July 1, 2020 Joel Black was appointed the new chairman of GASB. He talks to us about his background and what led him to the GASB. He also shares the challenges of taking office during a pandemic, his transition and collaboration with his predecessor Dave Vaudt and current FASB chairman Rich Jones, “The Big Three” projects the GASB is currently working or conducting research on, and what the future holds for the GASB.

5. Newly Appointed GASB Chairman Joel Black – A New Era

Summary Page (continued)

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1. Select discussion leaders who have the appropriate education and/or experience both to teach the segment subject and conduct the subsequent group discussion.

2. Have each discussion leader review the video segment and the written materials in the Subscriber Guide prior to the presentation of the segment.

3. Make sure that each discussion leader certifies the attendance at his/her discussion group by signing and dating the Group Live Attendance Form.

4. (Individuals) View the video segment (30 to 35 minutes).

5. (Individuals) Discuss the segment materials as they relate to his/her own work and/or organization (20 to 25 minutes).

6. (Individuals) Evaluate the instructor using the criteria listed on the Evaluation Form.

7. Check with your State Board of Accountancy for specific details, including group live sponsorship registration requirements.

Group Live Format

When taking a CPA Report segment on a group live basis, individuals earn CPE credits when they (or their organization) do the following:

CPE RequirementsWhen properly administered, the CPA Report educational program meets the requirements for group live and self-study participation as defined in the Statement for Standards in CPE Reporting.

Please note:

l You cannot earn additional credits by taking the same course in group live format and online self-study format.

l CPE requirements vary from state to state. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. CPAs should contact their state board regarding specific CPE requirements.

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e The following information will help you plan and implement the CPA Report program within your firm:

How to Implement the CPA Report

1. Each quarter, you may receive by email a CPA Report Summary Page in advance of the video segment notifying you of the upcoming Continuing Professional Education topics that will be covered.

2. The CPAR DVD is expected to arrive the month following the end of the quarter. If you do not have a standard day and time each quarter designated as CPE day, issue a memo with the date of your upcoming seminar. (If attendance is not required, please provide plenty of advance notice for optimum participation).

3. Select the topic(s) you wish to cover in your session when the CPAR Summary Page or the actual program arrives.

4. It is best for an organization to have its CPE classes on a regular and consistent basis, so it is easy for the staff to remember when scheduling clients.

5. You may wish to provide each group live attendee a “Certificate of Completion” noting the hours earned and the topic areas.

6. Always check with your State Board of Accountancy for specific details, including group live sponsorship registration requirements.

If you need more information or have any questions, please contact Customer Service at CPESupport@kaplan.com or 914-517-1177.

Note: CPE requirements vary from state to state. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. CPAs should contact their state board regarding specific CPE requirements.

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Please note: This issue of CPA Report Online Self-Study is scheduled to go live online on April 30, 2021.

If you need more information or have any questions, please contact Customer Service at CPESupport@kaplan.com or 914-517-1177.

Online Self-Study

Kaplan Financial Education is registered with the National Association of State Boards of Accountancy (NASBA) as a sponsor of continuing professional education on the National Registry of CPE Sponsors. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Complaints regarding registered sponsors may be submitted to the National Registry of CPE Sponsors through its website: www.nasbaregistry.org.

Self-Study Format

Participants can gain self-study credit by enrolling in the CPA Report Online Self-Study library of courses. All components of the program will be hosted online, including the video, interactive review questions, required reading, and final exam.

In order to ensure adherence to NASBA guidelines regarding self-study, the CPA Report and CPA Report Government/Not-for-Profit Self-Study Professional Education Centers are no longer available. Customers should contact their company administrators for information on taking course exams and receiving CPE credit for the courses.

Customers may contact Kaplan Financial Education at cpesupport@kaplan.com to obtain certificates previously earned through the CPA Report Self-Study and CPA Report Government/Not-for-Profit Self-Study Professional Education Centers.

Customers interested in the self-study format of the CPA Report can find information on Kaplan Financial Education's self-study libraries at Online Accounting CPE Courses.

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1. Structuring Equity Compensation

Learning Objectives:

Segment Overview:

Recommended Accreditation:Reading (Optional for Group Study):

Running Time:

Video Transcript:

Course Level:

Course Prerequisites: Advance Preparation:

Expiration Date: June 12, 2022

Work experience in financial reporting or accounting, or an introductory course in accounting.

None

1 hour group live 2 hours self-study online

Update

“Summarizing the CARES Act’s Impact on Executive and Equity Compensation” By Amanda Tan and David Outlaw

“Understanding Peer Volatility: Breaking Down the Drivers” By Josh Schaeffer, PhD and JP Damron

See page 1–13.

See page 1–22.

35 minutes

Equity compensation is a way to align the incentives of investors and executives. In economics, this is called a principal-agent problem; any time you need to get something done, you ask someone else (employee) to work on your behalf (shareholder investor.) In the “modern” stage of equity compensation, companies look to design appropriate ways to pay their employees using a combination of stock and a wide universe of equity instruments. But is this the only reason to pay in equity, besides alignment of incentives? Josh Schaeffer, director of Valuation and HR Advisory Practice at EquityMethods, starts our segment by addressing that very question.

Upon successful completion of this segment, you should be able to: l Identify reasons for giving stocks and reasons why equity

compensation can be part of a portfolio, l Recognize what stakeholders and investors care most about, l Determine other financial instruments for consideration and

the two primary forms of options, and l Identify the key models of restricted stock.

Field of Study: Accounting

A. Principal-Agent Problem

i. Someone else does your work on your behalf l Agent – employee l Principal – shareholder investors

B. Reasons for Giving Stocks

i. Participation in the company’s upside

ii. Saving cash

iii. Employee retention l Offer stock with vesting periods

iv. Potential favored accounting & tax treatments

C. Equity Compensation for Consideration

i. Stocks that pay out when they go up and give nothing when they go down

ii. Restricted stock l Vesting over time

iii. Performance-based restricted stock l Vesting based on

v Earnings v Performance

D. Limited Line of Sight

i. How to move stock price

ii. What makes stock price move

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I. Stock Compensation: Company & Executive Perspective

A. What Stakeholders Care About

i. Executives l Money l Few restrictions

ii. Investors l Performance l Good management team in place l Proxy advisory firms

l Independent monitoring

B. Proxy Advisory Firms

i. Advise on “say on pay” vote l Compensation fairness l Votes are non-binding

C. Single vs Double Trigger Options

i. Single trigger l Everything vests l Not an investor favorite

ii. Double trigger l Executive termination

II. Stakeholder Concerns

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A. Other Financial Instruments for Consideration

i. Restricted stock grant l Restricted stock award

l Share of stock with same rights as the shareholders

l Can sell at the end of vesting period

l Can take an 83(b) election l Restricted stock unit

l Having the right to get a share of stock

l May be able to defer taxes

B. Accounting Rules on Restricted Shares

i. Worth the same as the otherwise unrestricted share, unless restricted after: l You vest l You earn that right

ii. Expense is not recognized l If someone leaves before the

vesting period is over

iii. Discount is taken l If restricted after vesting

C. Why Are Options Attractive?

i. Giving employees the l Upside l Value they create

D. Two Primary Forms of Options

i. Non-qualified stock option

a. Vest over a certain period of time

b. Taxed on the difference between l Strike price l Value of company at exercise

date

c. Capital gain treatment on that stock

ii. Incentive stock options

a. Allowed to give up to $100,000 of stock

b. Capital gains tax on the upside l When stock is sold

E. Incentive Stock Option Rules

i. Holding period

ii. $100,000 limitation

III. Other Options for Compensation

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V. Compensation Expense and Equity vs. Liability A. IRC Section 162(m)

i. Exemption for executive pay over $1m is no longer allowed

ii. Tax needs to be paid on that compensation l Whether or not is performance-

based

“And really it is how we best want to incentivize our employees and how we want to put things together, that drives what our end mix is.”

— Josh Schaeffer

B. Equity Accounting in Theory

i. A $100 valued stock

ii. Vests in 3 years

iii. $33 for each of the years of service

C. Equity Accounting in Practice

i. Various stocks with different vesting periods

ii. Need to consider l Options

l Market-based awards l Performance-based awards l Catch-up grants l Turnover

D. Liability Treatment

i. Giving cash instead of stock l Know how much cash you need

to pay

E. Information to Investors

i. How much expense was given

ii. Types of grants given

iii. For newer listing and small companies l Emerging growth company status l Compensation information

iv. For large companies l Detailed compensation discussion

and analysis v Including structure and vesting

l Detailed stock options plan

IV. Valuing Options A. Intuition Behind Valuing Options

i. Stock with future value l Log normal distribution of stock

prices

ii. Strike price l Zero payoff if price goes down l Dollar for dollar if price goes up

B. Two Other Factors on Option Value

i. Stock pays dividends l Goes to stockholders l NOT to option holders l Pushes the stock down

ii. Risk-free rate l Earning on your money

C. How to Measure Stock Volatility

i. Past history

ii. Trading options

iii. Peer companies

iv. Dividend yield

D. Employee Stock Options

i. Employees can’t sell their options l Can exercise early l Calculate shorter terms if

exercised early

E. Restricted Stock Key Models

i. Market awards l Vested based on stock price

movement l Valued using a Monte Carlo

simulation

ii. Performance awards l Vested based on firm or

individual specific results l Valued upfront

v Value can change

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A. Payout Considerations

i. Set caps at the top

ii. Marketability restrictions l After the shares are earned

iii. Reduce payout

iv. Change amount of time of the payout structure

B. IRS Rule & IRC Section 409A

i. Cannot grant in money options for individuals to choose the tax year in which they get them

ii. Need to get a valuation l Ensure option strike price is

reasonable l Consistent with today’s value

VI. Making Adjustments Looking Forward

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Discussion Questions

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1. Structuring Equity Compensation

l As the Discussion Leader, you should introduce this video segment with words similar to the following:

“In this segment, Josh Schaeffer discusses equity compensation, and how companies look to design appropriate ways to pay their employees using a combination of stock and a wide universe of equity instruments.”

l Show Segment 1. The transcript of this video starts on page 1–22 of this guide.

l After playing the video, use the questions provided or ones you have developed to generate discussion. The answers to our discussion questions are on pages 1–8 to 1-10. Additional objective questions are on pages 1–11 and 1–12.

l After the discussion, complete the evaluation form on page A–1.

1. Companies try to find ways to pay their employees using a combination of stocks and other equity instruments. What are some reasons companies consider when deciding whether to give equity compensation to employees? What factors does your organization consider?

2. Different stakeholders have competing interests when it comes to equity compensation. What are the concerns of various stakeholders affected by equity compensation? How does your organization address their concerns?

3. Organizations can choose from a variety of forms of equity compensation. What are the main types of financial instruments used as compensation? Does your organization offer equity compensation and, if so, what forms does your company use?

4. The valuation of options can present challenges to organizations. What factors are considered in the valuation of options? How does your organization conduct its valuation?

You may want to assign these discussion questions to individual participants before viewing the video segment.

Instructions for Segment

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5. Employee stock options are generally valued in the same way that other options are. What are the features of employee options? How does your organization use stock options, if at all?

6. Another form of compensation is restricted stock. What are the forms of restricted stock? Which forms of restricted stock does your organization offer?

7. Accounting for cash-based compensation awards differs from the accounting for equity-based awards. What are the key differences in the accounting for these two types of awards? Do you agree that there should be differences in the accounting treatment? Why or why not?

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employees using a combination of stocks and other equity instruments. What are some reasons companies consider when deciding whether to give equity compensation to employees? What factors does your organization consider? l Factors Companies Consider

v Offering stock to employees allows them to participate in the potential upside of the company

v Also allows company to save on the amount of cash that would have been used to pay employees

v Employee retention can be achieved by issuing stock with vesting periods, so that employees are required to stay in the company in order to cash in the stock

v Companies can achieve favorable accounting and tax treatment with equity compensation that can improve the payout to employees and also what the company receives.

l Participant response based on personal/organizational experience.

2. Different stakeholders have competing interests when it comes to equity compensation. What are the concerns of various stakeholders affected by equity compensation? How does your organization address their concerns? l Stakeholder concerns

v Executives want as much money with as few restrictions as possible

v Investors want performance and the best returns for their investment

v Investors also want a good management team in place

v Proxy advisory firms conduct independent monitoring

v Also advise investors on how to vote for pay proposals

v Advise on “say on pay” vote v Compensation fairness v Votes are non-binding

l Participant response based on personal/organizational experience

3. Organizations can choose from a variety of forms of equity compensation. What are the main types of financial instruments used as compensation? Does your organization offer equity compensation and, if so, what forms does your company use? l Single vs Double Trigger Options

v Occur in a corporate buyout transaction

v Single trigger options k Everything vests upon the

occurrence of a buyout k Not a preferred choice for

investors v Double trigger options

k Requires the executive to be terminated upon the buyout in order for vesting to occur

k Allows buyers and the company to think about the best course of action

l Restricted stock grant v Restricted stock award

k Share of stock granted to employees

k Contains the same rights as the shareholders

k Employees can sell at the end of a vesting period

k Employees can take an 83(b) election to be taxed on the receipt on the date of grant rather than the date of issuance of the stock

v Restricted stock unit k Gives individuals the right to

receive a share of stock k May allow company to defer

taxes on payment until the security is paid out

Suggested Answers to Discussion Questions

1. Structuring Equity Compensation

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v Options are attractive to employees because they get chance to participate in the upside of the value they create

v Two types: k Non-qualified stock options

b Vest over a certain period of time

b Recipients are taxed on the difference between

j Strike price j Value of company at

exercise date v Capital gain treatment on the

underlying stock l Incentive stock options

v A company is allowed to give up to $100,000 of such options

v Capital gains tax treatment on the appreciation when stock is sold

v Mandatory holding periods l Participant response based on

personal/organizational experience

4. The valuation of options can present challenges to organizations. What factors are considered in the valuation of options? How does your organization conduct its valuation? l Intuition Behind Valuing Options

v Stock with future value providing returns

v Strike price k Zero payoff if price goes down k Dollar for dollar payout if price

goes up l Factors Affecting Option Value

v Dividends k If the stock pays dividends, the

dividends go to stockholders not option holders – this decreases stock values

v Risk-free rate k Earnings on money saved by

not purchasing the full stock v Strike price v Past history v Trading options v Peer companies

l Participant response based on personal/organizational experience

5. Employee stock options are generally valued in the same way that other options are. What are the features of employee options? How does your organization use stock options, if at all? l Employee stock options

v Employees can’t sell their options v They can be exercised early v Company must calculate shorter

terms if exercised early l Participant response based on

personal/organizational experience

6. Another form of compensation is restricted stock. What are the forms of restricted stock? Which forms of restricted stock does your organization offer? l Restricted Stock Key Models

v Market awards k Vested based on stock price

movement k Valued using a Monte Carlo

simulation v Performance awards

k Vested based on firm or individual specific results

k Valued upfront though the value can change

l Participant response based on personal/organizational experience

Suggested Answers to Discussion Questions (continued)

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7. Accounting for cash-based compensation awards differs from the accounting for equity-based awards. What are the key differences in the accounting for these two types of awards? Do you agree that there should be differences in the accounting treatment? Why or why not? l Accounting for Equity Awards

v In theory, accounting for equity awards is as simple as expensing items in each period of service

v In practice, however, accounting for such awards is more difficult because companies often have various stock awards with different vesting periods e.g.: k Options k Market-based awards k Performance-based awards k Catch-up grants k Turnover

l Cash Awards v Cash awards are easier to account

for so long as the company knows the amount of cash being paid and matches the liability to the outlay

l Participant response based on personal/organizational experience

Suggested Answers to Discussion Questions (continued)

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1. Equity compensation is a way to align the incentive of:

a) investors and executives

b) investors and auditors

c) auditors and executives

d) auditors and regulators

2. Reasons for companies giving stocks as compensation include all of the following EXCEPT:

a) allowing employees to participate in the potential increase in company's value

b) saving cash

c) minimizing the regulatory scrutiny associated with cash awards

d) retaining employees

3. Company executives care about:

a) stable management

b) having great opportunities

c) making the most money with the least number of restrictions

d) having the best returns possible

4. When it comes to single trigger options in corporate buyouts:

a) they are favored by investors

b) the entire amount of the option vests upon the occurrence of the buyout

c) in order to vest, they require only that executive to be terminated in the buyout

d) they make a lot more sense from a purchase's perspective

5. Restricted stock awards:

a) allow to employee to elect to be taxed before they actually get the shares

b) do not come with dividend rights

c) are saleable immediately upon receipt by the employee

d) allow the recipient to defer taxes

6. The accounting rules governing restricted shares:

a) provide that restricted shares are not worth the same as unrestricted shares

b) provide that restricted shares are worth the same as unrestricted shares even if they are restricted after they vest

c) require an expense to be recognized if the employee leaves the company before the vesting period is over

d) require a discount on restricted shares if they continue to be restricted after vesting

7. Companies are allowed to give incentive stock options:

a) only to C-suite employees

b) up to $100,000 in stock value

c) in an unlimited amount

d) only if they are cash flow positive

8. Under the Internal Revenue Code, companies may not deduct compensation to any covered employee if the compensation exceeds:

a) $500,000

b) $750,000

c) $1 million

d) $5 million

You may want to use these objective questions to test knowledge and/or to generate further discussion; these questions are only for group live purposes. Most of these questions are based on the video segment; a few may be based on the reading that starts on page 1–11.

Objective Questions

1. Structuring Equity Compensation

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9. The CARES Act places limits on compensation to employees once they make more than:

a) $425,000

b) $500,000

c) $1 million

d) $3 million

10. Recipients of assistance under the CARES Act:

a) can still execute stock buybacks but no issue dividends

b) can issue dividends but not execute stock buybacks

c) can still execute stock buybacks and issue dividends

d) may not issue dividends or execute stock buybacks

Objective Questions (continued)

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By Amanda Tan and David Outlaw Source: https://www.equitymethods.com/articles/summarizing-the-cares-acts-impact-on-executive-and-equity-compensation/

In response to the public health crisis caused by COVID-19 and the uncertainty and disruption—or worse—facing our population, Congress passed the CARES Act in late March. Formally titled the Coronavirus Aid, Relief and Economic Security Act, the $2.2 trillion CARES Act offers many forms of relief to people and organizations impacted by COVID-19. This includes assisting businesses through loans and guarantees designed to preserve jobs and keep businesses afloat.

CARES Act assistance, similar to the Troubled Asset Relief Program (TARP) executed in the last recession, comes with strings attached. Most relevant for equity

and executive compensation professionals are the compensation limits, which take effect when you enter into the loan or guarantee arrangement and end one year after the arrangement is no longer outstanding.

In this article, we’ll explore what you need to know—and what we still don’t know—about these limitations at this early stage.

What are the limits on compensation?

In short, companies that receive assistance under section 4003 of the CARES Act will have total compensation limits affecting all employees who made over $425,000 in 2019. The text of this part of the law is actually quite brief, so we’ve included it at the end of this article in its entirety as an appendix. We’ll unpack the basic idea of

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Reading (Optional for Group Study)

SUMMARIZING THE CARES ACT’S IMPACT ON EXECUTIVE AND EQUITY COMPENSATION

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l In order to ensure adherence to NASBA guidelines regarding self-study, the CPA Report and CPA Report Government/Not-for-Profit Self-Study Professional Education Centers are no longer available. Customers should contact their company administrators for information on taking course exams and receiving CPE credit for the courses.

l Customers may contact Kaplan Financial Education at cpesupport@kaplan.com to obtain certificates previously earned through the CPA Report Self-Study and CPA Report Government/Not-for-Profit Self-Study Professional Education Centers.

l Customers interested in the self-study format of the CPA Report can find information on Kaplan Financial Education's self-study libraries at Online Accounting CPE Courses.

CPA Report Update

1–141–141–14

the restrictions here, and also address some of the unanswered questions in light of the brevity.

The limitations on compensation for highly compensated employees are tied to the amounts they earned in 2019. Any employee who made at least $425,000 (but less than $3 million) in 2019 cannot make more than that 2019 amount in any 12-month period during the loan life.

In addition, employees who made over $3 million in 2019 must have their pay lowered to halve their excess earnings over $3 million. For example, if an executive made $5 million in 2019, then they cannot receive more than $4 million during any 12-month period covered by the loan. Their excess pay over $3 million was $2 million, which is cut in half and added to the $3 million base. Or to put it mathematically: $3M + (0.5* ($5M – $3M)).

These employees also cannot receive severance pay—or other benefits upon termination—that exceeds more than two times the maximum total compensation received in 2019 as defined by the limitations above.

Whereas TARP required a firm universal cap of $500,000, the CARES Act creates a dynamic compensation cap that varies based on prior compensation levels, with a bend in the slope at the $3 million point:

What are the big open questions?

With many implementation details yet to be ironed out and other parts of the Act receiving more attention, there are many open questions about exactly how the compensation limits will be applied. These may not be the driving factors behind business decisions to pursue government assistance, but it’s nonetheless crucial to understand them up front. Even aside from standard sorts of compliance consequences, getting this wrong can easily look like “company overpays executives with taxpayer money,” which is a public relations nightmare.

Under the act, total compensation includes salary, bonuses, awards of stock, and other financial benefits provided by the business to an officer or employee of the business. This would be easy enough to manage if all compensation were cash and there were no timing differences between granting, earning, and paying an arrangement. However, given the complexity of executive compensation packages, there are unanswered questions that will have a material impact. For example:

How and when is total compensation valued?

This is most acutely a question for equity compensation. Is it valued at grant (akin to

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accounting and proxy disclosure rules) or at vest (akin to tax rules)? Should the value be simply the intrinsic value of the grant, or a fair value-based measure? There is not yet an answer to these questions, so we must await further guidance. (We also can’t look to TARP for precedent, as that cap exempted grants of long-term restricted stock units that vested after the government was paid back.)

Beyond equity compensation, there is also a question of timing for annual incentive plans or bonuses. Is the 2019 baseline computed using the 2019 payout (based on 2018 performance) or the bonus earned in 2019 (paid in early 2020)?

In this period of volatility, the timing of measurement may greatly impact whether an executive’s compensation is capped and at what level.

How are employment contracts treated?

If an executive has a binding employment contract entitling them to higher compensation, something has to give. Exactly how to restructure contracts (and what to do if an executive doesn’t agree to a cut) is unclear. Further, decisions must be made about which aspect(s) of total compensation any cuts should come from, which is especially difficult if the forthcoming compensation is tied to long-term arrangements (such as restricted stock) granted in prior years. Note that if a contract is a part of a collective bargaining agreement, it’s entirely exempt from the limits. Otherwise, it remains undecided how companies should unwind and fix the conflict between one legal obligation to the government and another legal obligation to its employees.

Who is covered under these limitations?

The limitations under section 4004 clearly cover certain people, such as executives with high salaries. But even leaving aside the compensation measurement questions that might push borderline employees over

the threshold, it’s unclear whether other categories of service providers are affected. For example, the law is silent on the treatment of non-employees such as directors, partners, or independent contractors. A literal reading of the law would seem to exempt these non-employees, but this may change as implementation details become available.

In addition, it’s unclear if individuals hired in 2020 would be considered covered employees. Without any 2019 compensation from the company, there would be no way to set a limit on go-forward compensation under the rules. However, a blank check seems unlikely in the final rules.

How is compensation computed for 2019 hires?

Another boundary case the law doesn’t address is 2019 hires. For example, consider an employee who joined in July on a $1 million salary. If that was the only aspect of their pay, their 2019 compensation would be $500,000. That would make for a draconian cap that is much more stringent than for an equally paid individual who merely had a different hire date.

Practically speaking, the final rules may allow for annualization in such cases. This would need to be thoughtfully executed to avoid unintended consequences, considering unique onboarding situations like large one-time signing bonuses or new-hire equity grants that are larger than expected annual grants.

What other restrictions are there, and how might those affect compensation? Recipients of assistance may not issue dividends or execute stock buybacks. Narrowly looking at the direct impact on equity compensation, lower dividends translate into higher values for options under the Black-Scholes model, all else

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equal. So if companies grant awards based on a target value, this means fewer options granted for a given target value. On the flipside, all else again equal, this means that option payouts would be higher since shareholder returns that would have been paid as dividends (not received by option holders) will instead manifest as higher price growth (which option holders do receive). There will be a similar set of effects for restricted stock units that do not participate in dividends or equivalents.

In addition, there are various stipulations on maintaining most or all of the company’s pre-crisis workforce. Although these stipulations have no direct impact on compensation, there will be an effect on accounting for equity compensation. In particular, this may mean reduced forfeiture rates to account for the fact that layoffs won’t happen and voluntary turnover is likely lower in a poor job market.

What are the steps to take right now?

As we await more information and clarification on CARES Act assistance and related rules, there are a few steps that companies can take to prepare and set expectations.

1. Look out for updates. Naturally, businesses taking assistance under section 4003 should pay close attention to any updates relating to the act. We expect further guidance and clarifications from the Treasury Department on the open questions above, but there is no clear timetable currently.

2. Plan with available information. To get ahead of planning, we recommend computing 2019 pay for employees under a variety of feasible interpretations to figure out who may be impacted and quantify the impact of the cap on each person. This will help with managing the expectations of affected employees and will allow the

company to act quickly to comply when rules are finalized.

3. Consider methods to track compensation levels. Be prepared to put new processes in place for tracking compensation levels for impacted employees. For example, if the realized value of stock awards at vest is limited, know where that limit is and be ready to implement it rather than let awards vest on auto-pilot. If the grant value for 2020 is limited but you’ve already issued, understand how the award may be rescinded or modified.

4. Be ready for the accounting impact. As discussed above, the various limitations may have an accounting impact either directly or indirectly on equity compensation. Companies would need to adjust valuation assumptions due to the dividend limitation, adjust expense assumptions due to reduced forfeitures, and apply modification accounting to any award adjustments triggered by the compensation limitations. On top of it all, companies should to adjust forecasts for all of the above impacts, plus any other plan changes driven by COVID-19.

5. Consider more efficient compensation alternatives. As rules are finalized and attention turns to the longer-term future, we may find that certain compensation arrangements fail to provide an optimal level of incentive or retention benefit under the Treasury limitations. For this reason, companies should plan to actively consider alternative compensation or benefit arrangements for key individuals where there may be retention risk. This may mean simple adjustments; for instance, if the final rules define compensation as counted when taxable, companies can implement deferral arrangements for future-vesting RSUs. It may also mean more substantive adjustments, like shifting more pay to long-term incentives or directly tying payouts to loan repayment.

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As always, please don’t hesitate to contact us to discuss your specific situation. We also invite you to keep tabs on our COVID-19 equity compensation resource center for updates on the situation as it evolves.

Appendix – Text of Section 4004 of the CARES Act

LIMITATION ON CERTAIN EMPLOYEE COMPENSATION. (a) In General.—The Secretary may only enter into an agreement with an eligible business to make a loan or loan guarantee under paragraph (1), (2) or (3) of section 4003(b) if such agreement provides that, during the period beginning on the date on which the agreement is executed and ending on the date that is 1 year after the date on which the loan or loan guarantee is no longer outstanding—

(1) no officer or employee of the eligible business whose total compensation exceeded $425,000 in calendar year 2019 (other than an employee whose compensation is determined through an existing collective bargaining agreement entered into prior to March 1, 2020)—

(A) will receive from the eligible business total compensation which exceeds, during any 12 consecutive months of such period, the total compensation received by the officer or employee from the eligible business in calendar year 2019; or

(B) will receive from the eligible business severance pay or other benefits upon termination of employment with the eligible business which exceeds twice the maximum total compensation received by the officer or employee from the eligible business in calendar year 2019; and

(2) no officer or employee of the eligible business whose total compensation exceeded $3,000,000 in calendar year 2019 may receive during any 12 consecutive months of such period total compensation in excess of the sum of—

(A) $3,000,000; and

(B) 50 percent of the excess over $3,000,000 of the total compensation received by the officer or employee from the eligible business in calendar year 2019.

(b) Total Compensation Defined.—In this section, the term “total compensation” includes salary, bonuses, awards of stock, and other financial benefits provided by an eligible business to an officer or employee of the eligible business.

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by Josh Schaeffer, PhD and JP Damron Source: https://www.equitymethods.com/articles/understanding-peer-volatility-breaking-down-the-drivers/

For private and newly public companies who grant options, it’s hard to develop an appropriate volatility assumption. Without historical trading data or market traded options, they have to develop an assumption from scratch. Companies who recently emerged from bankruptcy, revamped their company structure, or saw other significant changes find themselves in a similar position. All must turn to leverage adjusted peer volatility to get a better estimate of volatility they can use in fair value calculations.

Due to their inherent diversification, ASC 718-10-55-25 discourages the use of broad or even sector indices as a peer group for volatility purposes. That makes it critical to select a relevant set of peer companies. In this article, we’ll discuss four key criteria for determining a comprehensive peer group: company size, lifecycle stage, industry, and capital structure. We’ll wrap with a brief discussion of other factors to consider when developing a leverage adjusted peer volatility methodology.

Company Size

To make sure peers are roughly the same size, focus on market cap. Small cap companies tend to have higher volatility than large caps (Figure 1), so it doesn’t make a ton of sense to compare (for example) a small software startup to a global technology company like Microsoft.

Each of the following graphs shows one and five-year volatilities. This is to illustrate the effects more volatile periods, such as the Covid-19 pandemic, have on each subset as well as a more representative picture of market volatility.

Lifecycle Stage

It’s important to have peers that are close to the same life stage because volatility tends to go down with maturity (Figure 2). While many startups may not find companies as early stage as they are, a volatility assumption based on peers that

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UNDERSTANDING PEER VOLATILITY: BREAKING DOWN THE DRIVERS

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are much more mature is not going to yield an estimate that’s accurate enough for fair value calculations.

Industry For a volatility peer group, aim for companies that are in the same industry. Companies within sectors tend to have similar risk exposures and therefore volatilities. For example, utilities have relatively stable revenues compared with the consumer discretionary sector, which is heavily driven by the broader economy (Figure 3).

Capital Structure There are many ways to gauge the capital structure of a company, but we use the long-term debt to equity ratio. Generally speaking, the more debt a company has, the more volatile the stock price will be (Figure 4). So peers with similar debt ratios will yield a more accurate volatility estimate. (One caveat: Companies with no long-term

debt tend to be newer and thus more volatile.)

Another way to think about capital structure is to gauge how changes in a company’s overall value impacts the equity. Imagine a company that has no debt and is worth $100. A 20% decline in the value of the company results in a 20% loss in equity (Figure 5).

However, if the company has a 50/50 debt to equity ratio, that same 20% decline in value results in a 40% loss in the equity value—assuming the debt value stays

constant at $50 (Figure 6).

Leverage does vary from the other three factors in a significant manner. While size, stage of business, and industry are immutable characteristics of a company at a given time, a company can issue or pay down debt in order to change its capital structure and, as a result, its equity volatility. A key

concept here is that we can independently consider the impact of leverage with a mathematical adjustment. The AICPA’s Valuation of Privately-Held-Company Equity Securities Issued as Compensation lays out the steps in adjusting for leveraged volatility:

1. The term-matched daily historical volatilities for each of the peer firms are calculated. These volatilities

represent the observed volatility of returns of the equity shares of each of the peers (equity volatilities)

2. These equity volatilities are then used to determine an unlevered asset volatility for each peer. An estimate of the subject company’s unlevered volatility is selected based on the asset volatility of other companies, often using the average.[1]

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3. This assumed asset volatility is then re-levered, based on the target company’s long-term debt to market capitalization ratio, resulting in a leverage adjusted volatility estimate for the subject company

Note that leverage adjusting a peer’s volatility alone does not make it a good fit. It’s important to account for the other criteria first, then use leverage adjustment to smooth out any bumps that a difference in capital structure causes.

In addition, peers should meet the above criteria as closely as possible for the volatility estimate. There may be dozens of qualified options, and that’s where this process veers between science and art. As long as any prospective peer reasonably fits into the framework, it’s up to management to include it or not. However, some leeway is available if a given company is in a newer or small industry such as electric vehicles. It may be difficult to find enough suitable peers that meet the framework, so companies are allowed to expand the guidelines as needed. This might include

opening up the search from, say, strictly electric vehicle manufacturers to automotive component or diversified vehicle manufacturers.

Other Considerations

A common question is what the right number of peers is. The answer is that it depends, as there are tradeoffs involved. If a company chooses to go with fewer peers that are all a great fit, then they run into an issue if any of them is acquired or goes bankrupt. On the flip side, if the company chooses to include a larger number of peers, they run the risk of some not being a very good fit and thus not producing an accurate volatility estimate. We typically recommend a peer group of four to six companies, but may recommend more or fewer depending on the fact pattern.

One thing the guidance doesn’t specifically point out, but should be considered, is the stability of the peer companies relative to the target company. Historical price

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volatility doesn’t always capture this. Special consideration should be given to make sure companies don’t have extended periods of different volatility from the rest of the peers due to specific events.

It’s also worth considering whether the methodology reflects a time of extraordinary volatility in the broader market. (For example, Figure 7 shows the effect that the COVID-19 pandemic had on the S&P 1500.) If so, the company should look at different terms of historical volatility to make sure there are no unexpected volatility outliers among the peers.

Finally, what happens if one peer’s volatility is completely different from the others? The guidance does allow for periodic testing and, if needed, updates to a company’s peer volatility methodology. If a peer no longer meets the above criteria, they can be replaced with a better match. Keep in mind that auditors may ask about any changes, so make sure the case for making them is supportable.

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SURRAN: Equity compensation is a way to align incentives between investors and executives. In economics, this is called a principal-agent problem; any time when you need to get something done, you ask someone else to work on your behalf. In this case, the agent is the employee, working on behalf of the shareholder investors.

In 1952, Pfizer issued the first broad-based statutory options, but they didn't take off until the 1980's. During that time, some of the early new technology companies were starting to rely on stock options.

In 1988, an amendment to certain rules allowed for companies to loan money to exercise options, and this allowed borrowing from option proceeds sales. And at that time, granting options was free from an earnings perspective, so, not surprisingly, options were the tool of choice.

Fast forward to 2006, after the world caught up to the fact that the dilution from stock options wasn't free, but instead was a cost to shareholders, a new accounting regulation, FAS 123R, known now as ASC 718, came out and explained that when you grant any equity based compensation to your employees, you needed to take into account its value.

Many companies are now trying to design effective plans, but also have different tools at their disposal such as forgoing options for restricted stock or performance-based awards that make a lot more sense when it's a tradeoff versus when it's free.

WILLIAMS: In the "modern" stage of equity compensation, companies look to design appropriate ways to pay their employees using a combination of stock and a wide universe of equity instruments. But is this the only reason to pay in equity, besides this alignment? Josh Schaeffer, director of Valuation and HR Advisory Practice at EquityMethods, joins us this month and begins our segment by addressing that very question.

SCHAEFFER: Yeah, there are some very good reasons to do so. Say you're a new company and you're a bit constrained as far as how much cash you have to spend and to pay your executives.

By giving them stock, not only are you letting them participate in your upside, but also you save the money of the cash you would have to pay them. Now also, you might want to keep your employees around for a long period of time. You can set stock with vesting periods, such that you don't get to actually cash what you have unless you stay around for one, two, maybe even five years.

Finally sometimes you do get some decent accounting and tax treatment, with these sorts of things that can improve the payout to employees and what you get. Not going to talk about that too much in depth right now, but there are certainly some reasons that you can lock in a value today and potentially pay much more later if things go well for your company.

WILLIAMS: It seems there is a good reason equity compensation may be part of a portfolio. Josh elaborates further on the choices and the decision.

Video Transcript

1. Structuring Equity Compensation

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t SCHAEFFER: It's easy to think about these things in terms of broad kinds of categories, of what we're trying to do. So I like to think of options which payout if the stock goes up and don't really give you anything if the stock goes down.

Restricted stock, which just vests over time, and also performance-based restricted stock, that might vest based on how you do over the future, either based on your earnings or your stock performance.

Another thing to think about is not just how your company is doing on its own, but how you're doing relative to other companies. So what we'll see a lot of the time is, I'll take Coke as an example, Coke might pay their executives, not just based on how Coke does, but how Coke does relative to Pepsi, as an obvious competitor. That means that if they're doing well and developing new lines that people like, their stock will probably outperform. But if we find out that soda cures some sort of disease, well that'll impact both companies pretty evenly, and therefore you won't be compensating for that external factor.

So those kinds of thoughts and how you want to make sense and what sort of thing you want to encourage, plays a big step in what kind of choices you're going to make for compensation.

Now some companies might worry that their executives have a limited line of sight into how to move the stock price and what makes it move.

We know there are a lot of factors that go in there, a lot of things. And some of them are kind of well beyond the control of the executives. So you might want to give them a little more line of sight by focusing on things like earnings, revenues or other things where they might have more of a direct impact. So thinking through that and what the right incentives are and how you're going to drive them is critical. Now with all of these different designs, this isn't an "if" or "or" decision, this is an "and", because we can design combinations that are best fitting for any company no matter what our objectives are.

WILLIAMS: Josh gives us his insights as to the various stakeholders and what they care about.

SCHAEFFER: We got a lot of different people at play here, right? The executives of course want to have as much money as they can have. They want as few restrictions as they can.

That might not be on the same page as the company who really wants stable management, wants good opportunities and wants to encourage people to be there and wants to pay the right amount.

Investors want performance, investors want to get the best returns they can for investing in the stock. So they want to know that they have a good management team in place who's going to make the right decisions for them. So, another group stepping in here are proxy advisory firms. And Glass Lewis and ISS or Institutional Shareholder Services, are the two biggest and most well-known proxy advisors.

They step in and advise investors on how to vote for various pay proposals. So they act as kind of independent monitors of the firms. They are going to look and see whether the payment seems to be fair and encourage votes, and are therefore taken very seriously. They're going to look at questions like, are you paying too much? And if you're paying a lot, are you getting performance? Do you have teeth? Do you have the

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t ability to take it back? What happens if performance isn't good? Are your executives still going to get a lot of money?

They might also be thinking about what happens in case of a termination and is somebody going to be made wealthy because the firm didn't agree with them?

What happens if there's a buyout? Do you get paid a lot of money then or only if you lose your job as part of it? Now, there are a few ways that ISS and Glass Lewis come in. They don't get to go directly into a company and say, do this not that.

But they do get to advice and every year companies will typically do a "say on pay" vote, which allows investors to say whether they believe the compensation is fair or needs to be adjusted. So they can say, hey look, we don't believe that you should be paying as much as you can, or as much as you are.

Now those votes are non-binding, but they tend to be taken very seriously by companies. Also whenever a new plan comes up, so a company needs new shares to grant, they need to go and solicit investors to get those shares.

WILLIAMS: Buyouts add a lot of complications, not only on a transaction level but also for shareholders. They also add another wrinkle when the shares have contingencies the way compensation does. Josh elaborates and starts with a few questions that need to be thought out beforehand.

SCHAEFFER: Any sort of corporate transaction is going to be a big deal and we want to be very proactive about what's going to happen. What do we want to do with the compensation instruments that the executive has? For example, do we want everything to vest right away if they're not vested?

Do we want to have everything cash out right away or do we want to have an additional period where people need to wait and people need to stick around in order to get these things? What about performance grants that might payout between zero and 200%, do we just want to stop the clock, right at the point in time that we are? Do we want to payout at max or at target at that 100%?

All of these questions need to be thought in and what we want to do, right? Do we want to keep our executives on or is there a big question that if somebody comes in, hey, look and buys you out, you're probably going to replace the executive team. So we want to carefully think about what these are.

Oftentimes when we think about this, we have what's called a single trigger and a double trigger option. The single trigger simply says, if there's a buyout, everything vests and the CEO can ride off into the sunset if they want to on their own. Investors don't really like that, because in a buyout, it kind of discourages it because people don't want to go in and have to pay the former CEO all of this money.

A double trigger means that not only does the buyout have to happen, but that executive needs to be terminated for everything to vest. That makes a lot more sense because then the company, the buyer really gets to think about what they want to do and what the best course of action is.

WILLIAMS: That was a great introduction into the granting world. Josh gives us some more insights as to some other types of instruments.

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t SCHAEFFER: So the first type of instrument to consider is just the restricted stock grant. What that means is we're just giving somebody a share of stock, and there are two ways to do this.

The first is through a restricted stock award, which is basically just giving them a full-fledged share of stock, dividend rights, voting rights, whatever else any shareholder has, they have it. It just happens that they don't get to sell or really earn their share until the end of a vesting period.

These have a useful feature, you can take what's called an 83(b) election, which means you get taxed as of the grant date and don't have to worry about tax when it pays out at a later date, when you actually get the share.

So that can be beneficial, however, there are some other issues where people might not want all those shares of stock outstanding and might use what's called a restricted stock unit, instead. A restricted stock unit allows somebody to have the right to say you're eventually going to get a share of stock.

What's nice about these is that there are some ways that you can defer the taxes at the end, because you've never actually given them the share of stock, you just said, I promise that I'll give you the share of stock eventually, and what that is. Both of them have the same payout, which is at the end of the day, at the end of the period you're going to get a share of stock.

WILLIAMS: But if the stocks are restricted why isn't there a discount?

SCHAEFFER: When we value restricted stock, we're looking at them and we just take the full value of the share of stock. And typically people think about these and say, "hey, look, if I don't get to sell this thing for three years, shouldn't it be worth less than a share of stock?" Well, you and I might agree that the answer to that is, yeah, probably it should.

The accounting rules have stated that a restricted share is worth the same as the otherwise unrestricted share. Unless it's restricted after you vest, after you earn that right. So because the rules say it, we follow the rules and we give that whole stock a price.

Now with that said, if somebody does leave before the three-year period is over, then the company never actually recognizes that expense.

So I think that's a pretty logical answer, right? That you have the share and you can't have it, until the end of the vesting period. That you would pay less than that, less than, an otherwise unrestricted share of stock. The accounting rules, however, are pretty strict on this and say that if it's only restricted until it vests, the value of that is the same as the value of a fully unrestricted share.

The rules change a little if they're restricted after they vest, and then you get to take a discount, but this isn't that typical. Not a lot of companies use that sort of post vest holding restriction. With that said, you do get to back out any expense for employees who leave the company, for shares that don't vest. So I guess when they were looking at it, the FASB said that was kind of a double count, to not recognize expense per shares that don't vest and also to take a discount.

WILLIAMS: Earlier Josh mentioned the growth of options as an important piece of the evolution of compensation. He further elaborates.

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t SCHAEFFER: So options are a way to pay employees based on the upside. When we give a stock option, we're saying the stock is trading at $10 today and I'm going to allow you to buy the share in the future. You don't have to if it goes down, but if it goes up, you only have to pay $10. So if the price goes up to 20 you make that $10 spread, all you're giving people is upside.

You're giving them the value that in some sense they created with the firm or participated in the creation of. And that's one of the things that makes options attractive.

So just like restricted stock, options come in two primary forms. The first one is called a non-qualified stock option and these are the much more common type.

Non-qualified options vest over a certain period of time. And at the time that you exercise you are taxed on the difference between the strike price and the value of the company at the date of exercise, you then have a stock and subsequently get capital gains treatment on that stock.

The other side is incentive stock options, and you're allowed to give these for up to $100,000 of stock for individuals and they allow for capital gains tax on all of the upside, only when the stock is sold.

Now there are a few rules with incentive stock options that make them kind of tricky to do. You've got holding periods, of course the $100,000 amount and whatnot. So some companies who really want to have that advantage, will use them, will use those ISOs, but other companies say it's just not worth it. We have to monitor holding periods and all of these other things and just don't want to deal with it.

WILLIAMS: Josh continues by telling us how options are valued.

SCHAEFFER: I really don't want to go into the technical details here. Black Scholes is tricky equation with lots of Greek letters and normal distribution functions and, nobody wants to worry about that now, but let's focus a bit on intuition, right? We've got two things. We've got a stock and that stock is going to have a value in the future.

So we can draw a curve to say what the future value is. Typically, when we do that we want a nice kind of bell curve of returns, and what that means because stock prices can't go zero, you have this kind of return, what we call a log normal distribution of stock prices.

Now with that you also have the strike price, right? As we discussed the strike price, if the stock price goes down, this thing pays off zero and if the stock price goes up, but you kind of get dollar for dollar, so you have this hockey stick shape.

Now putting those two together, what we figured out is there are ways to do that. At their core, Black Scholes and Merton figured out how you could use a physics equation for these kinds of things, to make things move, make stock move and multiply these two curves, and understand what the value is. So where we have value, is we have value because there's a probability of making a profit and an amount of profit. And that just comes to form what the Black Scholes equation is. Now thinking about some of the mechanics will tell you a bit about the various inputs. Say for example, we have a stock that's lower in price, we dropped $5, well that means that this curve with the stock price is going to be a lower

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t curve with fewer outcomes as high up, so that's going to make this option less valuable.

Now, say that instead you have more time or more variability. You've got a stock that might go way up or way down. Well, way down doesn't affect you, right? You don't care if the stock drops from $10 to nine or to one, you're going to walk away, but if it can go up to 50 instead of 15, you're going to see the benefit of that value. So volatility and more time for the stock to move increases an option value.

Now say we move the strike price up. What that does is it doesn't affect where the stock prices, nothing changes there, but this hockey stick moves to the side. And that means that the stock needs to go up a bit before you get any value. So that, of course, makes the option value down.

Now two other factors. If the stock pays a dividend, that goes to the stockholders but not to the option holders. So it kind of pushes the stock down, right? If the stock is trading at $10 and they pay all their shareholders three bucks, you're not going to have a $10 stock at the end of that, you should have about a $7 stock.

The other thing is the risk free rate, right? What you can earn on your money, and the reason that impacts stock options isn't really in these curves.

Instead, it's just a notion of you have money left on the side, that you didn't use to buy the full stock and you can use that money to invest and get some money back. So that's why the risk free rate impacts the option value. And with that you can kind of see how Black Scholes works and how all of these option pricing formulas do, because it is really just these two curves moving together.

WILLIAMS: So what about the other inputs?

SCHAEFFER: The other inputs, some of them are pretty easy to get from the market, right? The stock price, if you're a public company, is just out there, the strike price, typically we set options equal to the stock price. We can't set them because of various tax rules in section 409A. We cannot set the strike price below the stock price on most options. So we're going to have that. But you just look at the contract and you have it.

Volatility is a measure of how much a stock is expected to move. We can get that a few ways. We can get that based on how the stock has moved in the past, we can get it based on any traded options that are out there, or we can get it based on peer companies that we think should move similarly in the future.

We also have the dividend yield that we discussed, will lower the value of those options. That's based on where a company has been and where a company expects to pay their dividends. And then the risk-free rate is pretty easy to find. It's on the Federal Reserve's website, so you can go ahead and get that at any time.

WILLIAMS: There are other options on the market to buy and sell, but are employee stock options looked at just like other options from a valuation perspective?

SCHAEFFER: For the most part they are, right? Both of them have the same core feature. The biggest difference between the stock option that you'd buy on the market and one that's given to employees, is that employees can't sell their options.

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t So if they feel that it's time, maybe they think the stock price is going to go down, maybe they're leaving the company, maybe Junior needs to go to college or that new sports car is just looking too good to pass up. You don't have any way to get that money other than to exercise the option.

So, while it might be better to hold for a longer period of time, you have employee stock options being exercised early. We recognize that and we use shorter terms and we use ways to calculate out how you might have a lower life or exercise early based on where the option is.

The Black Scholes model that I discussed earlier, just looks at a shorter time, says we might have 10 years, but on average we exercise it four years and use that. Other models might say, hey look, if the stock price goes from $15 to $40 I'm going to exercise then, but otherwise I'm going to wait. And that's really the key difference: it's all about how we're going to deal with exercise.

WILLIAMS: Josh continues by telling us about some tools, other than options and stocks, companies can offer and how are they valued.

SCHAEFFER: So other than options and stocks, what we see is this broad class of restricted stock units that are based on some sort of performance. And there are two key models here.

The first one is, where you vest based on how the stock price moves. So those are called market awards and that might be, hey, if the stock price makes $30 at any time in the next year you get a share. And if it makes $50 you get two shares. Or it might be how you do relative to the Coke, Pepsi example I gave earlier on how Coke does relative to Pepsi, or even how Coke does relative to the rest of the S&P 500 right? We want Coke to be the best company out there, and it could pay two shares if you're at the top and no shares if you're at the bottom and some sort of sliding scale in between.

For those, we're going to value those using what's called a Monte Carlo simulation, and again, not getting into details, but what this is, is we're going to look and we're going to draw a world, just like we did when we drew that graph of where the stock price could be, of where Coke is and where the 500 other companies in the S&P 500 are. And we're going to look at that and see how much they got paid and what the value is. Now, just doing that once isn't very useful because anything can happen, but when you run that 100,000 times, you get a good estimate on average. So what do we do? Do we have somebody sitting there hitting refresh and reload calculation 100,000 times? Yes. And that's why we have a lot of interns. No, actually, we have some software packages that allow us to do 100,000 or even when we need to do 500,000 or a million paths right away, very quickly.

That allows us to do these sorts of fancier things. Now alongside market awards, we also see performance awards and performance awards vest based on how earnings are or revenues or whether we hit the right timeline or anything else you can think of, that's more firm or individual employee specific, not depending on the stock price.

For those it's a bit tougher to think about how to value them. And the FASB recognized this and said, hey look, just pick whether it's likely to vest or not vest, take what actually happens. And then at the end of the period, use what actually happened and the grant date stock price. So one way I typically remember this is, for market awards you value using

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t Monte Carlo simulation based on everything that could possibly happen. And you never change that value.

On the other hand, for performance restricted stock, you value it upfront, but then you change that based on what actually happens because you only valued what was the most likely option upfront.

SURRAN: The Internal Revenue Code (IRC) section 162(m), provides that a publicly traded corporation may not deduct compensation in excess of $1 million per year paid to any covered employee of the corporation

On December 18, 2020, the IRS issued final regulations under section 162(m) limiting the deduction for compensation paid for covered employees, almost a year after the proposed regulations and after taking under consideration taxpayer comments. Even though the final regulations are substantially the same as the proposed regulations, there are several modifications and clarifications. Josh Schaeffer discusses how those changes impact the equity compensation landscape.

SCHAEFFER: So there was a substantial change in equity compensation with respect to the Tax Cuts and Jobs Act of 2017. And what that said, was that section 162(m) of the tax code, which had previously allowed an exemption for executive pay over a million dollars, for some of your top executives, would no longer provide the exemption. Instead you have to pay tax on all of that compensation, whether or not it's performance-based.

Of course there was a lower tax rate attached to that as well. So many people thought that this might cause people to use more cash and more non-performance-based awards, versus performance-based. But I think people quickly realized that taxes are only one reason, but let's be honest, it's good governance, and it's smart to provide performance equity and it aligns investor incentives very well.

So I think what we saw was, there was a good reason to keep it. ISS as well, we talked about the proxy advisory firms, they also saw that. So again, you just didn't see many companies driving to get rid of any sort of performance just because they didn't get a tax break, they weren't going to other easy-to-earn forms of compensation.

WILLIAMS: Josh continues our discussion by explaining the intuition behind the adjustment for accruals for one type of goal and not for another.

SCHAEFFER: Restricted stock options and these performance shares, we look at them as kind of the Legos of equity compensation. They're the pieces that we can use, but we can put them together however we want to, and what's important is we can also join them, right? We can have options that have a performance component. Maybe they only vest if the stock, if the earnings are high enough to justify it or if the stock price goes up, you can have market based options.

You can have restricted stock that's based on any sort of performance and market conditions. So you have this kind of hybrid condition. Those are very common in the market now because we have different things that we want to draw together. So you can have all of these pieces put together. And really it is how we best want to incentivize our employees and how we want to put things together, that drives what our end mix is.

A lot of thought and a lot of time goes into that for companies who are thoughtful about this and we advise that all companies should be very careful to make sure they get it right. Think about what could go right and

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t what could go wrong with any plan. What's the structure you're going to be looking at in three years, in the payout?

WILLIAMS: So, what else do we need to know regarding compensation expense and equity versus liability?

SCHAEFFER: We talked a touch about compensation expense and didn't get too much into it, but what's going on in compensation expense is, say you're giving a share of restricted stock and your company is worth $100. If that restricted stock vests over three years, realistically you shouldn't take it as if you paid $100 today, because you're getting three years of service.

So what's very fair is to take $33 in year one, $33 in the year two and $33 in the year three, and the guidance recognizes this and allows you to do it. So in its core, equity accounting for all of these things is very simple. Now in practice, it gets to be quite a bit more difficult. Why?

You don't just have one share vesting in three years. You have shares vesting in one year, two years, three years, four years and five years. You have options, you have market-based awards, you have performance-based awards, you have catch-up grants for people later with different vesting periods. You have people joining on, you have people leaving. All of these things goes into the overall puzzle of, that needs to be put together to get all of these earnings right. Now that's as long as you're only giving stock.

If at the end of the day you're giving cash and not stock, that goes into liability treatment. And liability treatment, instead of giving out this equity day one, where you just say, hey look, we gave out the share of stock and however it moves, we're not concerned. Now you actually need to be concerned with the motion and how much actual cash you're going to pay. So at the end of the day, the liability matches the cash outlay.

WILLIAMS: Josh explains what investors will be made aware of.

SCHAEFFER: Obviously, investors are going to get a hold of the expense numbers and know how much expense was given. In addition for your executives, you need to disclose a lot of information about what kinds of grants were given. For companies that are newer, you might get what's called an emerging growth company status, that's for newer listings, smaller companies, they just have to give a little bit of compensation information. That includes a little bit about the grants and overall camp, but not too much.

Once you grow up and become a big company, you get to do a whole compensation discussion and analysis section, that you have to disclose what your pay mix is, why you've elected to do that. Kind of everything that goes to all of your top executives and how it's structured and when it might vest. So really a full tier on that for your top employees. Also in the annual report, you need to give out things about your plan, how many shares are there, when you want to get new shares, the value of shares that were granted, at the grant.

So there are disclosures if you look through the easy way to find that for any company, it's if you look it up for the numbers 718 that is the accounting standard for all executive compensation. So that's what it's all going to be filed under.

WILLIAMS: Once a company has everything together, Josh gives us some of the tweaks they should be thinking about.

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t SCHAEFFER: Sometimes when companies look at the values, they might realize that the values are a bit higher than they expected. We see that a lot, for example, with market-based awards, especially those relative TSR awards. And the reason for that is simple. While they might only pay two shares some of the time and no share some of the time.

So you think they pay one on average. In fact, when the stock price goes up, they're more likely to pay those more shares. So they have this sort of leverage associated with them in that higher value.

Well, if you come up with a value that's too high, you can apply some sort of caps at the top. So you can't pay more than say, $100 per unit for a $25 share of stock. You can do some sort of marketability restriction after the shares are earned, or just lower your payout or change the amount of time that the payout structure will do. All of these things can change the expense and can result in different numbers that a company can use as part of their program.

WILLIAMS: But are the rules the same between public and private companies?

SCHAEFFER: The rules are kind of the same for private companies, but you've got to do things a little bit differently. First things first, you don't just know the stock price, so you need to figure out what the right strike price is to issue at.

The IRS has a rule that says you cannot grant in the money options, where individuals would be able to choose the tax year in which they get them. That's called Section 409A and you need to get a valuation done to make sure that your option strike price is reasonable, is consistent with the value today.

So we're not giving value today that you can choose when you're going to get. Metrics might be different, right? You might be very interested in earnings or when something happens, but you're probably not going to do a relative return award because you can't measure that on a typical basis.

You might think about timing differently. Maybe you don't want things to vest until you get bought out or have an IPO. And if you do have shares that payout, what are you going to do about the fact that some of your Silicon Valley unicorns have all of this stock outstanding, that people aren't able to sell?

They are stuck trying to figure that out and they might be stuck in a job that they don't like, because they have millions of dollars in what's called dry income. They're sitting there with all of this stock that they can't do anything with. But if they leave the company they might lose a lot of it. Also for volatility, of course, you can't just go and find your own historical volatility based on the market and there are certainly no options traded on your company. So based on that, you need to use peer companies to figure out the volatility.

WILLIAMS: Josh Schaeffer concludes our segment on equity compensation and leaves us with his final thoughts.

SCHAEFFER: There are so many choices that a company has when it comes to this. I would advise to be careful and thoughtful to get yourself aligned in the right frame of mind. And think about what matters and then just think long and hard about what could happen, what could go right and what could go wrong, with the plan and what's going to happen. We've had a lot of companies say to us, hey look, this plan didn't pay out and now we realize

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Segment Two

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two 2. Current Expected Credit Losses – What

You Need to Know

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Learning Objectives:

Segment Overview:

Field of Study:

Recommended Accreditation:Reading (Optional for Group Study):

Running Time:

Video Transcript:

Course Level:

Course Prerequisites:

Advance Preparation:

Accounting

Work experience in financial reporting or accounting, or an introductory course in accounting.

None

1 hour group live 2 hours self-study online

Update

“CREDIT LOSSES:

ACCOUNTING STANDARDS UPDATE 2016-13, FINANCIAL INSTRUMENTS—CREDIT LOSSES (TOPIC 326)”

“FASB STAFF Q&A: TOPIC 326, NO. 1: WHETHER THE WEIGHTED-AVERAGE REMAINING MATURITY METHOD IS AN ACCEPTABLE METHOD TO ESTIMATE EXPECTED CREDIT LOSSES”

See page 2–13.

See page 2–22.

35 minutes

On June 16, 2016 the FASB issued Accounting Standards Update No. 2016-13, Financial Instruments – Credit Losses (Topic 326). The new guidance requires organizations to measure all expected credit losses for financial instruments held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. It affects organizations that hold financial assets and net investments in leases that are not accounted for at fair value, and amongst other areas on the balance sheet, also affects loans and debt. ASC-326 is certainly a very complex standard. Chris Brown, senior managing director, Forensic & Litigation Consulting at FTI Consulting, discusses in detail the accounting standard and the reasons that drove FASB to issue it.

Upon successful completion of this segment, you should be able to: l Understand the reasons behind FASB’s decision to issue

CECL, l Identify ways COVID-19 impacted CECL portfolio specific

conditions, l Recognize modeling risks associated with CECL and

considerations for preparers, and l Identify control considerations when developing estimates.

Expiration Date: June 12, 2022

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A. Measuring Expected Credit Losses

i. Historical experience

ii. Current conditions

iii. Reasonable and supportable forecasts

B. What Drove CECL

i. Old model of an allowance for loan losses did not allow for timely adjustment of reserves

ii. When valuations were going down GAAP prohibited such consideration and inclusion into estimates for loan losses

iii. Negatively impacted Investors, banks and financial institutions

C. The Difference with CECL

i. Expected loss instead of probable loss model

ii. Lifetime losses are recognized at origination

iii. Required preparers to create an allowance for lifetime expected losses rather than incurred l Use of reasonable and

supportable forecasts of future economic conditions

l Resort to historical losses to create an estimate

iv. New disclosures on l Credit quality of financial assets l How allowance for loan losses

was calculated

I. CECL Background

Outline

A. In the Absence of Loss History

i. Look to peers

ii. Look how the industry is doing

iii. Layer in qualitative factors based on your l Specific portfolio l Expectation of how future

conditions will impact that portfolio over the life of the loan

iv. Validate and test model

v. Look back for accuracy and calibrate

B. CECL Effective Dates

i. Interim periods beginning after December 15, 2019 l Large SEC filers

ii. Fiscal years beginning after December 15, 2022 l Everyone else

iii. Early adoption is allowed

C. CARES Act & CECL

i. Allowed users to delay adoption l Uncertainty & difficulty in

estimating the impact of the pandemic

ii. Allowed a moratorium on treatment of troubled debt restructurings

II. Implementing CECL

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Outline (continued)

A. CECL – Portfolio-Specific Conditions vs COVID-19

i. Portfolio-specific conditions l External sources l Conservative vs. aggressive

management l Use of various approaches

allowed by CECL l Adoption of comparability

ii. COVID-19 l Strong ramp-up in reserves l Q1 & Q2 l Slowing down due to

stabilization in l Unemployment l Macroeconomic indicators

B. Preparers’ Focus

i. Think about different probabilities l As evidence mounts

ii. Stay true to beliefs l As time & patterns change

C. Fair Value Option

i. Incorporates the element of the return on the risk l Potentially less punitive upfront

ii. Assumptions need to be validated

iii. Management review controls need to be in place

iv. Data elements need to have the right inputs and controls

D. CECL in 2020 & Pattern of Provisions

i. Large charges going through equity

ii. Significant increase in provisions in Q1 l Due to a change in fact pattern

iii. Larger provisions in Q2 l Due to uncertainty

iv. Softening in Q3 forward l Due to economic conditions at

the time

III. Other Ways COVID-19 Impacts CECL

A. CECL & Modeling Risks

i. Engineered valuations l Management utilizing model

complexity to game the valuation

l Potential flaws in the methodology

l Unpredictability on elements of borrower behavior

l Exposure and scrutiny if methodology changes

B. Considerations for Preparers

i. If estimates change l Why now?

ii. Confirming & dis-confirming evidence l Do they make sense?

iii. Strong model governance l Risk assessment l Monitoring estimates

l Reconciling actual vs. expected results

iv. Robust internal control structure

C. Impact of Lack of TDR Disclosures

i. Hide restructuring activities

ii. Hide extent of troubled borrowers

D. Ways Management Can Alleviate Risk

i. Strong model governance

ii. Model validation

iii. Model testing when there are changes l Embed changes in policy

“It's a really key piece of model governance I think is essential for management to protect themselves as they try to predict the future.”

— Chris Brown

IV. Reporting Risks Related to CECL

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A. When & Why to Engage Specialists

i. Keyman risk l One individual with the

knowledge to review

ii. Mitigating potential future l Lawsuits l Regulatory scrutiny

B. Points for Consideration

i. Increased pressure on CFOs to l Manage costs l Maintain internal controls

ii. Company’s culture that encourages l Strong controls l Challenges to status quo

iii. Scrutinizing estimates

iv. Recognizing, documenting and assessing bias and how it is mitigated

C. Control Considerations When Developing Estimates

i. Controls over completeness and accuracy

ii. General information technology controls l Ensuring appropriate access l Authorizing, testing &

validating changes

iii. Management review controls l Well documented l All types of evidence need to be

evaluated l Positive l Dis-confirming l Indicating wrong assumption

D. Additional Control Considerations

i. Monitoring controls

ii. Model governance controls

E. Proper Timing on Making Changes

i. When the economy is improving l Go back & revisit the

assumptions l Ensure there is weight of

evidence l Have an answer as to “why

now”

ii. Look at the market & peers

F. Pressure for Auditors

i. Auditors face the same pressures as businesses l Limited staff and employees

getting sick

ii. Doing an audit virtually l Observing inventory over a

screen

iii. Pressure on timing

iv. Use of judgment

v. Increased documentation

V. Using Controls to Mitigate Risks

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A. Managing the Risk of Fraud

i. Auditors can be viewed as the gatekeepers l Protecting and ensuring financial

reporting is l Accurate l Absent of fraud

B. Management Review Controls

i. Embedded controls to validate l Completeness l Accuracy of inputs

ii. Methodology needs to be challenged

iii. Ensure policy is l Satisfactory l Meets the requirements of the

standard

iv. Review controls needed to operate in silos

C. Communication with Stakeholders

i. Clear & timely communication l Providing warning if there are

trends in disclosures

ii. Concentration risk l Signaling slow recovery l Stock valuation drop l Trying to avoid future lawsuits

VI. Addressing Fraud Risk

A. Pandemic & CECL Impairment

i. Significant issues revealed with underlying model used to support credit losses

B. SEC Focus

i. Timing of impairments l Subject of scrutiny

ii. Transparency & informative disclosures

C. Chris Brown’s Final Thoughts

i. Management should consider l Tone l Ethics l Culture

ii. Shareholders should understand l Where the risk is l How management addresses risk

iii. Risks with CECL or fair value l Understand inputs and

assumptions l Ensure robust and timely

documentation l Model governance

VII. Increased Scrutiny of Financial Results

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1. FASB has issued Accounting Standards Update No. 2016-13, Financial Instruments – Credit Losses (Topic 326), which deals with the measurement and reporting of expected credit losses. Why did FASB issue this Standard? How has the Standard impacted you, your role and your organization?

2. The COVID-19 pandemic has had a significant impact on the issuance of CECL guidance. What are some of the ways the guidance was impacted? How has your organization dealt with the effects of COVID-19 on the CECL model?

3. Companies that chose to adopt CECL were already dealing with the implementation process when the COVID-19 pandemic began. How were these adopting companies impacted by the COVID-19 pandemic? How did your organization handle the implementation, if at all?

4. Financial statement preparers and management need to be cognizant of reporting risks related to CECL. What are some of the more prevalent reporting risks? How have these risks affected you, your role, and your organization?

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2. Current Expected Credit Losses – What You Need to Know

l As the Discussion Leader, you should introduce this video segment with words similar to the following:

“In this segment, In this segment, Chris Brown discusses in detail Accounting Standards Update No. 2016-13, Financial Instruments – Credit Losses (Topic 326) and the reasons that drove FASB to issue the accounting standard.”

l Show Segment 2. The transcript of this video starts on page 2–20 of this guide.

l After playing the video, use the questions provided or ones you have developed to generate discussion. The answers to our discussion questions are on pages 2–8 to 2–10. Additional objective questions are on pages 2–11 and 2–12.

l After the discussion, complete the evaluation form on page A–1.

Discussion Questions

You may want to assign these discussion questions to individual participants before viewing the video segment.

Instructions for Segment

Group Live Option

For additional information concerning CPE requirements, see page vi of this guide.

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5. Although there are reporting risks associated with CECL, management can mitigate them. What are some of the things that management can do to lessen the risks associated with CECL? What efforts have you and your organization taken?

6. The current business, economic and regulatory environment has created pressures on stakeholders with and outside the organization. What pressures are being faced by the various stakeholders? How does your organization deal with such pressures?

7. Management is responsible for the design and implementation of review controls over CECL. What factors should be considered in the design of such controls? What factors has your organization considered when designing such controls?

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sDiscussion Questions (continued)

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1. FASB has issued Accounting Standards Update No. 2016-13, Financial Instruments – Credit Losses (Topic 326), which deals with the measurement and reporting of expected credit losses. Why did FASB issue this Standard? How has the Standard impacted you, your role and your organization? l Accounting Standards Update No.

2016-13 v The origin of ASU 2016-13 stems

from the 2007-2008 financial crisis.

v Old model of an allowance for loan losses did not allow for timely adjustment of reserves.

v GAAP in effect at the time prohibited consideration and inclusion of declines in value in estimates for loan losses.

v Negatively impacted Investors, banks, and financial institutions.

v The current CECL model under ASU 2016-13: k Provides for an expected loss

instead of probable loss model k Requires estimation of lifetime

losses to be recognized at loan origination

k Intended to contemplate a forecasted period that considers economic conditions and a whole economic cycle over the life of the financial instrument

k Requires preparers to create an allowance for lifetime expected losses rather than incurred b Use of reasonable and

supportable forecasts of future economic conditions

b Resort to historical losses to create an estimate

v Requires disclosures on b Credit quality of financial

assets b How allowance for loan losses

was calculated.

v In the Absence of Loss History k Look to peers k Look how the industry is

doing k Layer in qualitative factors

based on the company’s o Specific portfolio o Expectation of how future

conditions will impact that portfolio over the life of the loan

k Validate and test model k Look back for accuracy and

calibrate. l Participant response based on

personal/organizational experience

2. The COVID-19 pandemic has had a significant impact on the issuance of CECL guidance. What are some of the ways the guidance was impacted? How has your organization dealt with the effects of COVID-19 on the CECL model? l CARES Act & CECL

v Allowed users to delay adoption due to uncertainty & difficulty in estimating the impact of the pandemic

v Allowed a moratorium on treatment of troubled debt restructurings

l Companies initially reported a wide variety in the nature and extent of amended loan losses under CECL attributable to: v Portfolio-specific conditions

k External sources with different economic outlooks

k Conservative vs. aggressive managements

k Use of various approaches allowed by CECL

k Adoption of comparability l Subsequent uncertainty subsequently

created by COVID-19: v Led to increased reserves su

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v Slowing down due to stabilization in k Unemployment k Macroeconomic indicators

l Participant response based on personal/organizational experience

3. Companies that chose to adopt CECL were already dealing with the implementation process when the COVID-19 pandemic began. How were these adopting companies impacted by the COVID-19 pandemic? How did your organization handle the implementation, if at all? l Trends Identified by Companies

Adopting CECL in 2020 v Large charges going through

equity on the balance sheet but not on the income statement

v Significant increase in provisions in Q1 due to changes in fact pattern

v Larger provisions in Q2 due to uncertainty

v Softening in Q3 forward due to economic conditions at the time

l Participant response based on personal/organizational experience

4. Financial statement preparers and management need to be cognizant of reporting risks related to CECL. What are some of the more prevalent reporting risks? How have these risks affected you, your role, and your organization? l CECL & modeling risks stemming

from engineered valuations v Management utilizing model

complexity to game the valuation v Potential flaws in the

methodology v Unpredictability on elements of

borrower behavior v Exposure and scrutiny if

methodology changes

l Considerations for Preparers v If estimates change, ask why

now? v Confirming & dis-confirming

evidence to ascertain whether it makes sense

v Strong model governance k Risk assessment k Monitoring estimates k Reconciling actual vs.

expected results l Risks for Management to Consider

v Impact of Lack of TDR Disclosures k Hide restructuring activities k Hide extent of troubled

borrowers l Participant response based on

personal/organizational experience

5. Although there are reporting risks associated with CECL, management can mitigate them. What are some of the things that management can do to lessen the risks associated with CECL? What efforts have you and your organization taken? l Ways Management Can Alleviate

Risk v Strong model governance v Model validation v Model testing when there are

changes k Embed changes in policy

l Engage Specialists: v In situations where there is key

man risk (i.e., one individual with the knowledge to review models and data)

v This will assist in mitigating potential future lawsuits and regulatory scrutiny

l Participant response based on personal/organizational experience

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sSuggested Answers to Discussion Questions (continued)

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6. The current business, economic and regulatory environment has created pressures on stakeholders with and outside the organization. What pressures are being faced by the various stakeholders? How does your organization deal with such pressures? l Increased pressure on the C-Suite:

v CFOs must k Manage costs k Maintain internal controls

v While at the same time, the company must develop a culture that k Encourages strong controls k Challenges the status quo k Scrutinizes estimates k Recognizes, documents, and

assesses bias and how it is mitigated

l Pressure for auditors: v Auditors face the same pressures

as businesses k Limited staff and employees

getting sick v Doing an audit virtually

k Observing inventory over a screen

v Pressure on timing v Use of judgment v Increased documentation v Managing the risk of fraud

k Auditors can be viewed as the gatekeepers

k Protecting and ensuring financial reporting is accurate and absent of fraud

l Participant response based on personal/organizational experience

7. Management is responsible for the design and implementation of review controls over CECL. What factors should be considered in the design of such controls? What factors has your organization considered when designing such controls? l Management review controls are

embedded controls to validate v Completeness v Accuracy of inputs

l Methodology needs to be challenged v Ensure policy is satisfactory and

meets the requirements of the standard update.

l Review controls needed to operate in silos

l Participant response based on personal/organizational experience

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sSuggested Answers to Discussion Questions (continued)

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1. Accounting Standards Update (ASU) No. 2016-13, Financial Instruments - Credit Losses requires organizations to measure all expected credit losses:

a) based solely on historical experience.

b) based on current conditions only.

c) without regard to forecasts.

d) based on historical experiences, current conditions and reasonable and supportable forecasts.

2. As compared to prior practices, the CECL standard under ASU 2016-13:

a) does NOT allow for timely adjustment of loss reserves.

b) does NOT take into account consideration of loan losses into estimates for loan losses.

c) requires potential lifetime losses to be recognized at loan origination.

d) uses a probable loss model.

3. The CECL standard is effective:

a) for all filers beginning after December 15, 2019.

b) for large SEC filers beginning after December 15, 2022.

c) for non-large SEC filers beginning after December 15, 2022.

d) for non-large SEC filers beginning after December 15, 2019.

4. The CARES Act:

a) requires users to early adopt the CECL model.

b) allowed a moratorium on the treatment of troubled debt restructurings.

c) requires companies to increase their loan reserves as a result of the COVID-19 pandemic.

d) does NOT allow management to use a variety of approaches in estimating loan losses.

5. The fair value option to value loans differs from the CECL standard in that it:

a) is less punitive to the organization adopting it.

b) allows unvalidated assumptions to be used in the measurement of loan losses.

c) does NOT require management controls to be in place.

d) is less complex than the CECL standard to implement.

6. Modeling risks associated with the use of the CECL standard include all of the following EXCEPT:

a) potential flaws in the methodology.

b) unpredictability associated with borrower behavior.

c) scrutiny resulting from changes in methodology.

d) adverse tax consequences.

7. With respect to the modeling risks associated with the use of the CECL standard:

a) preparers should NOT overly scrutinize estimate changes.

b) the company should have strong governance over the modeling process.

c) preparers need only confirm evidence presented to them by management.

d) management should address any changes to methodology as they happen.

You may want to use these objective questions to test knowledge and/or to generate further discussion; these questions are only for group live purposes. Most of these questions are based on the video segment, a few may be based on the reading for self-study that starts on page 2–12.

Objective Questions

2. Current Expected Credit Losses – What You Need to Know

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8. Which of the following groups will likely face pressure stemming from adoption and implementation of the CECL standard?

a) Regulators

b) Auditors

c) Wall Street investors

d) Creditors

9. ASU 2016-13:

a) eliminates the probable initial recognition threshold in current GAAP.

b) restricts the amount of information companies can consider when measuring credit losses.

c) results in less useful financial statements.

d) decreases comparability of purchased financial assets with credit deterioration.

10. When it comes to the use of the weighted average remaining maturity (WARM) method to estimate credit losses:

a) ASU 2-16-13 does NOT consider the WARM method to be acceptable for estimating credit losses.

b) less-complex entities are not allowed to use this method.

c) AUD 2016-13 only provides only way to estimate the allowance for credit losses using the WARM method.

d) the WARM method begins with the use of an average annual charge off rate.

Objective Questions (continued)

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Self-Study Option

Reading (Optional for Group Study)

CREDIT LOSSES

Source: https://www.fasb.org/jsp/FASB/FASBContent_C/CompletedProjectPage&cid=1176168232014

ACCOUNTING STANDARDS UPDATE 2016-13, FINANCIAL INSTRUMENTS—CREDIT LOSSES (TOPIC 326)

Overview

On June 16, 2016, the FASB completed its Financial Instruments—Credit Losses project by issuing Accounting Standards Update No. 2016-13, Financial Instruments—Credit Losses (Topic 326). The new guidance requires organizations to measure all expected credit losses for financial instruments held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts.

To that end, the new guidance:

1. Eliminates the probable initial recognition threshold in current GAAP and, instead, reflects an organization’s

current estimate of all expected credit losses over the contractual term of its financial assets

2. Broadens the information that an entity can consider when measuring credit losses to include forward-looking information

3. Increases usefulness of the financial statements by requiring timely inclusion of forecasted information in forming expectations of credit losses

4. Increases comparability of purchased financial assets with credit deterioration (PCD assets) with other purchased assets that do not have credit deterioration as well as originated assets because credit losses that are expected will be recorded through an allowance for credit losses for all assets

5. Increases users’ understanding of underwriting standards and credit quality trends by requiring additional information about credit quality indicators by year of origination (vintage)

6. For available-for-sale debt securities, aligns the income statement recognition of credit losses with the reporting period

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l In order to ensure adherence to

NASBA guidelines regarding self-study, the CPA Report and CPA Report Government/Not-for-Profit Self-Study Professional Education Centers are no longer available. Customers should contact their company administrators for information on taking course exams and receiving CPE credit for the courses.

l Customers may contact Kaplan Financial Education at cpesupport@kaplan.com to obtain certificates previously earned through the CPA Report Self-Study and CPA Report Government/Not-for-Profit Self-Study Professional Education Centers.

l Customers interested in the self-study format of the CPA Report can find information on Kaplan Financial Education's self-study libraries at Online Accounting CPE Courses.

CPA Report Update

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in which changes occur by recording credit losses (and subsequent changes in credit losses) through an allowance rather than a write down

The new guidance affects organizations that hold financial assets and net investments in leases that are not accounted for at fair value with changes in fair value reported in net income.

The new guidance affects loans, debt securities, trade receivables, net investments in leases, off-balance-sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash.

Effective Dates The effective dates for Update 2016-13 are as follows:

1. Public business entities that meet the definition of an U.S. Securities and Exchange (SEC) filer, excluding entities eligible to be smaller reporting companies as defined by the SEC, for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years

2. All other entities for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years.

Early application is permitted.

Additional Information l Download the Accounting Standards

Update

l Read the Press Release introducing the ASU

To Learn More

l Read the FASB In Focus—a summary of the ASU

l Read the FASB: Understanding Costs and Benefits

l Watch Why a New Credit Losses Standard?—a video featuring FASB Chair Russ Golden and FASB Members Hal Schroeder and Marc Siegel

Post-Issuance Activities

l Read the FASB Staff Q&A No. 1—Whether the Weighted-Average Remaining Maturity Method Is an Acceptable Method to Estimate Expected Credit Losses

l Read the FASB Staff Q&A No. 2—Developing an Estimate of Expected Credit Losses on Financial Assets

l Learn more about upcoming CECL workshops

l Visit the Transition Resource Group for Credit Losses webpage to stay up to date on implementation issues discussed and addressed by the TRG.

Have A Question?

Submit questions about the new requirements using our Technical Inquiry System.

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Source: https://www.fasb.org/cs/ContentServer?c=FASBContent_C&cid=1176171932723&d=&pagename=FASB%2FFASBContent_C%2FGeneralContentDisplay

TOPIC 326, NO. 1: WHETHER THE WEIGHTED-AVERAGE REMAINING MATURITY METHOD IS AN ACCEPTABLE METHOD TO ESTIMATE EXPECTED CREDIT LOSSES

BACKGROUND

Topic 326, Financial Instruments—Credit Losses, requires entities (and other organizations) to measure all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts with the objective of presenting an entity’s estimate of the net amount expected to be collected on the financial assets. Under this guidance, entities will use reasonable and supportable forecasts to better inform their credit loss estimates. The standard does not require a specific credit loss method; however, it allows entities to use judgment in determining the relevant information and estimation methods that are appropriate in their circumstances.

Questions have been posed to the staff on acceptable, practical methods that may be relevant and appropriate for smaller, less complex pools of assets. Specifically, the FASB has received questions about whether the weighted-average remaining maturity (WARM) method is an acceptable method to estimate expected credit losses. This Q&A represents the view of the FASB staff. Official positions of the FASB are determined only after extensive due process and deliberation.

The WARM method uses an average annual charge-off rate (see calculation in Question #3 below). This average annual charge-off rate contains loss content over several vintages and is used as a foundation for estimating the credit loss content for the remaining balances of financial assets in a pool at the balance sheet date. The average annual charge-off rate is applied to the contractual term, further adjusted for estimated prepayments to determine the unadjusted historical charge-off rate for the remaining balance of the financial assets. The calculation of the unadjusted historical charge-off rate does not include a reasonable and supportable forecast period. Like other loss rate methods that can be used to estimate expected credit losses, consideration of reasonable and supportable forecasts when applying the WARM method can be accomplished in other ways, as illustrated later in this Q&A (See Question #5).

QUESTION 1

Is the WARM method an acceptable method to estimate allowances for credit losses under Subtopic 326-20?

RESPONSE

The WARM method as described in the background section above may be an acceptable method to estimate expected credit losses under Topic 326. Specifically, the WARM method considers an estimate of expected credit losses over the remaining life of the financial assets (that is, losses occurring through the end of the contractual term).

Paragraph 326-20-30-3 states that “…the allowance for credit losses may be determined using various methods.” The Board elaborated on its intent in paragraph BC50 of the basis for conclusions to Accounting Standards Update No. 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments:

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The Board has permitted entities to estimate expected credit losses using various methods because the Board believes entities manage credit risk differently and should have flexibility to best report their expectations…. The complexity of the portfolio, size of the entity, access to information, and management of the portfolio may result in approaches with varying degrees of sophistication. Because entities may have different levels of sophistication, the Board did not prescribe one type of methodology for measuring expected credit losses for financial assets measured at amortized cost.

The FASB staff believes that the WARM method is one of many methods that could be used to estimate an allowance for credit losses for less complex financial asset pools under Subtopic 326-20.

QUESTION 2

What factors should an entity consider when determining whether to use the WARM method?

RESPONSE

There are a range of methods currently in use under the incurred loss method scaled to the size and the complexity of the entities that use them, ranging from simple spreadsheet calculations to complex econometric models. It is expected that entities will continue to employ an array of methods when Update 2016-13 is implemented. However, the complexity and sophistication of the methods used should consider the complexity and sophistication of the credit risk management processes being performed by the entity for specific pools of financial assets.

There is no expectation that a less complex entity should have to implement a sophisticated model to satisfy the requirements of Update 2016-13. If an entity is using a loss rate-based method today, that entity may be able to continue with a comparable method, including the WARM method. However, compared with the method it uses today to estimate

incurred losses, the entity’s assumptions and inputs will need to change to arrive at an estimate for expected credit losses that contemplates the contractual term of the financial assets adjusted for prepayments as well as reasonable and supportable forecasts.

In selecting a specific method, an entity should consider whether the method is appropriate for estimating the reserve for a pool of financial assets. Consideration should be given to the complexity, size, and composition of the pool of financial assets, and the entity’s access to information (for example, is the pool homogenous with sufficient size and loss history with a predictive pattern) as well as the size of the entity and the risk-management strategy for the pool (for example, while the entity may be large and complex, the specific pool could be insignificant to the entity, lending itself to a less complex risk management strategy).

Certain common challenges can exist regardless of the loss rate method selected by an entity. These include, but are not limited to, situations involving minimal loss history, losses that are sporadic with no predictive patterns, low numbers of loans in each pool, data that is only available for a short historical period, a composition that varies significantly from historical pools of financial assets, or changes in the economic environment. In some instances, these challenges will be minor and can be effectively resolved using qualitative adjustments thereby making the WARM method acceptable. In other instances, these challenges will be more significant, and an entity may find that the WARM method is inappropriate for its situation.

QUESTION 3

How can an entity estimate the allowance for credit losses using a WARM method?

RESPONSE

The FASB staff has adapted the following example from a webinar the staff participated in with the bank regulatory agencies. For additional educational

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information, the archived webinar hosted by the bank regulatory agencies is available using this link. The following example focuses on using annualized loss data as a foundation for estimating the allowance for credit losses for a pool of financial assets and is illustrative in nature. The facts and circumstances of an entity’s situation should be considered.

The example illustrates estimating an allowance for credit losses on a pool of financial assets as of December 31, 2020. The pool has an outstanding balance of approximately $13.98 million as of December 31, 2020 and has financial assets with a contractual life of 5 years. The $13.98 million amortized cost is for a pool of financial assets with similar credit risk characteristics.

Management expects a rise in unemployment rates for 2021 and 2022 and cannot reasonably forecast beyond 2022.

The example assumes a 0.25% qualitative adjustment for current conditions and reasonable and supportable forecasts discussed further below. It is important to note that this input will be a significant assumption when estimating expected credit losses under Update 2016-13 because it represents amounts for the current conditions and reasonable and supportable

forecast. Moreover, because the example is for illustrative purposes, the staff has not assumed a specific type of financial asset pool given the breadth of products that exist in the market place and the specific facts and circumstances that may exist for a particular entity. Rather, the calculations are meant to depict the mechanics of the model in various ways. Therefore, as noted in the example calculations, an entity will need to determine if adjustments need to be made to historical loss data in accordance with paragraph 326-20-30-8 in addition to the reasonable and supportable forecasts.

Fact Pattern

l Estimate the allowance for credit losses as of 12/31/2020 l Pool of financial assets of similar risk characteristics

b Amortized cost basis of ~$13.98 million b 5-year financial assets (contractual term adjusted by prepayments)

l Management expects the following in 2021 and 2022: b Rise in unemployment rates

l Management cannot reasonably forecast beyond 2022 l Assume 0.25% qualitative adjustment to represent both current conditions and

reasonable and supportable forecasts

Step 1: Calculate Annual Charge-Off Rate

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In Table 1 above:

1. Red bolded number of 0.36% is an average of 5 years of annual charge-off rates.

2. The historical time period used to determine the average annual charge-off rate is a significant judgment that will need to be properly supported and documented in accordance with paragraph 326-20-30-8. For this example, assume the entity compared historical information for similar financial assets with the current and forecasted direction of the economic environment, and believes that its most recent 5-year period is a reasonable period on which to base its expected credit-loss-rate calculation after considering the underwriting standards and contractual terms for loans that existed over the historical period in comparison with the current pool. Additionally, assume the entity considered whether any adjustments to historical loss information in accordance with paragraph 326-20-30-8 were needed before considering adjustments for current conditions and reasonable and supportable forecasts but determined that none were necessary. It should be noted that this is a simplified example using a generic pool. An entity that estimates the allowance for credit losses using the WARM method (or any method) should determine if its historical loss information needs to be adjusted for changes in underwriting

standards, portfolio mix, or asset term within the pool at the reporting date.

In Table 2 above:

1. First column titled “Year End” displays subsequent years, until 2025, which represents the time anticipated for the pool to be paid off.

2. Second column titled “Est. Paydown” represents expected payments in the future periods until the pool is expected to fully pay off. Management will need to estimate the future paydowns, which includes the scheduled payments + prepayments.

Note: Do not include the expected credit losses in this column. Paydowns should include scheduled payments and non-credit related prepayments.

Note: Estimated prepayments are also a significant judgment that will need to be properly supported and documented.

3. Third column titled “Projected Amort Cost”:

a. Begin with $13.98MM outstanding balance as of the balance sheet date of 12/31/2020.

b. Subtract projected paydowns from the “Est. Paydown” column to estimate future projected amortized

Step 2: Estimate the Allowance for Credit Losses

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cost for each of the remaining years of the pool’s life (for example, $13,980M minus $3,700M equals $10,280M).

4. Fifth column titled “Allowance for Credit Losses”:

a. Take each of the future years’ projected amortized cost and multiply by the average annual charge-off rate, thereby estimating each of the remaining years’ losses and aggregating to estimate the cumulative losses (for example, in the first year, $13.98MM of amortized cost is multiplied by the average annual charge-off rate of 0.36% for a first year’s credit loss estimate of $50K dollars).

b. For the second year, which is 2022, the $10.28MM representing the ending balance as of 2021 and the beginning balance as of 2022 is multiplied by the average annual charge-off rate of 0.36% to estimate the second year’s credit losses of $37K dollars. This process is repeated for each remaining year.

c. Sum the last column to estimate the total expected credit losses of $126K dollars.

Note: This is not the full allowance for credit losses because the entity has not yet accounted for current conditions and reasonable and supportable forecasts.

d. Convert $126K of expected losses into a loss rate of 0.90% by dividing $126K by the amortized cost of $13.98MM.

5. Finally, add 0.25% of qualitative adjustments as an assumption established as part of the fact pattern of the example to estimate the allowance for credit losses rate of 1.15%. The 1.15% is multiplied by $13.98MM to estimate the total allowance for credit losses of $161K dollars.

Note: 0.25% is a significant assumption made by management that will need to be adequately documented and supported. For this example, in accordance with paragraph 326-20-55-4, the entity considered significant factors that could affect the expected collectability of the amortized cost basis of the pool and determined that the primary factor is the unemployment rate. As part of this analysis, assume that the entity observed that the unemployment rate has increased as of the current reporting period date. Based on current conditions and reasonable and supportable forecasts, the entity expects that unemployment rates are expected to increase further over the next one to two years. To adjust the historical loss rate to reflect the effects of those differences in current conditions and forecasted changes, the entity estimates a 25-basis-point increase in credit losses incremental to the 0.9 percent historical lifetime loss rate related to the expected deterioration in unemployment rates. Management estimates that the incremental 25-basis-point increase based on its knowledge of historical loss information during past years in which there were similar trends in unemployment rates. Management is unable to support its estimate of expectations for unemployment rates beyond the reasonable and supportable forecast period. Under this loss-rate method, the incremental credit losses for the current conditions and reasonable and supportable forecast (the 25 basis points) is added to the 0.9 percent rate that serves as the basis for the expected credit loss rate. No further reversion adjustments are needed because the entity has applied a 1.15% loss rate where it has immediately reverted into historical losses that reflect the contractual term in accordance with paragraphs 326-20-30-8 through 30-9. This approach reflects an immediate reversion technique for the loss-rate method. It is important to note that the 25-basis-point increase reflects the entity’s estimate of the incremental losses in years 2021 and 2022 from unemployment and assumes no incremental losses for the remaining years. Further, the reversion technique selected by the entity is a significant assumption that will need to be

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supported by management and is not a policy election or practical expedient.

QUESTION 4

The example in question #3 provides one way to estimate the allowance for credit losses using the WARM method. Are there other ways to perform the WARM estimation?

RESPONSE

Yes, there may be other acceptable ways for estimating the allowance for credit losses using a WARM method. An entity could choose to do the following:

Step 1: Calculate Annual Charge-Off Rate

Step 1 is the same. Therefore, entities should follow the steps above in Table 1 for determining the average annual charge-off rate.

Step 2: Estimate the Allowance for Credit Losses

In Table 3 above:

1. The first three columns labeled “Year End,” “Est. Paydown,” and “Project Amort Cost” are identical to the estimation above in Question 3.

2. The last column titled “Remg Life” is used to determine 2.52 years of weighted-average amortization adjusted contractual life (see Table 4 for calculation). This column represents the time period that the “Projected Amortized Cost” will remain outstanding.

a. For example, assume that all paydowns are provided on the last day of the year. Therefore, the numbers shown in the “Estimated Paydown” column will occur on December 31st of every year. Consequently, every single dollar of 12/31/2020’s outstanding amount of $13.98MM will have a life of 1 year because some of that amount will be paid down at the end of the year. Therefore, the “remaining life” of $13.98MM is 1 year. Applying the same logic to the “Projected Amort Cost” balance in year 2021, every single dollar of 2021’s ending balance of $10.28MM will have a life of 2 years.

Note: The “Remg Life” column represents the number of years the entire “Projected Amort Cost” will be outstanding. For purposes of this example, the staff has made a simplifying assumption that all paydowns occur at the end of the year. Those numbers likely will be fractions of years (for example, 0.5, 1.5, 2.5, and so on) depending

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on when the paydowns are estimated to occur. Management will need to estimate and support the timing of those paydowns.

3. An entity should use the numbers in the table above to determine 2.52 years. This can be done in the following manner:

4. 2.52 years are multiplied by the average annual charge-off rate of 0.36% to arrive at 0.90% representing the unadjusted historical charge-off rate for the remaining balance.

5. In the example provided, the entity would add the same 0.25% of qualitative adjustment to arrive at the allowance for credit losses rate of 1.15%. The 1.15% is multiplied by $13.98MM to arrive at the total allowance for credit losses of $161K dollars.

The examples in questions #3 and #4 use simplifying assumptions to arrive at the answers calculated. Entities should be aware that all assumptions could have a significant effect on the ultimate allowance for credit losses estimated. Examples of those assumptions include, but are not limited to, the following: the estimated payoff profile considering contractual terms and any estimated prepayments (for example, straight line, amortizing or bullet loan), the historical time period an entity references as representative of the current pool’s remaining contractual life (for example, the most recent past 5 years or a different 5-year period representing the characteristics of the current pool), and the qualitative factors considered (for example, any qualitative factors that may be used to adjust historical information as discussed in Step 1 of Question #3 above or those qualitative factors used to adjust historical information for reasonable and supportable forecasts as discussed in Question #5 below). Entities should consider the guidance in paragraph 326-20-30-8, which states:

Historical credit loss experience of financial assets with similar risk characteristics generally provides a basis for an entity’s assessment of expected credit losses. Historical loss information can be internal or external historical loss information (or a combination of both). An entity shall consider adjustments to historical loss information for differences in current asset specific risk characteristics, such as differences in underwriting standards, portfolio mix, or asset term within a pool at the reporting date or when an entity’s historical loss information is not reflective of the contractual term of the financial asset or group of financial assets.

For the full Q&A please refer to:

https://www.fasb.org/cs/ContentServer?c=FASBContent_C&cid=1176171932723&d=&pagename=FASB%2FFASBContent_C%2FGeneralContentDisplay

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tVideo Transcript

SURRAN: On June 16, 2016 the FASB issued Accounting Standards Update No. 2016-13, Financial Instruments - Credit Losses (Topic 326). The new guidance requires organizations to measure all expected credit losses for financial instruments held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts.

The new guidance affects organizations that hold financial assets and net investments in leases that are not accounted for at fair value with changes in fair value reported in net income. It also affects loans, debt securities, trade receivables, net investments in leases, off-balance sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash.

The FASB provides a plethora of information on their website on post-issuance activities. There are two rounds of FASB Staff Q&A, access to CECL workshops and a Transition Resource Group for credit losses to learn more about the status of the credit losses project.

WILLIAMS: ASC-326 is certainly a very complex standard. Chris Brown, senior managing director, Forensic & Litigation Consulting at FTI Consulting, joins us to discuss the accounting standard in further detail and what drove FASB to issue it.

BROWN: We have to go back to look at what happened during the financial crisis of 2007, 2008. That time period really demonstrated that the old model of an allowance for loan losses really didn't allow for a timely adjustment of reserves. What we saw was that preparers of financial statements and the people that are doing the valuations, they knew real estate was crashing.

When valuations were going down GAAP prohibited such consideration and inclusion into estimates for loan losses. They knew valuations were going down but GAAP prohibited them from including that or incorporating that into their estimate for loan losses.

By the time that those losses were actually incurred under the old model, it was way too late. Investors had lost money and banks and other entities that had that standard were on the brink of failure.

They went back and they revisited it and they created CECL, which basically you take instead of a probable loss model, now it's expected loss so lifetime losses over the instrument are recognized at origination or day one. That's really intended to contemplate a forecasted period that thinks about what are economic conditions going to do and contemplates a whole economic cycle over the life of the financial instrument.

WILLIAMS: Chris elaborates on the expected loss model required by CECL.

BROWN: CECL requires an expected loss model. What that means is you're going to estimate expected losses over the estimated life of the loan and that's the contractual term of the loan.

Historical guidance, as I mentioned before, uses a probability threshold and CECL eliminates that and replaces it with a model of the expected loss over the life of the loan. It requires preparers to create an allowance for lifetime expected losses rather than incurred. To do that, you consider

2. Current Expected Credit Losses – What You Need to Know

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reasonable and supportable forecasts of future economic conditions to estimate the losses.

Then users, if they can't forecast out that forward, then revert to historical loss history in order to create an estimate. That's one of the approaches. The intent of the FASB was to improve financial reporting by requiring more timely recording of credit losses, again in response to what happened in the Great Recession.

CECL also requires entities to provide new disclosures about the credit quality of their financial assets and how they calculate their allowance for loan losses, so enhanced credit disclosures as well.

WILLIAMS: Talking about forecasting future economic conditions, it seems to be close to impossible in the current economic environment. Well-established companies may be able to go back to historical results in order to set up an allowance. But what happens in fairly new companies, or startups where there is not much history a creditor can rely upon?

BROWN: It's certainly a challenge. One thing we know is that none of us can predict the future.

For entities that don't have that loss history, and that is a common challenge, then the real challenge is looking to peers, looking how the industry is done and whatever type of financial instrument you have and finding proxies. Then what you need to do is layer in qualitative factors based on your specific portfolio and your expectation of how future economic conditions are going to impact that portfolio over the life of the loan. It's a difficult process for sure and so it really requires preparers to go through and establish why what they're using is relevant and reliable as it comes to the estimate.

Then as things go forward, the model needs to be validated and tested and then look back and see how accurate it is and calibrate it and adjust it. It definitely is a challenge and I think the preparers knew, CECL knew that that would be a challenge but, again, they felt that the upside of considering those future events was much better than just the lag in the timing of recognition of losses.

WILLIAMS: So when is CECL effective?

BROWN: CECL actually became effective for large SEC filers this past year, so interim periods beginning after December 15, 2019 and then for others it takes into effect fiscal years beginning after December 15th, 2022.

One thing I would say is that the CARES Act actually impacted the adoption and it allowed users that were intending to delay if they wanted to and so I think for the most part the large institutions all adopted but you did see some that chose to take that delay and they'll have until basically fiscal 2023 to implement. You are allowed to early adopt and I think that there are some entities that are planning on early adopting possibly as of January 1st, 2021.

WILLIAMS: But is there a benefit to early adoption?

BROWN: For large sophisticated entities, yes. Getting ahead of it and getting your processes and controls in place is good. I would say for smaller entities it's probably better on the back end to let the ones ahead of you forge through the snow and basically break the path and really see how the market reacts and see how regulators react. What we've seen, at least in

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t the current year because of the impact of Coronavirus and the uncertainty, is a really, really vast variability in how things look.

There's not a lot of comparability out there right now. There's some entities that did adopt, some that didn't, some that have adopted fair value and so you have just a multitude of models that are going through, let alone everyone has their own unique forecast and they may be relying on different economic analysis from different external providers to do that as well as different vendors in their model. A lot of variability. I would expect over time that we'll see that come into alignment as the industry gets better and as users get comfortable with CECL and get more process improvements in place but for now we're seeing a lot of lack of comparability.

WILLIAMS: One of the economic relief measures under the CARES Act allows large public banks to temporarily postpone the current expected credit loss standard. Chris elaborates.

BROWN: There are two big things that I think are important relative to what the CARES Act did around CECL. First, it's a significant government step to intervene in the adoption of a standard so we just have to acknowledge that. As I mentioned, they allowed for the delay of implementation I think because they recognized the uncertainty and maybe the difficulty of trying to estimate the impact of what at the time was a looming pandemic.

Secondarily, they allowed for a moratorium on the treatment of troubled debt restructurings. As long as a lender was looking at a loan and restructuring it, if there was some relation to COVID, that was presumed to be excluded from troubled debt restructuring disclosures. If you look at historical disclosures around TDRs, those wouldn't be in place this year, at least according to the Cares Act. That provision expired at the end of 2020 but you do have a good nine months of activity where loans were being restructured and just not treated as TDRs where historically they probably would've been treated as TDRs because the entity's being restructured were having difficulties paying.

WILLIAMS: Chris Brown discusses other ways COVID-19 impacts CECL.

BROWN: We did see a wide variability in the nature and extent in the amount of loan losses recorded and some of this is attributed to portfolio-specific conditions but just as likely differences are based on other factors such as external sources with different economic outlooks, conservative versus aggressive management or use of different approaches which are allowed by CECL. As I mentioned previously, for early phases of adoption, comparability is really yet to be determined.

When you add into that the uncertainty related to the Coronavirus and the current pandemic, what we saw was a pretty strong ramp-up in the first two quarters of reserves. Then as unemployment stabilized and some of the macroeconomic indicators stabilized, you saw a slowing down of that and I think we'd expect that to continue as the economic outlook gets stronger in 2021 with the potential for vaccines.

You probably see a stabilization of those ramping up reserves. For those that adopted it at the beginning of this year, perhaps even releasing reserves at some point down the road once the economy stabilizes.

WILLIAMS: As COVID vaccines are now available, most expect the economy to start picking up by the 3rd quarter of 2021. So, would it be prudent for

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companies, in order to be conservative, to establish a heavy allowance in the first quarter and then release it towards the end of the year, if that prediction becomes reality? Chris gives us his insights.

BROWN: First of all just talking about a change in administration and policy, how do you incorporate the impact of what the new administration is going to do relative to regulation and stimulus? None of us know what's going to happen. What I think preparers need to do is to think about the different probabilities of what they think could occur and then basically change the weighting as more evidence mounts as time goes on, so it kind of leaves you in a position to stay true to what you believe yet, as time changes and the fact patterns change and you get a better sense of really when things are going to start to improve and you see tangible improvement, that allows you to shift the probabilities within the model to allow for maybe a more opportunistic or an optimistic view. You really need to consider each of those probability paths and really we think weighting and changing the weighting of those as time goes on is the best way to adjust the models.

WILLIAMS: Chris discusses certain sectors of the industry that are impacted more than others by CECL.

BROWN: One thing we've seen is particularly higher-yield lending, so higher-risk, higher-yield lending is disproportionately impacted by CECL. We see this in subprime auto, maybe some of the higher consumer lending, some of the fintech space where the day one impact of recognizing a life of loan loss for a nontraditional loan or one with higher credit risk is a much larger charge to expense to create a reserve. The economics of that lending, that gets made up over time but it is overly penalizing for entities like that.

We have seen a number of entities in that space choose to go with the fair value option, because that does incorporate the element of the return you're getting on your risk and maybe is a little bit less punitive up front. That being said, all of the trips and traps that are difficult with CECL exist in the fair value option as well.

You still have a number of assumptions that you need to validate. You need to have the right management review controls, the right inputs and controls over all the data elements so it's still a very complex approach but at least that does alleviate a little bit of the pressure of the capital hit you take on day one with especially a higher-risk loan portfolio.

WILLIAMS: 2020 was a very difficult year to say the least, and large public companies had just adopted CECL. Chris discusses the impact of COVID in 2020 for those companies that adopted the standard.

BROWN: It's all over the board. We saw pretty large charges taken day one and those charges on adoption go through equity. They don't actually run through the income statement.

Then as the first quarter rounded up, you saw a pretty significant increase in provisions because you had a change in fact pattern in March where the pandemic really started to rear its teeth. As the year went on, more uncertainty in the second quarter so larger provisions, so a significant ramp-up, and then a softening in the third quarter as economic conditions started to really reveal themselves to be better.

When I point to comparability, it really comes back to different approaches in forecasting and assumptions but also the nature of the

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t portfolios that you're looking at. If you've got a concentration of lending in, for example, restaurants, travel, movie theaters, those are industries and sectors that are going to take a while to recover and there's other sectors such as healthcare that are much stronger.

You have to look at the portfolio-specific metrics to really understand how CECL is impacted and there is a fog due to basically the volatile nature of the economy this year as well as the uncertainty and frankly the lack of experience that institutions have with using CECL. I expect comparability to come in line but it's still a few years away.

WILLIAMS: Chris gives us his views of reporting risk related to CECL in the current environment.

BROWN: There are a number of risks I think that need to be considered. Really what we talk about is modeling risk. The risk is you have engineered valuations so think if you're a board member, for example, or you're in the C-suite or you're a shareholder, is management trying to game an answer and utilizing the complexity of the model to arrive at that place? That is a real risk and when things deteriorate or improve, at some point there's going to have to be a change in assumptions or perhaps there's flaws in the methodology that you're finding out as you move forward, maybe elements of borrower behavior that you didn't predict. Then to the extent that changes have to be made in the methodology, that's when what I would say exposure and scrutiny can come into play.

The question that preparers have to ask as they put together the estimates is if I've got significant changes, why now? They need to consider both the confirming and dis-confirming evidence around whether or not those changes make sense.

The best way to do this is really strong model governance, so that includes risk assessment, controls around monitoring estimates, reconciling very accurately the actual versus expected, because we know that they're never going to get it right. The ability for management to concisely explain why their estimates were off and communicate that timely to shareholders and stakeholders is really key to management maintaining confidence of its stakeholders.

Those that are prepared to do that, that have a very good robust internal control structure and are able to analyze the data quicker are going to be much better prepared to stave off plaintiffs' counsel and potential litigation down the road if things don't go right, or at least consistent with their estimates.

WILLIAMS: But are there any other risks of which executives need to be aware?

BROWN: Certainly I think the lack of TDR disclosures in the current year has the potential impact to maybe hide restructuring activities and maybe the extent of troubled borrowers. How those will play out in the current year will remain to be seen but to the extent that you had loans, for example, in some of the sectors I mentioned earlier like theaters, restaurants, health clubs, gyms, to the extent that those have been restructured, those loans would still appear to readers of the financials to be high-quality, good-credit loans and so when we've talked to clients, we've encouraged them to be transparent to their investors in investor presentations or in the financial statements as to the level of modifications that are being made, even if they're not calling them TDRs, because that will give you a sense of how those entities are going to perform later. Because, again, we expect the recovery for some of these industries to be much slower and

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t so you don't want to catch your investors off guard with suddenly saying, "We've got a load of troubled loans that just really aren't going to perform," and not have some type of leading indicator into that trouble.

WILLIAMS: Chris gives us his insights as to how management can alleviate those risks.

BROWN: I think it goes back, again, to strong model governance, model validation and testing the model when changes are being made, when are they going to be made and having that embedded in policy is really important.

Just not having changes made ad hoc, and we saw that in the Great Recession where the allowance model suddenly broke because of the drastic shift in borrower behavior and when management made changes that at the time they felt were appropriate, they found themselves later being challenged by regulators and by plaintiffs' counsel in lawsuits who viewed those changes as very timely and trying to help management stave off what they saw as impending doom for some of these entities. You put yourself at risk if you don't have embedded in your policies how you're going to address methodology changes, when they're going to be appropriate and when you're going to actually make adjustments to your model itself. It's a really key piece of model governance I think is essential for management to protect themselves as they try to predict the future.

SURRAN: The pandemic has rapidly affected our lives. It has posed and continues to pose a threat as it created social and economic chaos. Management, C-suite executives and those charged with governance had to assume a bigger role overnight, had to focus even more on risk management, and often alter their strategies to alleviate, minimize or mitigate risk.

Internal controls programs had to be redesigned as they were applicable under a different setting, an office setting that no longer exists. Segregation of duties has been one of the biggest challenges as more roles are now assumed by one individual.

Have decisions been impacted while determining allowances? Will those decisions affect financial reporting in the future for boards and management? Should engaging specialists be a consideration?

BROWN: I think it's a fact pattern that institutions that are having to deal with, whether it's turnover, employees being sick or just frankly being overwhelmed by a completely different environment of doing business. Those are all real factors.

COSO provides us a framework with how to deal with that and it's in the risk assessment process so it's really key upon senior management and frankly the board to insist on this that the entities that are responsible for creating these estimates are going through a risk assessment process to adjust and address these risks before they hit the ground.

If you've got a keyman risk of only one person who really has the knowledge to be a reviewer, that might be an element there where you engage specialists as a safety net. You may go find experts to help you get yourself limping through a time that's very challenging and while there may be some cost to that, I think the costs that you're mitigating down the road of potential lawsuits or regulatory scrutiny around the fact that you didn't have really good controls in place, review controls in place is really a prudent way to think through it instead of just trying to

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t put a band aid and suspenders on it and trying to hope and pray that you're close.

WILLIAMS: Earlier, Chris discussed governance. Is there anything more we need to know?

BROWN: I think there's two points, around the pressures on the C-suite. I don't think they've ever been greater than they are today.

You've got pressures as a CFO to manage costs and at the same time maintain internal controls that are going to satisfy your shareholders and your regulators, your ownership. That's a very delicate balance and you need to keep that long-term view in mind. I think one of the keys that we talk about a lot but you don't see it until what I would say in the wake of problems, you can look back and find identifiers, is culture and making sure that the entity from the very top, the board and the tone at the top and the C-suite, emphasizes a culture that encourages strong controls, encourages challenging the status quo and making sure that entities are putting the right level of scrutiny into their estimates and really recognizing the potential for management bias and documenting and assessing how they've mitigated that bias.

The other side of the coin with that is if you don't do it, then you really run the risk of going down a slippery slope at the benefit of saving cost early and then later having to deal with the fact that you just didn't have the right processes or people or expertise in place.

WILLIAMS: Chris gives us his views on control considerations that management needs to think about when developing loss estimates under CECL.

BROWN: There's a myriad of control issues and basically challenges with CECL. It's a very complex estimate and you have a number of data points that go into play so you have a large amount of information that's needed to derive the estimate. All of that information that's used, all the provisions of the terms of the financial instruments that you're assessing under CECL have to have controls over completeness and accuracy of the data. It's very key.

To the extent you have models, those models need to be locked down. You need to have general information technology controls around those to ensure access as appropriate. Changes can't be made unless they're authorized and those changes are tested and validated.

In addition to that, you have a number of assumptions and management needs to have review controls over those significant assumptions that can really cause variability in the estimate.

Those management review controls need to be well-documented and they need to consider both evidence that's positive as well as what we call dis-confirming evidence or evidence that might indicate that there's maybe not the best assumption. Both of those things need to be documented to ensure that you're demonstrating there isn't bias in the process.

Then after that, you've got monitoring controls. How well is the model working? Back-testing it and looking to see is it functioning as we intended?

Then of course the controls that I mentioned earlier around model governance, so when are changes going to be made to the model? When would we change assumptions based on actual versus estimate analysis?

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t All those things layer in a very complex control structure that you really need to have around the estimate. That's not easy to do, particularly around the management review controls where there's a lot of judgment in place. There's a tendency to say, "I've seen it. I know what a duck looks like. I know how it walks. I can call that there but you really need to have better metrics and KPIs that are documented, demonstrated to show how you're applying that judgment. That will withstand the scrutiny of folks down the road that maybe second-guess your approach.

WILLIAMS: And that brings us to our next point about the proper timing on making changes in assumptions or enhancing methodologies.

BROWN: It's one of the challenging ones because in the moment you generally aren't 100% confident. For example, if you're looking and you think the economy is improving to the point where you might need to release reserves, that's a time to go back and revisit your assumptions and really double-check and make sure that you have the weight of evidence and you can answer the question as to why now.

That's really important because when you're doing that, you are taking a step a little bit on faith. Going back to what I mentioned earlier around having a governance around your methodology and a framework that provides rails for you is really important there. You can still build judgment into when that happens but at least having your methodology talk about the factors you're going to consider and how you're going to consider them when you make those changes is going to really provide you air cover down the road if you're challenged.

That's probably the biggest piece and then, again, looking to market and looking to peers and seeing what's happening.

Then from the SEC's point of view, they want to see you signal things. If you start to see things deteriorate, you need to communicate that timely. That signaling is very important so that you don't catch the market off guard and we see sophisticated entities and what I would say kind of the leading edge financial reporting institutions show that in their investor presentations and even in their filings with the SEC.

WILLIAMS: The current environment left many decisions to be based on judgment to justify a certain position or approach they are taking with respect to those estimates and the SEC is seeking robust disclosures on credit losses, which puts pressure on management as well as auditors.

BROWN: As a recovering auditor, I can tell you that the PCAOB puts auditors on notice that the approach that is taken to audit these estimates, and particularly management review controls, is difficult and the documentation needs to be robust for the auditors to do their job. There's almost a default that if that documentation isn't thorough, the auditors can't audit it and therefore you have a deficient audit which is also problematic for management as well as the auditor.

The PCAOB has ratcheted up its scrutiny of the audit profession around this in order to help provide more transparency and really better signaling of issues to come.

If you think about the same impact on businesses out there of just staffing and employees getting sick and then trying to do an audit virtually, observing inventory not being able to see with your own eyes but over a screen is something that hasn't really been done much and now the audit firms are being faced with that.

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t Then on top of all of that, you add the SEC's remarks of saying, "Hey, we're going to look out for folks that use COVID to basically unearth problems they've had and should've dealt with already or to cookie-jar and use that to put in reserves and write things down when the timing isn't appropriate."

There are massive amounts of pressure on timing right now and with all the uncertainty it really falls on you to use your best judgment and really document it well to give yourself a little bit of protection down the road. The one thing we all know is that we don't know what's going to happen in the future. Things change very dynamically and you just can't predict it.

WILLIAMS: Creative accounting never had a positive connotation, yet in this environment, auditors have to come up with creative ways to get comfortable with estimates, allowances, yearend inventories, inventory markdowns and the like. It is certainly a challenging time for the profession as the risk of fraud is higher.

BROWN: There's no doubt. It's a huge challenge and as a recovering auditor, I definitely feel for the profession because the stakes have never been higher and they're going to have to be creative and they're going to have to figure out ways to ensure that they're managing the risk of fraud basically because the risk of fraud is much, much higher and the pressure on management is much higher.

You've got elements of the good old fraud triangle here that are all being tapped and the auditors can be viewed by the market as really the gatekeepers and the ones that are supposed to protect and ensure financial reporting is accurate and absent of fraud and that's very difficult when you don't have your ability to touch the product and see it with your own eyes, open the boxes make sure that everything there is what it's supposed to be and validate it back to the books and records.

I'm sure that the auditors have thought through this and they're dealing with it and on top of that you've got the staffing challenges of having employees that may be sick. It's a very complex thing and has a lot of human elements to it and my best advice is make sure that for the auditors out there you sign the opinion when you know you're comfortable and make sure that you've got procedures. It might just take you more time and different ways to audit to really substantiate what's there, not easy but it's not a task that everyone's going to lighten up on. It still has to get done.

WILLIAMS: Chris Brown discusses how management review controls over CECL are designed and how they should operate.

BROWN: The first thing they need to contemplate is precision, so how precise are they? Typically, a management review control by itself isn't enough to validate an estimate so there needs to be controls embedded that validate the completeness and accuracy of inputs and so on. The methodology itself needs to be challenged and put down in policy to make sure that it's satisfactory and meets the requirements of the standard.

From there, you can build if you've got those two pillars there, the third pillar of management review control that can function looking at peer data, looking at macroeconomic data and taking that 30,000-foot view and saying, "Does this make sense?" After all of the machinations of things I've put into this model, when it comes out does it make sense?

That review control can't operate at the top. It's got to operate in silos that go all the way down because you might have a portfolio that's got 12, 15 segments that are broken down by vintage so really depending on the level

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t of estimation risk you've introduced by cutting and slicing to follow the standard itself. You've got to have controls around each of those elements that come out that are subject to review so it's not easy and it requires really a robust documented policy and methodology to lean on so that you can come back and when you make changes or when you decide you need to shift, you can point back to that policy and say, "Look, this is what I told you a year ago and this is what our policy says we do and we're doing it." That will definitely mitigate the risk of you being challenged as to that seems very convenient, management, that you suddenly changed this estimate at a time when it would've probably been really penalizing on you. You've got to be able to answer and defend that question

WILLIAMS: Chris gives us his views and offers some recommendations when it comes to communication with stakeholders.

BROWN: Clear and timely communication, providing warning if you're seeing trends. Talking about those trends in your disclosures to your investors or stakeholders is really key. You don't want to catch them off guard. The quickest way to lose faith and confidence is to catch someone off guard with a surprise and not be able to concisely and clearly explain why that happened and what you missed. That's a big piece is really trying to stay ahead of it. We see entities, even without the TDR requirements, still disclosing the number of restructurings they're doing just to give the users a sense of how much activity is really going on and how much borrower workouts we're having to do because there's a presumption. We know that there's a ton of entities out there that need workouts. They're cash flow-positive going into 2020 and then pandemic hits. We've been given wind at our backs by the government and through various programs to basically help those entities sustain until they can get recovered.

Some entities are going to recover a lot faster than others and so if you've got a concentration of risk in entities and industries that are slow recovering, you definitely need to signal that to your investors otherwise you're going to create surprises. It's going to cause your stock valuations to drop and take hits and that's when lawsuits come.

Then you're really stuck with the scrutiny of why now and why didn't you say before? The SEC's been clear that they expect those kinds of forewarning disclosures to be made.

SURRAN: Warren Buffett once said "Someone is sitting in the shade today because someone planted a tree a long time ago."

Difficult times bring opportunities, renegotiating cheaper real estate deals, getting new talent from a larger pool of available employees, minimizing competition. For some, it can be a time to start planting trees, start building for a better future, but for others, economic downturns can bring fallouts, loss of jobs, financial losses and a plethora of litigations.

Not only the SEC but also investors and stakeholders are scrutinizing financial results and fixed asset and goodwill impairment, as well as CECL impairment; these are front and center. The pandemic seems to have revealed significant issues with the underlying model used to support credit losses.

Chris gives us his insights on lessons learned from impairment related litigations and enforcement actions that occurred in the last recession.

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BROWN: During the last recession the SEC dramatically increased its scrutiny around the timing and magnitude of loan loss reserves and the calculation of ultimate charges and timing was really important there. Then they focused on changes in methodology and why they were made when they were made.

We'd expect that that's going to be a continued focus, particularly on timing of impairments. It could be CECL or it could be fixed assets or goodwill. All those things are going to be subject to the same level of scrutiny. They're going to expect disclosures and indicators or early warning signs. In relation to COVID-19, we've noted the SEC has taken efforts to forewarn issuers about the need for transparent and informative disclosures and those warnings seem to have been heard.

We've noted fewer comments from the SEC with regards to COVID-19 disclosures than we may have expected so it's a good trend but certainly kind of that cadence and that forewarning needs to continue as we hope and pray that the pandemic will get resolved here sometime in the near future.

WILLIAMS: Chris Brown ends our segment and leaves us with his final thoughts.

BROWN: If you're in the seat of management, making sure that you're considering tone, making sure that you're thinking ethically and you've got a culture that is going to have people step up and do the right thing is important. That might mean forewarning bad news and it's like fish. It doesn't sit well if you let it sit so you need to get those things out.

From the perspective of shareholders and so on, it's really kind of digging into what's the business and understanding where that risk is and how is management addressing those risks. Those are key elements of what I think is good prudent governance, and finally looking out and understanding the risks you take on with a standard like CECL or fair value where you're just taking a lot of inputs and assumptions in, making sure that you've got really good robust and timely documentation around that and model governance is hugely important.

COSO provides a framework for all of this. It's just a matter of revisiting it and turning the theory into application. The entities that do that and have a robust risk assessment really do win the day when it comes down the road to defending your estimate and defending your processes. I would definitely recommend that entities that don't feel like they've got that structure in place, there's great experts out there and there's people that really know this well that can really help you and put into place processes and procedures that are going to sustain the challenge of hindsight.

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Segment Three

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3. Human Capital, Management Oversight &

Disclosure – Is Your Board Ready?Learning Objectives:

Segment Overview:

Field of Study:

Recommended Accreditation:

Running Time:

Video Transcript:

Course Level:

Course Prerequisites:

Advance Preparation:

Expiration Date:

Business Law

June 12, 2022

Work experience in a corporate staff environment, or an introductory course in business law.

None

1 hour group live 2 hours self-study online

Update

See page 3–21.

34 minutes

In August 2020, the Securities and Exchange Commission (SEC) issued its long-awaited amendments to Regulation S-K, the regulation which contains the detailed disclosure requirements, including a new requirement that public companies need to disclose information about “human capital resources”. Boards often focus on key areas of a business and how to drive it forward, but have not been tasked with direct oversight of human capital management, as it has been historically viewed as management’s responsibility. Gillian Emmett Moldowan, partner in the Compensation, Governance and ERISA group at Shearman & Sterling, discusses human capital management and how it fits into the broader framework of ESG.

Upon successful completion of this segment, you should be able to: l Identify SEC rule requirements on human capital

disclosures, l Recognize employee engagement changes and human capital

data collection considerations, l Identify the five primary sustainability dimensions under

SASB, and l Determine the HCMC protocols and human capital

measures.

Reading (Optional for Group Study):

“Preparing the Board for Human Capital Management Oversight and Disclosure” By Gillian Emmett Moldowan and Maxmilien R. Bradley “Sharpening the Board’s Oversight of Human Capital Management” By Annalisa Barrett Source: EBSCO See page 3–12.

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A. Human Capital Resources Disclosures

i. Number of employees

ii. Human capital measures or objectives to manage business

B. Traditional Governance Issues

i. Investor advocacy

ii. Governance of a company by the board

C. Environment & Social

i. Environment l Sustainability l Global climate

ii. Social l Impact on employees &

communities l Issues of social importance to

stakeholders

D. What is Human Capital?

i. Focus on l Employees l Service providers l Ways companies manage the

people that work for them

ii. Essential piece of maintaining l Sustainability l Long-term performance and

growth

I. ESG and Human Capital

A. Potential SEC Rule Requirements

i. Detailed company finances

ii. Capital assets l Real estate l Large-scale capital materials

B. Board New Focus

i. Long-term sustainability

ii. Companies’ strategic direction

C. Employee Activism

i. Employees are interested in and advocating for changes in company direction

D. Employee Engagement Changes

i. Spending less of their career with one company

ii. Thinking about what the company is saying

iii. Connecting themselves to what the company is saying and doing

iv. Evaluating their involvement with the company

II. SEC Focus Impacts Asset Management

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A. Human Capital Data Collection Considerations

i. Workforce l Entire l Dedicated l Discrete sectors l Important aspects

ii. Employees vs. outside contractors l Determine if both should be

measured

iii. Full-time vs. part-time

iv. Seasonal employees

v. How measurements relate to company’s l Overall business plan l Risk management goals

B. Steps Companies Can Take

i. Evaluate and understand subjective information

ii. Look over l Long-term trends l Turnover rates l Employee participation in a

particular type of benefit plan l Safety incident reports

iii. Compare how human capital management goals intersect with compensation goals

C. Data Source Before vs. Now

i. Before l Retention performance at the

executive group

ii. Now l Go beyond the executive group l People who drive what is

happening within a company

III. Leveraging Data about Human Capital

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A. Functions of SASB

i. Accountable for due process, outcomes & ratification of SASB standards

ii. Enables identification, management & communication of financially material sustainability information to investors worldwide

iii. Developed a complete set of 77 standards

iv. Provides guidance

B. Five Primary Sustainability Dimensions

i. Environment

ii. Social capital

iii. Human capital

iv. Business model & innovation

v. Leadership & governance

“addresses the management of a company’s human resources (employees and individual contractors) as key assets to delivering long-term value.”

IV. SASB – Background

A. SASB Measurements

i. Absolute & relative measurements at your company

ii. Peer comparison

B. SASB Measurement Categories

i. Labor practices

ii. Employee health and safety

iii. Employee engagement, diversity & inclusion

C. Labor Practices

i. Number of employees covered by collective bargaining agreements

ii. Strike and lockout activity

iii. Turnover rates

D. Employee Health & Safety

i. Incident rates for safety breaches

ii. Average hours of health and safety

iii. Emergency response training

iv. Monetary losses on safety incidents

E. Employee Engagement, Diversity & Inclusion

i. Percentage of gender, race, or ethnicity

ii. Percentage of U.S. vs non-U.S. based employees

iii. Monetary losses from legal proceedings on discrimination

V. SASB – Human Capital Measurements

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A. HCMC Protocols

i. Not required

ii. Can help on comparisons across industries

B. Workforce HCMC Measures

i. Demographics

ii. Composition

iii. Stability & turnover

iv. Health & safety

v. Productivity

C. Referral Sources on Human Capital Disclosures

i. CSR reports

ii. SASB protocols

iii. HCMC

“… for companies that… haven't been measuring human capital in a board ready way or with an eye towards disclosure at all, these two protocols give companies a place to start.”

— Gillian Emmett Moldowan

D. Building a Measurement Rubric

i. Look at SASB & HCMC measurements

ii. Disclosures of peer companies

iii. Talk to management

VI. SASB vs. HCMC Measurements

VII. Moving ForwardA. Company Obligations

i. Identify issues that are material in the space of human capital l Disclosures are principle-based

NOT prescriptive

ii. Determine what human capital resources are material

B. Other Non-Required Disclosures

i. General disclosures to shareholders & consumers on company sites as to l How they think about human

capital or people

ii. Proxy statements with specific detail on l The operation of the board l Compensation of executives l How they think about their

employee population

C. Company Considerations on Human Capital

i. Factors they need or think about measuring

ii. Why those factors are l Material to the company l Responsive to disclosure

requirements

iii. Identify relevant information

D. Gillian Emmett Moldowan’s Final Thoughts

i. Area of growth and evolution

ii. People that make up the companies are essential

iii. Companies need to think how to manage human capital l For long-term sustainability

iv. Investors will be on the lookout for shared information from companies

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3. Human Capital, Management Oversight & Disclosure – Is Your Board Ready?

l As the Discussion Leader, you should introduce this video segment with words similar to the following:

“In this segment, Gillian Emmett Moldowan discusses human capital management and how it fits into the broader framework of environmental, social and governance issues.”

l Show Segment 3. The transcript of this video starts on page 3–22 of this guide.

l After playing the video, use the questions provided or ones you have developed to generate discussion. The answers to our discussion questions are on pages 3–8 to 3–10. Additional objective questions are on pages 3–11 and 3–12.

l After the discussion, complete the evaluation form on page A–1.

1. What is human capital? What are the SEC rule requirements on human capital resources disclosures? What does your human capital resources disclosure look like?

2. How has employee engagement changed? What are some changes you see in employee engagement as the workplace evolves?

3. What are some human capital data collection considerations? How would you measure the human capital at your organization?

4. What are the five primary sustainability dimensions under SASB?

5. What are the SASB’s topics and metrics that relate to the three human capital measurement categories: labor practices, employee health & safety, and employee engagement, diversity & inclusion? Which of these metrics would you include in your organization’s protocols on measurement?

Discussion Questions

You may want to assign these discussion questions to individual participants before viewing the video segment.

Instructions for Segment

Group Live Option

For additional information concerning CPE requirements, see page vi of this guide.

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s6. What are the HCMC protocols for human

capital measurement? Which set of human capital measurements do you think is best to follow, the SASB or HCMC, and why?

7. What is the nature of the SEC human capital management disclosure and what other non-required disclosures are some companies making regarding human capital? What non-required information might you include in your organization’s human capital management disclosure?

Discussion Questions (continued)

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s1. What is human capital? What are the

SEC rule requirements on human capital resources disclosures? What does your human capital resources disclosure look like? l Human capital

v A focus on employees and service providers to a company

v How the company manages the people who work for them

v An essential piece of maintaining sustainability and long-term performance of the company and its growth

l Disclosure requirements v Number of employees v Any human capital measures or

objectives that the company focuses on in managing the business

l Participant response based on personal/organizational experience

2. How has employee engagement changed? What are some changes you see in employee engagement as the workplace evolves? l Employees spend less of their career

within one company l They think about what the company is

saying l They connect themselves to what the

company is saying and doing l They think about those aspects to

determine whether they want to be involved with the company

l Participant response based on personal/organizational experience

3. What are some human capital data collection considerations? How would you measure the human capital at your organization? l Think about whether the human

capital data collected measures the entire workforce, or the dedicated or discrete sectors of the workforce

l Think about which aspects of the workforce are most important to the company

l Determine whether outside contractors should be measured

l Determine whether to measure part-time or seasonal employees

l You may want to use different metrics for employee or contractor sectors within the company

l Think about how the categories and measurements relate to the company’s overall business plan and risk management goals

l Participant response based on personal/organizational experience

4. What are the five primary sustainability dimensions under SASB? l Environment l Social capital l Human capital l Business model & innovation l Leadership & governance

5. What are the SASB’s topics and metrics that relate to the three human capital measurement categories: labor practices, employee health & safety, and employee engagement, diversity & inclusion? Which of these metrics would you include in your organization’s protocols on measurement? l Labor practices

v Number of employees covered by collective bargaining agreements

v Strike and lockout activity v Turnover rates

l Employee health & safety v Incident rates for safety breaches v Average hours of health and safety v Emergency response training that

workers are receiving v Monetary losses related to safety

incidents

3. Human Capital, Management Oversight & Disclosure – Is Your Board Ready?

Suggested Answers to Discussion Questions

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sl Employee engagement, diversity, and

inclusion v Percentage of gender, race, or

ethnicity v Percentage of workers located in

the U.S. or outside the U.S. v Monetary losses as a result of legal

proceedings that have to do with employee discrimination or related issues

l Participant response based on personal/organizational experience

6. What are the HCMC protocols for human capital measurement? Which set of human capital measurements do you think is best to follow, the SASB or HCMC, and why? l Workforce demographics

v Number of full-time and part-time workers

v Number of contingent workers l Workforce composition

v Diversity v Pay equity ratios

l Workforce stability v Turnover (voluntary or

involuntary) v Internal hire rate

l Workforce health and safety v Work-related injuries and fatalities v Lost day rate

l Workforce productivity v Return on cost of workforce v Profit/revenue for full-time

employees l Participant response based on

personal/organizational experience

7. What is the nature of the SEC human capital management disclosure and what other non-required disclosures are some companies making regarding human capital? What non-required information might you include in your organization’s human capital management disclosure? l Nature of the SEC human capital

management disclosure v Part of the obligations that a

company has in their annual report on Form 10-K

v Identify issues that are material in the space of human capital

v Disclosures are principles-based, not prescriptive

v Leaves companies to determine what human capital resources are material to the company and its particular circumstances

l Non-required disclosures v General disclosures to shareholders

and consumers through their website as to how they think about human capital or people

v Proxy statements with specific detail about: k The operation of the board k Compensation of executives of

the company k How they think about their

employee population l Participant response based on

personal/organizational experience

Suggested Answers to Discussion Questions (continued)

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1. SEC required human capital resources disclosures include:

a) the number of seasonal employees and their functions

b) any human capital measures or objectives that the company focuses on in managing the business

c) the number of contractors that comprise a large portion of the company's service provider population

d) a description of how management determined its considerations for human capital data collection

2. One trend in employee engagement is that employees are:

a) spending less of their career with one company

b) spending more of their career with one company

c) spending their entire career with one company

d) spending more time in family-owned companies

3. One of the five primary sustainability dimensions under the SASB's conceptual framework is:

a) recognition

b) presentation & disclosure

c) social capital

d) financial reporting

4. A metric the SASB provided as a consideration for human capital measurement under labor practices is:

a) number of legal employees

b) number of applicants

c) pay raise rates

d) turnover rates

5. One of the HCMC protocols includes:

a) workforce budget

b) workforce training

c) workforce productivity

d) workforce referrals

6. The SEC human capital management disclosure:

a) leaves companies to determine what human capital resources are material to the company

b) should identify all issues in the space of human capital, both material and immaterial

c) should include how the company thinks about their employee population

d) is not required

7. New categories of human capital measurements should:

a) be similar to measurements used by other companies in the same industry

b) align with the company's business planning goals and risk management objectives

c) result in a body of data measurements that change every year

d) all be sourced from the Sustainability Accounting Standards Board

8. One of the human capital measurements under the HCMC is:

a) percentage of workers located offshore

b) percentage of staff who work in areas where smoking is allowed

c) return on cost of workforce

d) average hourly wage

You may want to use these objective questions to test knowledge and/or to generate further discussion; these questions are only for group live purposes. Most of these questions are based on the video segment, a few may be based on the reading for self-study that starts on page 3–13.

Objective Questions3. Human Capital, Management Oversight & Disclosure – Is

Your Board Ready?

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9. Which of the following is true regarding human capital management disclosures?

a) they are GAAP disclosures

b) the SEC is likely to develop prescriptive disclosures

c) most companies have already been disclosing robust information about their human capital

d) the pressure to include human capital disclosures is growing

10.Which of the following is true regarding human capital management?

a) investors are seeking confirmation that boards are exercising robust oversight of human capital

b) many boards have assigned responsibility for monitoring human capital matters to management

c) they are not of interest to most investors

d) they are not important to the financial success of a company

Objective Questions (continued)

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Self-Study Option

Reading (Optional for Group Study)

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IDENTIFIABLE INTANGIBLE ASSETS AND SUBSEQUENT ACCOUNTING FOR GOODWILL

Source: http://digital.shearman.com/i/1293427-2020-corporate-governance-and-executive-compensation/27?_ga=2.156055867.1614332676.1608685487-1340962929.1607633618

Insights Gillian Emmett Moldowan and Maxmilien R. Bradley

Boards have long focused on executive hiring, leadership transition and compensation as key areas of oversight, but largely have not been tasked with direct oversight of human capital management more broadly, which has historically been viewed as an area of management responsibility. In a recent paper, former Delaware Supreme Court Chief Justice Leo Strine and co-author Kirby Smith argue that the focus of the board should expand. Strine and Smith encourage a “reconceived compensation committee” that “would focus on the company’s entire workforce, not just senior management” and oversee workforce pay, benefits, safety, racial and gender equality, sexual harassment, inclusion, training and

promotion.1 In short, a board committee focused on workforce issues at large.

Increased focus on human capital management, and the perspective that workforce considerations can be material to shareholders, have also influenced a separate but related change in corporate governance: mandatory human capital management disclosure by public companies. The SEC recently adopted rules that require public companies to describe, to the extent material to an understanding of the company’s business taken as a whole, their human capital resources, including the number of employees and any human capital measures or objectives that the company focuses on in managing the business.2

These changes in corporate governance in the human capital management area are motivated by developments that predate the COVID-19 pandemic. The pandemic has made them all the more germane. The impacts of the pandemic on workforces should have made clear to every company and to every board that there must be at least some aspect of enterprise risk management and long- term strategic

l In order to ensure adherence to NASBA guidelines regarding self-study, the CPA Report and CPA Report Government/Not-for-Profit Self-Study Professional Education Centers are no longer available. Customers should contact their company administrators for information on taking course exams and receiving CPE credit for the courses.

l Customers may contact Kaplan Financial Education at cpesupport@kaplan.com to obtain certificates previously earned through the CPA Report Self-Study and CPA Report Government/Not-for-Profit Self-Study Professional Education Centers.

l Customers interested in the self-study format of the CPA Report can find information on Kaplan Financial Education's self-study libraries at Online Accounting CPE Courses.

CPA Report Update

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planning that focuses on workers outside the executive group. And, clearly, that aspect of human capital management — the issues that form a component of enterprise risk management and long-term strategic planning — is a board issue.

But positioning human capital management as a board issue, and expanding board focus from executive compensation to the workforce at large, will, for many boards, require significant change. The first practical step boards can take in implementing this change is the development of a robust body of year-over-year human capital data. Developing this data will allow the board to effectively oversee the aspects of human capital management that fall within its oversight and simultaneously help the company to provide meaningful human capital management disclosure to meet the requirements of the new human capital management disclosure rule.

HUMAN CAPITAL MANAGEMENT IN THE BOARDROOM

Boards need a robust body of year-over-year human capital data to provide an effective and measurable method of oversight. Certain basic human capital data, like retention and turnover rates, may already be collected by some companies, and some boards may already review this data on a periodic basis. But these basic measurements do not provide the full range of human capital information needed for effective board oversight. To fulfill their oversight role, boards need more

robust and more expansive human capital measurements, particularly those that will result in a body of year-over-year data that boards may use to track human capital management progress over time.

Where should boards look to develop these human capital measurements? The human resources management team should identify for the board the human capital data that is already collected and tracked. As a process matter, this will require the company to establish a “board-ready” human resources management team member or other executive trained to report to the board on this issue.

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The answer to this last question may be the most important. Not only is tying human capital management to larger business planning initiatives and risk management necessary for meaningful board oversight of those initiatives, it is also an important step in developing disclosure that meets the requirement of the new human capital management disclosure rule to discuss, to the extent material, the human capital

measures or objectives that management focuses on in running the business.

Any new categories of human capital measurements should then be added to the categories that are already collected and tracked. These new categories should align with the company’s business planning goals and risk management objectives and allow the board to oversee management’s achievement of those goals. Therefore, it is important that companies choose categories that will result in a body of year-over-year data that boards may use to track human capital management progress over time.

Companies may look to various sources for categories of potential human capital measurements from which to choose. One such source is Sustainability Accounting Standards Board (SASB). These fall into the general categories of labor practices, employee health and safety and employee engagement, diversity and inclusion and include the specific measurements listed below.

Companies may also consider categories of human capital information and measurements that investors and other stakeholders have asked the company to disclose or that peer companies disclose. Human capital management issues in shareholder proposals (both for the company and for competitor or peer companies) should be reviewed. In addition, companies should consider the categories of human capital measurements that have been advocated for by strong proponents of these disclosures such as public pension funds and social impact funds. For example, the Human Capital Management Coalition (HCMC), a group representing large and influential public

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pension funds, has proposed the following measures.

A company that identifies how human capital issues relate to business planning and risk management and builds selected categories of human capital measurements will take a strong first step in developing the robust body of year-over-year human capital data necessary for its board to fulfill an expanded human capital management oversight role. Of course, companies, in certain instances in collaboration with their boards, will need to select among these categories with discretion, considering the particular business and industry of the

company and the company’s specific human capital goals.

Are boards already beginning to expand their oversight role from the narrow focus on executive compensation to the broad scope of workforce issues at large? One indication is the name given by the Top 100 Companies to the board committee focused on executive compensation, which suggests that some boards have made this change or are preparing to do so. Many of these names are no longer simply “compensation committee,” but instead use key words indicating a broader focus, as shown below.

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In addition, in describing the focus of these committees, the proxy statements of many of the Top 100 Companies indicate a scope that expands well beyond executive compensation. Examples of the most common areas of committee focus in addition to executive compensation are shown below.

HUMAN CAPITAL MANAGEMENT IN PUBLIC DISCLOSURE

Developing a robust body of year- over-year human capital data is important not only for effective board oversight of human capital management, but also for approaching the newly required human capital management disclosure.

The new disclosure rule resulted, in significant part, from increasing calls over the past few years for mandatory human capital management disclosure. Select examples include the HCMC petition to the SEC for rulemaking requiring human capital disclosure; the views expressed by SEC Chairman Jay Clayton to the SEC Investor Advisory Committee that human

capital is, for some companies, a “mission-critical asset” and by the SEC’s Investor Advisory Committee in turn that human capital is the “primary source of value” of many of the most dynamic U.S. companies; and BlackRock’s identification of human capital management as an engagement priority and an important

investment issue.4

These developments have significantly influenced the adoption of a new disclosure rule requiring public companies to describe, to the extent material to an understanding of the company’s business taken as a whole, the company’s human capital

resources, including the number of employees and any human capital measures or objectives that the company focuses on in managing the business. Importantly, the rule is not prescriptive and is principles- based, leaving it to the company to determine what human capital resources are material to the company and its particular circumstances. This means that the rule does not require companies to disclose any particular human capital metrics or measurements (other than number of employees, if the company determines that metric to be material to an understanding of the company’s business as a whole). While this approach is not unexpected, it is likely to be viewed as inadequate by many public commenters who supported more prescriptive, and from their perspective, rigorous, requirements and the mandatory disclosure of specified quantitative human capital metrics. The new rule has already been criticized by

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two SEC Commissioners who did not approve its adoption. Commissioner Allison Lee criticized the rule for failing to require the disclosure of even “simple, commonly kept metrics such as part time vs. full time workers, workforce expenses, turnover, and diversity” and Commissioner Caroline Crenshaw characterized the rule as “a generic and vague principles-based requirement” that will not give investors the human capital information they need because of its “failure to adopt detailed, specific disclosure requirements concerning human capital.”5

The new disclosure rule does not prescribe specific metrics that must be disclosed, but companies do need to consider human capital measurements that could be material to their disclosure. The rule gives as non-exclusive examples of the types of measures that may be material measures that address the attraction, development, and retention of personnel. These are just examples, and each company must perform its own analysis of the human capital measures that are material to an understanding of its business. SEC Chairman Jay Clayton underscored the fact that the new disclosure rule is principles-based, but also noted that he does “expect to see meaningful qualitative and quantitative disclosure, including, as appropriate, disclosure of metrics that companies actually use in managing their affairs” and that “as is the case with non-GAAP financial measures, [he] would also expect companies to maintain metric definitions constant from period to period or to disclose prominently any changes to the metrics used or the definition of those metrics.”6

How should companies prepare to meet this new disclosure requirement? The steps outlined in the section above can serve as an excellent start. Discussions between the board, executive management and the human resources management team regarding the categories of human capital measurements that are already collected and tracked, and, crucially, how those categories relate to the company’s business planning goals and risk management, are necessary to prepare to meet the requirement to disclose the “human capital measures or objectives that the company focuses on in managing

the business.” Companies can then use the robust body of year-over-year human capital data developed for the board’s expanded human capital management oversight rule to provide human capital disclosure, including progress over time, on an ongoing basis. In this way, developing this data now will allow the board to more effectively oversee and measure human capital management and simultaneously allow the company to provide meaningful human capital management disclosure in accordance with the new disclosure rule.

Even before the new disclosure rule, were companies already providing these enhanced human capital management disclosures? Of course, companies have long disclosed certain information relating to employees to the extent it directly impacts financial statements (for instance, valuation and liability matters with respect to pension plans). But outside of this area and the area of executive compensation, available data suggests that notwithstanding the calls for enhanced human capital disclosures, the only workforce-related measurement many companies disclose what had been the minimum required by Item 101 of Regulation S-K prior to its amendment with the new disclosure rule: total number of employees.

Human capital management disclosures mandated by new SEC rules are uncertain. Any mandated disclosures are unlikely to be prescriptive ones that identify specific measures that all companies must report. The SEC is more likely to provide principles-based disclosure rules that require companies to determine what is important to each company from a human capital perspective.

Although the new disclosure rule is not prescriptive and does not identify measures that all companies must report, the pressure to include human capital disclosures (including measures) is growing and unlikely to slow down. Institutional investors, proxy advisory firms and investor advocates are all expecting more in this area. It is important to prepare the board for this now.

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CONCLUSION

For every company, there is likely at least one aspect, if not more than one aspect, of enterprise risk management and long-term strategic planning that is a function of workers outside the executive group. And those identified aspects make up the company’s human capital management that is a board issue. Developing a robust body of year-over-year human capital data will enable the board to more effectively oversee and measure the aspects of human capital management that fall under its oversight and simultaneously allow the company to provide meaningful human capital management disclosure in accordance with the new human capital management disclosure rule.

_________________________________ 1 See Strine, Leo E. Jr. & Kirby M. Smith, “Toward Fair Gainsharing and a Quality Workplace for Employees: How a Reconceived

Compensation Committee Might Helpake Corporations More Responsible Employers and Restore Faith in American Capitalism,” forthcoming in The Business Lawyer (Winter 2020-2021).

2 Modernization of Regulation S-K, Items 101, 103, and 105, SEC Release Nos. 33-10825; 34-89670 (August 26, 2020).

4 Letter to William Hinman, Director, SEC Division of Corporation Finance, from the Human Capital Management Coalition (July 6, 2017); Chairman Jay Clayton, Remarks to the SEC Investor Advisory Committee (March 28, 2019); Recommendation of the SEC Investor Advisory Committee, Human Capital Management Disclosure (March 28, 2019); BlackRock, Commentary, Investment Stewardship’s Approach to Engagement on Human Capital Management, https://www.blackrock.com/corporate/about-us/investment-stewardship#engagement-priorities.

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Director Advisory Workforce Matters By Annalisa Barrett Source: EBSCO This article is for educational use only. Please do not use, distribute or share outside this course.

In today’s boardrooms, directors are expected to have a good understanding of the circumstances facing the workers who contribute to the company’s long-term success. Whether it is corporate culture, workforce satisfaction, or developing high-potential employees, directors must look beyond the C-suite when evaluating opportunities and risks associated with the firm’s human capital. However, many boards are still determining the best way to execute oversight of the company’s most important resource. In addition, investors are seeking confirmaion that boards are exercising robust oversight of human capital, just as they do over financial capital.

Given the importance of the company’s workforce to its financial success, many boards have assigned responsibility for monitoring human capital matters to the compensation committee, and some have renamed their committees to reference their expanded roles (e.g., human resources and

compensation committee, compensation and human capital committee). An August 2019 study by Willis Towers Watson found that nearly 40 percent of S&P 500 companies have renamed the committee responsible for compensation to better reflect its broadened scope to include matters not historically overseen at the board level, such as corporate culture, diversity and inclusion, employee engagement, and succession planning below the C-suite.

In addition to focused committee oversight of human capital management, all directors may spend time talking with the employees on the front lines of the business (e.g., customer service representatives, factory workers, engineers) to gain comfort that workers are engaged and their contributions to the company are maximized. Indeed, the compensation committee can be the catalyst for monitoring metrics such as employee turnover, workplace safety, and retention of high-potential leaders; however, face-to-face discussions with people who represent the company to customers and the public may help directors gain comfort that the company’s investments in human capital are protected and maximized.

Similarly, institutional investors are keenly interested in ensuring that funds allocated to

SHARPENING THE BOARD’S OVERSIGHT OF HUMAN CAPITAL MANAGEMENT

5 SEC Commissioner Allison Herren Lee, Regulation S-K and ESG Disclosures: An Unsustainable Silence (August 26, 2020); SEC Commissioner Caroline Crenshaw, Statement on the “Modernization” of Regulation S-K Items 101, 103, and 105 (August 26, 2020).

6 SEC Chairman Jay Clayton, Modernizing the Framework for Business, Legal Proceedings and Risk Factor Disclosures (August 26, 2020).

7 Many of the Top 100 Companies provide more than one of the additional measurements.

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human capital by their portfolio companies are used wisely. According to its website, the Human Capital Management Coalition (HCMC), a group of 28 institutional investors representing over $4 trillion in assets led by the UAW Retiree Medical Benefits Trust, engages with “companies and other market participants with the aim of understanding and improving how human capital management contributes to the creation of long-term shareholder value.” In addition to engagement with companies, investors are seeking consistent disclosure of meaningful human capital metrics. In July 2017, the HCMC petitioned the US Securities and Exchange Commission (SEC) to require companies to provide workforce disclosures within nine categories: workforce demographics, stability, composition, skills and capabilities, culture and empowerment, health and safety, productivity, compensation and incentives, and human rights commitments and their implementation.

Additionally, in March 2019, the SEC’s Investor Advisory Committee recommended that as the agency endeavors to modernize required disclosures, it should consider the important role human capital management plays in today’s companies, which, according to the committee, are “increasingly dependent on their workforces as a source of value creation.” In response to these and other requests, the SEC included requirements for disclosure on human capital management practices in an August 2019 rule proposal. Under the proposal, companies would have to disclose material “human capital resources, including any human capital measures or objectives that management focuses on in managing the business” using a principles-based approach.

No matter the outcome of the SEC’s proposed changes, it is clear that investors are increasing their efforts to understand how companies are managing their human capital and that boards are expanding their oversight of workforce contributions to long-term value creation.

Annalisa Barrett is a senior advisor to KPMG’s Board Leadership Center.

March/April 2020 NACDonline.org

Copyright of NACD Directorship is the property of National Association of Corporate Directors and its content may not be copied or emailed to multiple sites or posted to a listserv without the copyright holder's express written permission. However, users may print, download, or email articles for individual use.

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tSURRAN: SEC issued its long-awaited amendments to Regulation S-K, the

regulation that contains the detailed disclosure requirements (other than financial statements) applicable to registration statements, periodic reports, proxy statements, and other filings under the United States federal securities law.

It also includes a new disclosure requirement that public companies need to disclose information about "human capital resources". Such disclosures should include the number of employees and any human capital measures or objectives that the company focuses on in managing the business.

Boards have really been starting to focus on this issue over the last few years, in large part driven by investor interest. They are charged with looking at the long-term sustainability and strategic direction of companies, but direct oversight of human capital management was never one of their tasks. They have to take several steps in implementing this change and at the same time help the company meet all the SEC disclosure requirements.

WILLIAMS: Boards often focus on key areas of a business and how to drive it forward, but have not been tasked with direct oversight of human capital management, as it has been historically viewed as management's responsibility.

Gillian Emmett Moldowan, partner in the Compensation, Governance and ERISA group at Shearman & Sterling LLP, joins us this month and starts our discussion with a brief description of human capital management and how it fits into the broader framework of ESG.

MOLDOWAN: The place that might be sensible to start is with that term ESG and what we mean. ESG is environmental, social and governance issues. Environmental and social issues have really reached an inflection point in the context of corporate governance.

Traditional governance issues, the G, have been there for a while in connection with investor advocacy and with the everyday governance of a company by the board.

The E and the S have been becoming more prominent in the last few years and certainly at this point with the circumstances that have happened due to the pandemic, they have really come to the forefront and taken center stage.

The E is environmental, of course, having to do with sustainability and the earth and our global climate. The S is social and it's a broad area and can impact both employees and communities, really any issue that is of social importance to the stakeholders of the company.

The human capital element is really a focus on the employees and the service providers to a company and how companies manage the people that work for them.

One thing that's been said in the last few years is this idea of employees or human capital as an asset of the company and of course, people are not a traditional asset in the way that buildings or factories or other capital are, but for many businesses, especially as the types of

Video Transcript3. Human Capital, Management Oversight & Disclosure

– Is Your Board Ready?

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t businesses that are most critical to our economy are changing, the people who create the technology that we use, the people who provide the services that we use, that human capital within a company is an essential piece of maintaining the sustainability and long-term performance of the company and its growth.

WILLIAMS: Recently the SEC has adopted certain rules that require public companies to disclose and describe human capital resources, including a number of employees and any human capital measures or objectives that the company is focusing on in the way they manage their business. Why now?

MOLDOWAN: This is something that has been coming to the forefront over the last few years. The SEC had indicated, and the SEC chairman Jay Clayton has specifically said that human capital is for some companies a mission critical asset.

What the SEC rules that have been adjusted and amended do is to tell companies how to share the most material information and risk factors related to their company with the investors. What we've been seeing is that as the essential businesses of our economy shift and change, people are all the more important, but the rules regarding disclosure have perhaps not kept up with that.

The rules may require very detailed information about the finances of the company, the capital assets of the company, like it's real estate or large-scale capital materials, but haven't historically really gotten to what's happening with people, beyond very specific rules about the compensation of the executive officers of a company, which is a relatively small group, often making up just five to maybe 12 people at the company. The shift really shows the interest of the SEC as impacted by interest of investors and learning more about how companies manage and retain and consider the people who work for their businesses and what that means as an asset for the business.

WILLIAMS: A lot of boards are now focusing more on human capital, from the executive compensation side to the workforce at large. Is it because of the SEC requirement or are there underlying reasons for doing so? Gillian gives us her thoughts.

MOLDOWAN: Boards have really been starting to focus on this issue over the last few years in large part driven by investor interest. The boards are charged with looking at the long-term sustainability and strategic direction of companies. Historically that aspect with respect to people, has been focused at the key executive management team and then the idea being that the key executive management team would be responsible for all the other people who are working at the company.

And boards, in terms of the information that they assess regularly at board meetings, and that they oversee has not reached as far down into the employee population as we're seeing now. With trends that were occurring in terms of importance of companies' management and reputation and this certainly is impacted by things like the Me Too movement and activities of employees beyond the executive group that can clearly have impacts on the reputation and the growth of a company.

This has been coming more into the board purview. The SEC rules are going to bring this really to a head at this point, though, because there's going to need to be disclosure with respect to human capital that is considered material to the company, human capital issues that are

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t considered material. And if there's considered sufficient material for these reasons, they would be things that the board as well may be appropriate to oversee or to think about. Boards have been focused on executive hiring and leadership and transition, but less so with the rest of the employee base and how trends within the employee base are impacting the company.

It really is the SEC recognizing the change in how our economy and large-scale companies are working with respect to people side by side, with a change in investor interest, as well as something that we see now called employee activism, where employees themselves are actually becoming interested in and advocating for changes in company direction.

You see this at certain companies where employees have banded together to say, "We don't want to work for a company that sells products that are made in a certain manner or sells products that are sold to certain buyers. Because we don't think that's in the interest of all of the employees and we don't want to be part of supporting an organization that acts in that manner.

WILLIAMS: Many will argue that the employee activism stems from millennials, a generation that looks at the workplace from a different angle. They are concerned about a company's involvement in the better good and hold them accountable if they don't deliver on their mission. They don't just want to know that a company is helping the environment, they want to see how.

MOLDOWAN: Employee engagement has really changed and what does employee engagement mean and how do employees interact and think about their employers and the relationship. Which I think you're right is whether it be people who are in fact of a younger generation or just becoming more attuned to the current dynamics in the workplace, it's certainly that employees are spending less of their career with one company, and they think about what the company is saying, and they connect themselves to what the company is saying and doing, and really think about those aspects as part of whether they want to be involved with the company.

So I think as organizations look at employee engagement, particularly as employee engagement changes, as the workplace is evolving under the current pandemic circumstances, you're going to see that back and forth, that engagement and thinking about how to sustain and continue to have employees stay with the company and feel like they want to give their time and energy to what the company is creating.

WILLIAMS: Looking at relative and actual statistics means looking at peer companies and boards and seeing if you are falling behind, if you are ahead in certain areas, or if there is a variety within the different areas and how you can achieve more consistently best of practice circumstances. So what are some other considerations to be relative?

MOLDOWAN: You want to think about whether the categories of human capital data collected measure the entire workforce or dedicated or discrete sectors of the workforce. For each company, that's going to be something they want to think about as well, which aspects of our workforce are most important to the company?

For some companies, they use very little contract outside labor. They have full time employee staff for the most part, they use some contractors, but measuring contractors perhaps would be determined to not be important for the company. It's just not a big enough part of what they do.

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t For other companies, you wouldn't want to exclusively measure employees and not measure contractors because the contractors could be a very large portion of your service provider population.

You'd also probably think about depending on the company, are you measuring only full-time? Or full-time and part-time? Or seasonal employees? So, who are you measuring and what are you measuring? Because you want to look at both of those aspects. You may find that you want different metrics for different employee or contractor sectors within the company as well.

Then you want to think about how these categories and measurement relate to the company's overall business plan and risk management goals.

At the end of the day, I think that the human capital management team will find that that last question is what the board's going to ask back. For their own oversight, from the board's perspective, how is the information that you're presenting to me part of our long-term business plan, part of risk management for the entire company? And let's look at measuring those points that really are part of the material business plan and risk management and enterprise risk management, so that's what we can oversee and that's what the board can look at year to year to see if progress is being made.

SURRAN: But what exactly is relevant information and how reliable can it be? Changing jobs or even careers is never easy, even if you do it voluntarily. None of us leaves a job when they are happy, it's their dream job, they love their company and their coworkers. There is always a reason that makes us want to make a move and that's usually a negative reason and, in most cases, there is more than one.

Yet, we don't want to burn bridges, and that being said, during an exit interview, it's not likely we will ever disclose the true reasons we are leaving.

To what extent is that data reliable for a company to evaluate and say, "Okay, let's look at the history. Why are people leaving us?" They really don't know the true reasons as they may never be communicated to them. So how would a company use that data as a reliable source to take steps to make the company better and a desirable place to work?

MOLDOWAN: That's a great question about reliability and that's a tough area. I mean, we are talking about people. Some of the data that may get collected is from employees or contractors or other individuals who interact with the company, for example, another thing we see in this space are either supplier or customer reviews regarding how they're interacting with people at the company as well.

There is a subjectivity to this information. Companies are going to have to evaluate it, understanding, and I'm sure that they do, that the information may not always be reliable.

But I think it's about scale and looking over the long-term and looking for trends and seeing if you can identify trends that are meaningful to the company. There's going to be other data points that are more objective like a turnover rate, or how much of your employee workforce is participating in a particular type of benefit plan to assess whether employees think of that plan as valuable. You're going to have safety incident reports regarding employee safety, again, more objective measures.

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t So, it is going to be a mix in this space of what are more subjective measuring criteria that may need to be considered within the scope of reliability and you're going to have some more objective numbers as well that you can look at. When you look at it holistically it's thinking about trends and also again, identifying what's important to your company as it grows and changes. But reliability of course matters and the difficulty of measuring some of these aspects matters.

That's a very significant question when you look at a different intersection, which is human capital management goals, intersecting with compensation plans. That's another area that's of particular interest right now and we're certainly seeing a lot of companies build ESG, including human capital factors, into incentive compensation plans and investors have a variety of perspectives on that.

WILLIAMS: Gillian Emmett Moldowan discusses the source of the data companies use and if it is the entire workforce that participates in the pool or only certain sectors.

MOLDOWAN: When you're looking at human capital management and thinking about data and what to measure and what populations to measure, historically certainly at the board level and for public company disclosure, the measurements and what people have been looking at in terms of retention performance have been at the executive group.

What this trend within human capital is indicating is that we need to go broader, that there are people who are beyond the executive team at the company who really drive what is happening at the company and can be impactful on the long-term sustainability and growth of the company.

Now, what group is that? That's going to depend certainly on the company, the industry and who works there. If you have a company that is based upon the invention of technology, then you'd want to be measuring the people who are contributing to that, your programmers and engineers.

And you'd want to think about them maybe in terms of their job title or their job purview, as opposed to whether they're employees or independent contractors in that space, in terms of measuring the engagement or the productivity of your engineers. In other circumstances, you may be measuring only people who are employees, because the contractors are a less essential part of your business and they do a different job.

SURRAN: The Sustainability Accounting Standards Board, SASB, connects businesses and their investors in addressing the financial impacts of sustainability.

Their mission is to "help businesses around the world identify, manage and report on the sustainability topics that matter most to investors."

SASB is an independent standards board that is accountable for due process, outcomes and ratification of the SASB standards. It enables businesses around the world to identify, manage and communicate financially material sustainability information to their investors.

SASB has developed a complete set of 77 industry standards that are available to download on their website. SASB also provides guidance and has identified issues considered financially material, but in the end, it is a company's decision to decide what is financially material and should be disclosed.

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t The SASB's conceptual framework establishes five primary sustainability dimensions: Environment, Social Capital, Human Capital, Business Model & Innovation, and Leadership & Governance and has identified key themes associated with each dimension. According to the SASB, the Human Capital sustainability dimension "addresses the management of a company's human resources (employees and individual contractors) as key assets to delivering long-term value."

WILLIAMS: Gillian Emmett Moldowan gives us an overview of the Sustainability Accounting Standards Board's human capital measurements.

MOLDOWAN: One thing that companies are really trying to figure out is what to measure and we've been talking about that. There are different things you can measure and we also touched on, peers, that a lot of these issues you want to consider both absolute measurements at your company, but also relative measurements.

One of the pieces that is a challenge within ESG generally and human capital management specifically, is that peer comparison. How are we going to look at companies across an industry and compare if they're all using different measures to measure these ESG factors, including human capital?

So what SASB does and other organizations like it, but SASB is certainly a prominent company or player in this space right now, is they try to identify measures within ESG and human capital specifically that could be used by companies where there'd be comparability.

If for example, all companies in the auto industry adopted SASB human capital measures and measured them in line with the SASB protocols, then you may be able to see better comparisons across the auto industry for these factors.

Now, these aren't mandated protocols so companies are selecting if they want to use SASB for their human capital management. But when companies are looking to see what should we be thinking about measuring? It can be really helpful to look at SASB and either determine, "Yes, we're going to adopt looking at these factors in totality, or at least using the SASB measurements as a baseline of what's out there in terms of what peers might also be looking to measure, if they are also looking to SASB or looking to adopt the SASB measurements."

WILLIAMS: According to the SASB's Human Capital dimensions, there are topics and metrics that relate to three fundamental general issue categories: labor practices, employee health & safety and employee engagement, diversity and inclusion.

MOLDOWAN: If a company was, for instance, interested in looking to the SASB human capital measures and measurements, what SASB did is they broke down the human capital space into three categories and gave items that could be measured within each of those categories for companies to consider. This is just the way SASB looks at the human capital measurements, and it's not part of their required disclosures by any means, but it is something that companies can look to if they're looking for a way to set out their protocols on measurement.

SASB happened to break it down by labor practices, employee health and safety and employee engagement, diversity and inclusion. That might be a helpful rubric for companies that are starting off on this venture of measuring human capital.

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t In labor practices you have things regarding how many employees are covered by collective bargaining agreements? What's the strike and lockout activity at the company? What are your turnover rates?

In employee health and safety, you have things such as incident rates for safety breaches, the average hours of health and safety and emergency response training that workers are receiving and certain monetary losses related to safety incidents.

For employee engagement, diversity and inclusion you have issues such as the percentage of gender or racially or ethnically diverse employees within the population, the percentage of workers that are located inside the United States or outside the United States and potentially monetary losses as a result of legal proceedings that have to do with employee discrimination or related issues, so that's the way SASB looks at it. There are other ways to set forth your human capital measurements, but that's one way to look at it.

MOLDOWAN: Another way that has been looked at is by the Human Capital Management Coalition, which is a group of large and influential public pension plans that has proposed measures as well, that could be looked at by companies in this space and they've broken it down differently. So just to show you contrast in terms of how you can look at these items.

The HCMC human capital measures have broken things down into categories that include workforce demographics, workforce composition, workforce stability, workforce health and safety, and then workforce productivity, which is a little bit of a different type of measure there as well.

These are all protocols that a company could look to. None of them are required protocols, but companies may find that within their industry, there may be kind of a coalescing around one of these external measuring protocols so that there could be more comparison across the industry.

SURRAN: The Human Capital Management Coalition (HCMC) is a group representing large and influential public pension funds and has proposed its own human capital measures.

l Workforce demographics - number of full-time and part-time workers, number of contingent workers

l Workforce composition - diversity, pay equity ratios

l Workforce stability - turnover (voluntary and involuntary), internal hire rate

l Workforce health and safety - work-related injuries and fatalities, lost day rate

l Workforce productivity - return on cost of workforce, profit/revenue for full-time employees

The human capital measurements between SASB and HCMC are significantly different. So, if a company wants to start taking steps to address human capital, which is best to follow?

MOLDOWAN: One thing that's interesting is we don't necessarily know yet. Because the new disclosure obligations are not enforced yet. We'll start to see, as disclosure is made in 2021 and forward, if companies, when they do their human capital disclosure, are in fact citing one of these protocols. You

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t can look to CSR reports, which have been out there, which address a larger array of ESG measures and see what companies are looking to.

SASB has been a protocol provider that companies have come to in other spaces, including human capital management so I think we'd expect to see some reference there. But HCMC is also something that we could see reference to, especially companies that have large pension investors may look to those measurements as an indicator of what their investors are interested in.

I'm sure it'll take some time for there to be kind of consistency across industries and it may take many years. I think right now at this stage for companies that are coming at this anew and haven't been measuring human capital in a board ready way or with an eye towards disclosure at all, these two protocols give companies a place to start. How are we going to build the rubric, the measurement rubric for our company?

You can look at these two measurements as well as other disclosure of peer companies to the extent that there is anything useful there to start to see what would be a set of measurements for your company.

You'd also want to talk to management and see what they're measuring and what they think is important in terms of what they've already been measuring and what they've seen to be useful data versus less useful data in their prior measurements in these spaces.

WILLIAMS: There is a newly required human capital management disclosure. Select examples include the HCMC petition to the SEC for rulemaking requiring human capital disclosure. Gillian explains the extent and nature of the disclosures.

MOLDOWAN: I think it is early to know how extensive these disclosures will be. But I guess taking a step back, what we have is a new disclosure rule. It's part of the obligations that a company has in their annual report on Form 10-K, for most public companies in their annual report, to identify issues that are material in the space of human capital.

It's a principles-based disclosure; it's not a prescriptive disclosure. The disclosure guidance, which there really isn't much guidance yet the release of the new rule, but they're leaving it to companies to determine what human capital resources are material to the company and its particular circumstances. And in rules like this, we generally do have principles based disclosure as opposed to a prescriptive. So, I think for different companies, it will come to be different lengths.

Historically, the disclosure that companies have had to provide is really just around the number of employees they have and companies have tended to provide something that is in the nature of three to five sentences about how many employees they have and perhaps where they're located and, in some instances, how many are part of unions or other similar kind of employee numeric counting disclosures and it's been about a paragraph. So here, it'll be interesting to see how much this evolves.

I'd anticipate early on, we may see shorter disclosures in this area until companies see what's happening in their industries to see if they would want to come out with longer disclosures for the required parts.

Now, I mentioned that there are other disclosures that companies make that aren't necessarily part of this requirement and companies make disclosures in a general sense to their shareholders and consumers through their website. If you look at company websites, you may see sections on

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t how they think about human capital or people. Companies have a proxy statement, which is a different part of the disclosure regime and really gets into very specific information about the operation of the board and the compensation of executives of the company. You have been seeing for some companies' statements they're regarding how they think about their employee population and those statements have tended to be a relatively short overall paragraph or so.

You can see there may be growth in that area or more companies providing that disclosure and then companies do have outside reports that they publish on ESG factors and you see human capital disclosure in those reports at some point and they really are divergent among companies because companies are identifying what they think is most material to them. Again, going back to the fact, this is not a prescriptive reporting obligation. It's different than a financial reporting obligation for example, it really just says, tell us the investors, the SEC what's material to your company about human capital and the people who work for you.

WILLIAMS: So how should companies prepare to meet the new requirements?

MOLDOWAN: If companies are preparing to meet the new requirements, starting with what factors they are measuring and thinking about that, and thinking about why those factors are material to the company. Why are those going to be responsive to our requirement that you are supposed to disclose information that's material, to the understanding of the company's business taken as a whole?

Companies need to start at the point of identifying what information they think is material to the company, if any, and some companies it's certainly possible, will say that beyond the number of employees that we have and where they're located, we don't have other things that we think we need to share that are material to the operations of our business. That's certainly possible. It will be interesting to see how many companies in fact go that route and just stick to something that looks very close to what we've historically had in terms of disclosure in this space.

Also, because it's a part of your disclosure package it's something that your disclosure committee should be reviewing and considering as they consider all the disclosure that's made by the company for the annual report and you want to make sure that internally your teams are working together.

I find that a lot of companies, the teams that are responsible for the annual report, the 10-K, is a different team than perhaps has been responsible for the proxy statement where the employee executive package compensation is disclosed. You do want to make sure you have integration at the company between those teams so you aren't saying different things about how employees and executives for instance are managed in the 10-K versus what you're saying in the proxy statement. For some companies, there'll be some coordination that needs to be added to their planning to make sure there's consistency on how they talk about human capital issues across all of their filings.

WILLIAMS: Gillian Emmett Moldowan concludes our segment and leaves us with her final thoughts.

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t MOLDOWAN: Well, thank you so much for having me to talk about this issue. It's really going to be an area of growth and evolution in the coming years. The people that make up the companies that are part of our economy are essential.

We've seen that more than ever in terms of what's happened in connection with the pandemic, in the impact that whether employees are struggling to commute to the office, whether there's safety inside the workspace and how you engage with employees who may be remote or coming in in different waves into your offices and not all there together.

Companies are going to have to think about how they manage human capital for the long-term sustainability of the company and investors are going to be very interested in seeing what companies share with them in this regard, so investors can make decisions about their comfort level with the company and its long-term growth trajectory.

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Segment Four

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4. ARPA, Tax Program Extensions, Deductibility

Under CAA, and More

Segment Overview:

Field of Study:

Recommended Accreditation:

Reading (Optional for Group Study):

Running Time:

Video Transcript:

Course Level:Course Prerequisites: Advance Preparation:

Expiration Date:

Taxes

June 12, 2022

Work experience in tax planning or tax compliance, or an introductory course in taxation.

None

1 hour group live 2 hours self-study online

Update

“Guidance on the Employee Retention Credit under Section 2301 of the Coronavirus Aid, Relief, and Economic Security Act”

See page 4–12.

See page 4–18.

32 minutes

In the beginning of 2021, Congress was busy working on the American Rescue Plan Act (ARPA), a $1.9 trillion bill known as Stimulus 3.0. The bill was signed into law on March 11, 2021. It is the third Economic Impact Payment to eligible individuals as well as small businesses. At the same time the IRS was working, and still is, on several tax provision extensions and keeps issuing new guidance. Barbara Weltman, president of Big Ideas for Small Business, begins our discussion with ARPA and then continues with an update on various program extensions and their tax impact. Barbara also talks about income and losses from business activities, discharge of indebtedness, FSAs for 2021 and expense deductibility under CAA, and more.

Learning Objectives:

Upon successful completion of this segment, you should be able to: l Identify when and if essential businesses can be considered

having full or partial suspension due to government order, l Recognize the main areas where income and losses from

business activities raise interesting questions from taxpayers, l Determine the factors distinguishing a hobby vs. a business,

and l Determine when a credit can be taken for research activities

and what falls under qualified research expenses.

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Outline

A. Congress Considerations Prior to Law

i. ARPA - 3rd round of economic impact payments

ii. Unemployment benefits extension and other measures

iii. Tax provisions to expand l Child tax credit l Earned income credit l Premium tax credit l Payroll tax credits l Employee retention credit l Paid sick leave

B. Tax Implications

i. No impact in 2020

ii. Effective in 2021

C. ERC for 2020

i. 50% of qualified wages up to $10,000 per employee

ii. Maximum is $5,000 per employee

iii. Qualified wages include l Qualified health plan expenses

iv. Employers that experienced l Full or partial suspension of

operations l Significant decline in revenue

D. Key Questions Answered in Latest Guidance

i. Determining eligibility

ii. Establishing significant decline in revenue

iii. Defining full or partial suspension of operations

I. New Relief & Guidance

A. Full or Partial Suspension of Operations

i. Essential Businesses l Government order to remain open

v Not eligible for full or partial suspension

l Government order to suspend more than nominal portion v Partial suspension

qualification

B. Defining Nominal - Gross Receipts

i. From business operations l Not less than 10% of total gross

receipts l Compared to gross receipts of the

same calendar quarter in 2019

C. Defining Nominal - Hours of Service

i. Performed in that portion of business l Not less than 10% of total

number of hours performed by all employees

l Compared to number of hours of services performed by employees v Same quarter in 2019

D. Change on Bar Elimination to Credit

i. Retroactive for businesses that received a PPP loan

“The guidance makes it clear that …some employers are now eligible for the credit for the applicable part in 2020 even though they initially thought that they couldn't claim it.”

– Barbara Weltman

E. Can’t Claim the Credit

i. Self-employed individuals l On earnings from self-

employment

ii. Household employers l Not in a trade or business

II. Essential vs. Nonessential Business & Full vs. Partial Suspension

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eA. Management Fees

i. Deductions for compensation

ii. Cannot exceed what’s reasonable for services performed

iii. Need proof of services

B. Losses Are Disallowed When

i. There is no production of something l No business in existence

C. Factors Distinguishing Hobby vs. Business

i. Keeping limited books and records

ii. Absence of business plan

iii. No change in methods of operation to improve outcome

iv. Not conducting the activity in a business-like manner

v. Not putting in time to run the business

D. Loans vs. Capital Contributions

i. Intent to treat money as loans

ii. Treated as note payable on tax return

iii. No initial capital account balance on K-1s

iv. No evidence of 3rd party loans

III. Income and Tax Losses from Business Activities

A. FSA Mid-Year Election

i. Prospective only l Changes applicable for balance

after election is made

B. Because of CAA FSAs Can

i. Provide flexibility l Carry overs of unused amounts

ii. Extend permissible periods for claims

iii. Allow for special post-termination reimbursement

iv. Provide a carry over for dependent care

C. IRS Notice Clarifies

i. Employers with FSA in 2020 can amend the plan to l Allow employees to be

reimbursed for medical expenses incurred through December 31, 2021

ii. Carry over and extended grace period provide same relief

iii. Both options allow for unused remaining benefits in 2020 and 2021 to be made available for 2021 and 2022

D. COBRA Qualifying Event

i. Employer allows l A terminated employee or l An employee with reduced hours

ii. Reimbursement of expenses incurred after termination or reduction in hours l Through access to salary

reduction contributions l As of the date employee ceased

participation

E. When to Amend

i. Calendar year plan for 2020 l By December 31, 2021

ii. Non-calendar year plan for 2020 l By December 31, 2022

IV. Consolidated Appropriations Act and FSAs

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A. Annual Deduction

i. Individual educators - $250

B. Broadened Eligible Expenses

i. Costs incurred after March 12, 2020 l Personal protective equipment l Disinfectant l Other supplies to prevent the

spread of COVID-19

C. Annual Deduction

i. Individual educators - $250

ii. Married couple where both are teachers - $500

iii. Dollar limit covers related COVID-19 items in addition to regular classroom items

D. Emotional Distress

i. Can manifest itself in physical conditions

ii. Must result from the physical conditions l Damages are then excludable

E. Damages Can Be Tax Free

i. Direct causal link between them and the personal injuries sustained

F. Cash Charitable Contributions

i. Standard deductions l Up to $300

v Per tax unit for 2020 v Per taxpayer for 2021

ii. Itemized deductions l 100% of cash donations l Not applicable to carryovers

v 2019 carryovers limited to 60%

v 100% for both 2020 and 2021

G. The 85% Rate Applies If:

i. MAGI plus ½ of social security benefits exceeds the base amount

ii. Special rule for married filing separately l Automatically subject to 85%

rate v Living together for the entire

year v Regardless of the amount of

their benefits and income

V. Changes to Deductions & Exclusions

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A. IRS & Credit Card Rewards

i. Reductions in purchase price of goods & services

B. Barbara Weltman Clarifies

i. Using AMEX to buy Visa gift cards & generating rewards is okay

ii. Reloading those gift cards & buying money orders l Cash transactions l NOT purchase of goods &

services

C. Claiming Research Tax Credit

i. Can’t be claimed for research funded l By a grant contract l By another person

D. Qualified Research Expenses

i. At least 80% of research must constitute

ii. Process of experimentation

iii. Not physical components of a product being l Developed l Improved

iv. Providing supervision or support services did NOT constitute l Elements of a process of

experimentation

E. Special Tax Rule for Small Business

i. Research credit can be used to offset payroll tax liability l Up to $250,000

ii. Helpful to startups

iii. Payroll tax credit is claimed on Form 8974 l Attached to Form 941

VI. Guidance on Gift Cards & Research Credit

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l As the Discussion Leader, you should introduce this video segment with words similar to the following:

“In this segment, Barbara Weltman begins our discussion with ARPA and then continues with an update on various program extensions and their tax impact; she also talks about income and losses from business activities, discharge of indebtedness, FSAs for 2021 and expense deductibility under CAA, and more."

l Show Segment 4. The transcript of this video starts on page 4–20 of this guide.

l After playing the video, use the questions provided or ones you have developed to generate discussion. The answers to our discussion questions are on pages 4–8 and 4–9. Additional objective questions are on pages 4–10 and 4–11.

l After the discussion, complete the evaluation form on page A–1.

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4. ARPA, Tax Program Extensions, Deductibility Under CAA, and More

1. When and how can essential businesses be considered to have a full or partial suspension due to a government order for purposes of the Employee Retention Credit?

2. What are some of the factors used by the tax courts to determine when a business has begun and to distinguish between a hobby and a business?

3. What flexibility was introduced by the CAA Act into FSAs for 2021 relating to unused benefits? How is your organization or clients potentially impacted by the changes to the rules on unused benefits?

4. What are the general rules for the tax treatment of damage awards?

5. What are qualified research expenses and the limits on eligibility for the purpose of the research tax credit? How is your organization or clients going about the determination of whether its research expenses qualify for the research tax credit?

Discussion Questions

You may want to assign these discussion questions to individual participants before viewing the video segment.

Instructions for Segment

Group Live Option

For additional information concerning CPE requirements, see page vi of this guide.

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s6. What did Section 2301 of the CARES

Act and Section 206 of the Relief Act include in its definition of eligible employer for purposes of the Employee Retention Credit? What is the experience of your organization or clients in determining whether they meet the definition for this purpose?

7. What are the factors in determining qualified wages for purposes of the Employee Retention Credit?

Discussion Questions (continued)

4–8Suggested Answers to Discussion Questions4. ARPA, Tax Program Extensions, Deductibility Under CAA,

and More1. When and how can essential businesses

be considered to have a full or partial suspension due to a government order for purposes of the Employee Retention Credit? l Essential business employer is not

considered to have full or partial suspension if the government allows all operations to remain open

l Essential business employer may be considered to have a partial suspension of operations if more than a nominal portion of its operations are suspended

l Nominal is based on a 10% threshold and is measured based on a decline in either gross receipts or hours of service performed by employees in the portion of the business suspended

2. What are some of the factors used by the tax courts to determine when a business has begun and to distinguish between a hobby and a business? l Activities moved beyond an initial

experimentation and investigation into an operating business

l Maintaining books and records l Business plans l Changing methods of operation to

improve the outcome or otherwise conduct the activity in a business-like manner

l Time spent on the business activity

3. What flexibility was introduced by the CAA Act into FSAs for 2021 relating to unused benefits? How is your organization or clients potentially impacted by the changes to the rules on unused benefits? l Changes based on the CAA Act:

v Plans able to offer carry overs of unused amounts from 2020 and 2021

v Provides for extension of permissible periods for including claims for 2020 and 2021

v Allows for special post-termination reimbursements for health FSAs in 2020 and 2021

v Provides carry over for dependent care assistance plans when a dependent ages out during COVID-19

v Employers may, but are not required to, allow for a carry over for mid-year changes and other CAA rule changes.

v Employer sponsored health FSA can amend plan on a calendar year to allow employees to be reimbursed for medical expenses incurred through 2021.

l Participant response based on personal/organizational experience

4. What are the general rules for the tax treatment of damage awards? l Amounts received for personal

physical injury or sickness are excludable from gross income

l Damages for non-physical personal injury and all punitive damages are fully taxable

l Damages for emotional distress are excludable from gross income only if they result from physical injury or illness

l Malpractice awards from attorneys who mishandle a personal injury are damages resulting from legal matters and not physical personal injury and are therefore not tax free

5. What are qualified research expenses and the limits on eligibility for the purpose of the research tax credit? How is your organization or clients going about the determination of whether its research expenses qualify for the research tax credit? l Qualified expenses and eligibility:

v No credit can be claimed for research funded by a grant or another person

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Suggested Answers to Discussion Questions (continued)v At least 80% of research must

constitute elements of a process of experimentation

v 80% rule is not met simply because elements of developing or improving a product are different from those of products previously developed

v Small businesses can claim up to a $250,000 offset against payroll tax liability as opposed to an offset to income tax

l Participant response based on personal/organizational experience

6. What did Section 2301 of the CARES Act and Section 206 of the Relief Act include in its definition of eligible employer for purposes of the Employee Retention Credit? What is the experience of your organization or clients in determining whether they meet the definition for this purpose? l Eligible employer definitions:

v Employers carrying on a trade or business during calendar 2020

v Experienced, during any calendar quarter, either a full or partial suspension of operations due to government order or a significant decline in gross receipts

v Gross receipts decline measured as 50% in a quarter versus same quarter in the prior year

v Does not apply to any agency of federal or state government

v Section 206 of the Relief amended CARES Act to permit recipients of PPP loans to claim an employee retention credit

l Participant response based on personal/organizational experience

7. What are the factors in determining qualified wages for purposes of the Employee Retention Credit? l Wages and compensation are as

defined in sections 3121(a) and 3231(a) of the Code

l CARES Act includes amounts paid to provide and maintain a group health plan

l Qualified wages are different depending on size of the employer measured by average number of full-time employees

l For large employers, qualified wages are wages paid to employees not providing services when there is a full or partial suspension of operations from government order or a significant decline in gross receipts

l For small employers, qualified wages are wages paid to any employee during the period of a full or partial suspension of operations or a significant decline in gross receipts.

l Qualified wages are limited to $10,000 for all calendar quarters of 2020

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1. What was a focus of the latest guidance provided by the IRS on the Employee Retention Credit according to Barbara Weltman?

a) components of qualified wages

b) the period for which credits are applicable to qualified wages

c) defining what is considered a full or partial suspension of operations

d) maximum credit available per employee

2. What IRS form is filed by an employer to obtain an advance on an employee retention credit?

a) Form 7200

b) Form 8974

c) Schedule SE

d) Schedule EIC

3. Which of the following CANNOT claim an employee retention credit?

a) businesses that received a PPP loan

b) tax-exempt organizations engaged in a trade or business

c) essential businesses

d) household employers

4. Which of the following is correct regarding eligible expenses educators can deduct under the CAA?

a) The total maximum deduction is the same whether one or both spouses are educators.

b) The total dollar limit applies to all eligible items, COVID-related or not.

c) The CAA increased the above-the-line deduction limit for eligible classroom expenses.

d) The deduction is only available for the cost of PPE and supplies to prevent the spread of COVID-19 in the classroom.

5. Which of the following is always excludable from gross income?

a) damages for emotional distress

b) amounts received for personal physical injury

c) awards for defamation

d) punitive damages for any reason

6. In the case of Anikeev v. Commissioner, what did the taxpayer purchase with credit card rewards that generated taxable income?

a) frequent flyer miles

b) Visa gift cards

c) reloadable debit cards to buy money orders

d) discount dining

7. At least what portion of research costs must constitute elements of a process of experimentation in order to be considered qualified research expenses?

a) 33%

b) 50%

c) 80%

d) 95%

8. What percentage of gross receipts from one quarter to the same quarter in the previous year represents a significant decline under the CARES Act?

a) 50%

b) 75%

c) 25%

d) 20%

You may want to use these objective questions to test knowledge and/or to generate further discussion; these questions are only for group live purposes. Most of these questions are based on the video segment, a few may be based on the reading for self-study that starts on page 4–13.

4. ARPA, Tax Program Extensions, Deductibility Under CAA, and More

Objective Questions

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9. Section 206 of the Relief Act amended the CARES Act to permit which of the following to claim employee retention credits?

a) tax-exempt organizations

b) recipients of PPP loans

c) large employers

d) government agencies

10. The CARES Act provides a different definition of qualified wages for an employer depending on:

a) its annual revenues over the last two years.

b) whether or not it is exempt from tax under Section 501(a).

c) its industry classification.

d) its average number of full-time employees.

Objective Questions (continued)

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Self-Study Option

Reading (Optional for Group Study)

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GUIDANCE ON THE EMPLOYEE RETENTION CREDIT UNDER SECTION 2301 OF THE CORONAVIRUS AID, RELIEF, AND ECONOMIC SECURITY ACT

Source: https://www.irs.gov/pub/irs-drop/n-21-20.pdf

Notice 2021-20

I. PURPOSE

This notice provides guidance on the employee retention credit provided under section 2301 of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), Pub. L. No. 116-136, 134 Stat. 281 (March 27, 2020), as amended by section 206 of the Taxpayer Certainty and Disaster Tax Relief Act of 2020 (Relief Act), which was enacted as Division EE of the Consolidated Appropriations Act, 2021, Pub. L. No. 116-260, 134 Stat. 1182 (December 27, 2020). The guidance provided in this notice addresses the employee retention credit as it applies to qualified wages paid after March 12, 2020, and before January 1, 2021. This notice does not address the changes made

by section 207 of the Relief Act that apply to the employee retention credit for qualified wages paid after December 31, 2020. The Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) will address the modifications made by section 207 of the Relief Act applicable to calendar quarters in 2021 in future guidance.

II. BACKGROUND Section 2301 of the CARES Act allows a credit (employee retention credit or credit) against applicable employment taxes for eligible employers, including tax-exempt organizations, that pay qualified wages, including certain health plan expenses, to some or all employees after March 12, 2020, and before January 1, 2021. Section 206 of the Relief Act adopts amendments and technical changes to section 2301 of the CARES Act for qualified wages paid after March 12, 2020, and before January 1,

l In order to ensure adherence to NASBA guidelines regarding self-study, the CPA Report and CPA Report Government/Not-for-Profit Self-Study Professional Education Centers are no longer available. Customers should contact their company administrators for information on taking course exams and receiving CPE credit for the courses.

l Customers may contact Kaplan Financial Education at cpesupport@kaplan.com to obtain certificates previously earned through the CPA Report Self-Study and CPA Report Government/Not-for-Profit Self-Study Professional Education Centers.

l Customers interested in the self-study format of the CPA Report can find information on Kaplan Financial Education's self-study libraries at Online Accounting CPE Courses.

CPA Report Gov/Not-for-Profit Update

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2021, primarily relating to who may claim the credit.1 Section 207 of the Relief Act amends section 2301 of the CARES Act to extend the application of the employee retention credit to qualified wages paid after December 31, 2020, and before July 1, 2021, and to modify the calculation of the credit amount for qualified wages paid during that time.2

Following the enactment of the CARES Act, the IRS posted Frequently Asked Questions (FAQs) on IRS.gov to aid taxpayers in calculating and claiming the employee retention credit. As of the publication date of this notice, the FAQs have not been updated to reflect the changes made by the Relief Act. This notice incorporates the information provided in the FAQs and addresses additional issues, including the amendments to section 2301 of the CARES Act made by section 206 of the Relief Act. This notice also identifies instances in which section 206 of the Relief Act made changes to section 2301 of the CARES Act that resulted in rules that are substantially similar to the interpretation provided in the FAQs.

The remainder of this Section II provides a summary of the relevant provisions of section 2301 of the CARES Act, as amended by section 206 of the Relief Act, as they apply to qualified wages paid in 2020. References to section 2301 of the CARES Act include the amendments made by section 206 of the Relief Act, unless otherwise noted. This Section II also includes an overview of the options for employers to defer the deposit and payment of the employer’s share of social security tax under section 2302 of the CARES Act and to defer the withholding and payment of the employee’s share of social security tax under Notice 2020-65, as modified by Notice 2021-11, which may affect the amount that an employer can request as an advance payment of the credit.

Section III of this notice provides guidance in Q/A format regarding the application of section 2301 of the CARES Act. Any term defined in this Section II or within a Q/A in Section III applies to all Q/A’s in Section III.

A. Claiming the Employee Retention Credit and Accessing Funds in Anticipation of the Credit

An employer that is an eligible employer as defined in section 2301(c)(2) of the CARES Act and that, after March 12, 2020, and before January 1, 2021, pays qualified wages, as defined in section 2301(c)(3) of the CARES Act, is entitled to claim the employee retention credit against the taxes imposed on employers by section 3111(a) of the Internal Revenue Code (Code) (employer’s share of the Old Age, Survivors, and Disability Insurance (social security tax)), after these taxes are reduced by any credits claimed under section 3111(e) and (f) of the Code,3 sections 7001 and 7003 of the Families First Coronavirus Response Act (FFCRA), Pub. L. No. 116-127, 134 Stat. 178 (March 18, 2020),4 and section 303(d) of the Relief Act.5 Eligible employers subject to the Railroad Retirement Tax Act (RRTA) are entitled to take the employee retention credit against the taxes imposed on employers by section 3221(a) of the Code (Tier 1 tax under the RRTA) that are attributable to the rate in effect under section 3111(a) of the Code, after these taxes are reduced by any credits allowed under sections 7001 and 7003 of the FFCRA and section 303(d) of the Relief Act.

Section 2301(b)(3) of the CARES Act provides that if the amount of the credit exceeds the applicable employment taxes (reduced by any credits claimed under section 3111(e) and (f) of the Code, sections 7001 and 7003 of the FFCRA, or section 303(d) of the Relief Act) for any calendar quarter, then the excess is treated as an overpayment and refunded to the employer under sections 6402(a) or section 6413(b) of the Code.

Eligible employers report their total qualified wages for purposes of the employee retention credit and claim the employee retention credit (including any refund in excess of the employer portion of social security tax) on their federal employment tax returns; for most employers, this is the quarterly Form 941, Employer’s Quarterly Federal Tax Return.6

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Section 2301(k) of the CARES Act instructs the Secretary of the Treasury (or the Secretary’s delegate) to waive the penalty under section 6656 of the Code for failure to deposit the employer share of social security tax in anticipation of the allowance of the refundable credit under the CARES Act. In addition, section 2301(l)(1) and (2) of the CARES Act provides for the advance payment of the credit (subject to the limitations of the credit and based on information the Secretary requires) and the reconciliation of the advance payment at the time of filing the employment tax return.

Notice 2020-22, 2020-17 I.R.B. 664, provides eligible employers relief from the failure to deposit penalty imposed by section 6656 of the Code for an employer’s failure to timely deposit employment taxes to the extent the amounts not deposited are equal to or less than the amount of refundable tax credits to which the eligible employer is entitled under the FFCRA and the CARES Act.7 Under the notice, an eligible employer will not be subject to a penalty under section 6656 for failing to deposit employment taxes in a calendar quarter if (1) the eligible employer paid qualified wages to its employees in the calendar quarter prior to the time of the required deposit, (2) the amount of employment taxes that the employer does not timely deposit, reduced by the amount of employment taxes not deposited in anticipation of the credits claimed under sections 7001 and 7003 of the FFCRA, is less than or equal to the amount of the employer’s anticipated employee retention credit for the calendar quarter as of the time of the required deposit, and (3) the employer did not seek payment of an advance credit by filing Form 7200, Advance Payment of Employer Credits Due to COVID-19, with respect to the anticipated credits it relied upon to reduce its deposits. Accordingly, in anticipation of receiving the employee retention credit, eligible employers can (1) reduce their deposits of federal employment taxes, including withheld taxes, that would otherwise be required, up to the amount of the anticipated credit, and (2) request an advance of the amount of the anticipated credit that exceeds the reduced federal employment tax deposits by filing Form 7200. Reductions in deposits and advance

payments are accounted for on the eligible employer’s employment tax return.

B. Definition of “Eligible Employer”

The employee retention credit is available only to employers that are eligible employers. Section 2301(c)(2)(A) of the CARES Act defines the term “eligible employer” as any employer carrying on a trade or business during calendar year 2020, and, with respect to any calendar quarter, for which (1) the operation of the trade or business carried on during calendar year 2020 is fully or partially suspended due to orders from an appropriate governmental authority limiting commerce, travel, or group meetings (for commercial, social, religious, or other purposes) due to COVID-19, or (2) such calendar quarter is within the period in which the employer had a significant decline in gross receipts, as described in section 2301(c)(2)(B) of the CARES Act.

Section 2301(c)(2)(B)(i) of the CARES Act provides that the period during which an employer experiences a significant decline in gross receipts begins with the first calendar quarter beginning after December 31, 2019, for which gross receipts (within the meaning of section 448(c) of the Code) for the calendar quarter are less than 50 percent of gross receipts for the same calendar quarter in the prior year. Section 2301(c)(2)(B)(ii) of the CARES Act provides that the period during which an employer experiences a significant decline in gross receipts ends with the calendar quarter that follows the first calendar quarter beginning after a calendar quarter described in section 2301(c)(2)(B)(i) of the CARES Act for which gross receipts of the employer are greater than 80 percent of gross receipts for the same calendar quarter in the prior year.

Section 2301(c)(2)(C)(i) of the CARES Act provides that in the case of an organization described in section 501(c) of the Code and exempt from tax under section 501(a) of the Code (a tax-exempt organization), sections 2301(c)(2)(A)(i) (relating to the requirement of carrying on a trade or business) and 2301(c)(2)(A)(ii)(I) (relating to a full or partial suspension of the operation of a trade

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or business due to a governmental order) apply to all operations of the organization. Section 2301(c)(2)(C)(ii) of the CARES Act provides that, in the case of a tax-exempt organization, any reference to gross receipts in section 2301 of the CARES Act is treated as a reference to gross receipts within the meaning of section 6033 of the Code. Therefore, tax-exempt organizations should refer to the definition of gross receipts under section 6033 of the Code to determine whether they experienced a significant decline in gross receipts under section 2301 of the CARES Act.8

Section 2301(f) of the CARES Act provides that the employee retention credit does not apply to the Government of the United States, the government of any State or political subdivision thereof, or any agency or instrumentality of those governments. Accordingly, these entities are not eligible employers.

Prior to the Relief Act amendments, section 2301(j) of the CARES Act provided that an eligible employer that received a covered loan under paragraph (36) of section 7(a) of the Small Business Act (15 U.S.C. 636(a)), as added by section 1102 of the CARES Act (a Paycheck Protection Program loan or PPP loan) would not be eligible for the employee retention credit. Section 206 of the Relief Act amended section 2301 of the CARES Act to permit an employer that received a PPP loan to be eligible to claim an employee retention credit under section 2301 of the CARES Act by striking section 2301(j) of the CARES Act, effective retroactive to the original effective date of the CARES Act.

C. Definition of “Qualified Wages”

Section 2301(a) of the CARES Act provides that the credit amount is equal to 50 percent of qualified wages with respect to each employee for each applicable calendar quarter in 2020.

For purposes of determining “qualified wages,” section 2301(c)(5)(A) of the CARES Act provides that the term “wages” generally means wages as defined in section 3121(a) of the Code and compensation as defined in section 3231(e) of the Code. Section 2301(c)(5)(B) of the CARES Act

provides that “wages” include amounts paid by an eligible employer to provide and maintain a group health plan (as defined in section 5000(b)(1) of the Code), but only to the extent that the amounts are excluded from the gross income of employees by reason of section 106(a) of the Code. Amounts treated as wages under section 2301(c)(5)(B) of the CARES Act are treated as paid with respect to any employee (and with respect to any period) to the extent the amounts are properly allocable to the employee (and to the period), and, except as otherwise provided by the Secretary of the Treasury (Secretary), the allocation will be treated as proper if made on the basis of being pro rata among periods of coverage. References to “allocable qualified health plan expenses” or “qualified health plan expenses” in this notice are to the health plan expenses described in section 2301(c)(5)(B) of the CARES Act.9

Section 2301(c)(3)(A) of the CARES Act provides different definitions of “qualified wages” depending on the size of the employer, which is measured by the average number of full-time employees (within the meaning of section 4980H of the Code) employed by the eligible employer during 2019.

Section 2301(c)(3)(A)(i) of the CARES Act provides that if an eligible employer averaged more than 100 employees during 2019 (large eligible employer), qualified wages are those wages paid by the eligible employer with respect to which an employee is not providing services due to circumstances described in section 2301(c)(2)(A)(ii)(I) of the CARES Act (relating to a full or partial suspension of the operation of a trade or business due to a governmental order) or section 2301(c)(2)(A)(ii)(II) of the CARES Act (relating to a significant decline in gross receipts). For large eligible employers, section 2301(c)(3)(B) of the CARES Act limits qualified wages that may be taken into account to the amount that the employee would have been paid for working an equivalent duration during the 30 days immediately preceding the period in which the qualified wages are paid or incurred.

Section 2301(c)(3)(A)(ii) of the CARES Act provides that if an eligible employer

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averaged 100 or fewer employees in 2019 (small eligible employer), qualified wages are those wages paid by the eligible employer with respect to an employee during any period described in section 2301(c)(2)(A)(ii)(I) of the CARES Act (relating to a calendar quarter for which the operation of a trade or business is fully or partially suspended due to a governmental order) or during a calendar quarter within the period described in section 2301(c)(2)(A)(ii)(II) of the CARES Act (relating to a significant decline in gross receipts).

The flush language in section 2301(c)(3)(A) of the CARES Act provides that qualified wages do not include any wages taken into account for purposes of the credits under sections 7001 or 7003 of the FFCRA.

Section 2301(b)(1) of the CARES Act limits the amount of qualified wages with respect to any employee that may be taken into account under section 2301(a) of the CARES Act to $10,000 for all calendar quarters in 2020. Therefore, the maximum credit amount with respect to each employee for all four calendar quarters in 2020 is $5,000.

For the full guidance please visit https://www.irs.gov/pub/irs-drop/n-21-20.pdf

____________________

1 The amendments made by section 206 of the Relief Act take effect as if included in the provisions of the CARES Act to which they relate.

2 Section 207 of the Relief Act makes substantial changes to the employee retention credit that apply to qualified wages paid during the first and second quarter of 2021. Among other changes, section 207 of the Relief Act (1) makes the employee retention credit available for eligible employers paying qualified wages that are paid after December 31, 2020, and before July 1, 2021; (2) increases the maximum credit amount that may be claimed per employee (making it equal to 70 percent of $10,000 of qualified wages paid to an employee per calendar quarter); (3) expands the category of employers that may be entitled to claim the credit; (4) modifies the gross receipts test;

(5) modifies the definition of qualified wages; (6) broadens the denial of double benefit rule and applies it to sections 41, 45A, 45P, 51, and 1396 of the Code; and (7) changes the eligibility to receive advance payments and limits the amount of the advances.

3 Section 3111(e) of the Code permits qualified tax-exempt organizations that hire qualified veterans to claim a credit against the employer’s share of social security tax imposed under section 3111(a) of the Code. Section 3111(f) of the Code permits a qualified small business to elect to apply part or all of its research credit available under section 41 against the tax imposed under section 3111(a) of the Code.

4 Under sections 7001 and 7003 of the FFCRA, employers with fewer than 500 employees that provide paid sick and family leave, up to specified limits, to employees unable to work or telework due to certain circumstances related to COVID-19 may claim tax credits. The FFCRA, as amended by the COVID-related Tax Relief Act of 2020 (COVID Relief Act), provides employers with fewer than 500 employees (eligible FFCRA employers) refundable tax credits that reimburse them for the cost of providing paid sick and family leave wages to employees unable to work or telework for reasons related to COVID-19 under the Emergency Paid Sick Leave Act (EPSLA) and the Emergency Family and Medical Leave Expansion Act (Expanded FMLA), respectively. The credits are allowed against the employer’s share of social security tax imposed under section 3111(a) of the Code, and so much of the taxes imposed on employers under section 3221(a) of the Code as are attributable to the rate in effect under section 3111(a) of the Code. The FFCRA required eligible FFCRA employers to provide paid leave to such employees for periods after March 31, 2020, and before January 1, 2021. The COVID Relief Act extended the period for which tax credits are available for employers providing paid sick and family leave that otherwise would meet the requirements of the FFCRA until March 31, 2021, although the requirement that employers provide the leave expired on December 31, 2020. See Section 286 of the COVID Relief Act, which was enacted as

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Subtitle B of Title II of Division N of the Consolidated Appropriations Act, 2021, Pub. L. 116-260, 134 Stat.1182 (Dec. 27, 2020).

5 Section 303(d) of the Relief Act relates to a separate, unrelated employee retention credit for certain tax-exempt organizations affected by qualified natural disasters. Section 303(d)(3)(C)(iii) of the Relief Act added a reference to section 303(d) to section 2301(b)(2) of the CARES Act, which impacts the ordering of the credits.

6 Some eligible employers will use other federal employment tax returns, such as the Form 944, Employer’s Annual Federal Tax Return, Form 943, Employer’s Annual Federal Tax Return for Agricultural Employees, or Form CT-1, Employer’s Annual Railroad Tax Return, to report the amount of total qualified wages paid.

7 Treasury and IRS will address the application of Notice 2020-22 in relation to the employee retention credit available for quarters in 2021 in future guidance.

8 Prior to the changes made by the Relief Act, section 448(c) of the Code applied to determine gross receipts of tax-exempt organizations under section 2301 of the CARES Act. Although the Relief Act changed the definition of gross receipts applicable to tax-exempt organizations to reference the definition under section 6033 of the Code, the result under section 2301 of the CARES Act, as revised by the Relief Act, is substantially the same as the interpretation of “gross receipts” applicable to tax-exempt organizations in the FAQs posted on IRS.gov in 2020.

9 The Relief Act removed the term “qualified health plan expenses” from the definition of qualified wages under section 2301(c)(3) of the CARES Act and included health plan expenses as part of the definition of wages in section 2301(c)(5) of the CARES Act. The result under section 2301 of the CARES Act, as revised by the Relief Act, is substantially the same as the interpretation provided in the FAQs posted on IRS.gov in 2020.

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SURRAN: In the beginning of 2021, Congress was busy working on the American Rescue Plan Act (ARPA), a $1.9 trillion bill known as Stimulus 3.0. The bill was signed into law on March 11, 2021. It is the third Economic Impact Payment to eligible individuals as well as small businesses.

At the same time, the IRS was working, and still is, on several tax provision extensions and keeps issuing new guidance. The updates are constant and it seems that almost daily something else is changing, making it difficult for even the IRS to update their site and reflect all changes.

They do however provide one section that reflects “new releases for current month” and can be found on their site under “Newsroom.”

Barbara Weltman, president of Big Ideas for Small Business, joins us again this month and begins our discussion with ARPA and then continues with an update on various program extensions and their tax impact.

WELTMAN: When we recorded this program, Congress was considering a massive bill, the American Rescue Plan Act of 2021, to provide a third round of economic impact payments, extend unemployment benefits, and make other spending measures to help the economy. It also included a number of tax provisions, such as an expansion of the Child Tax Credit, the Earned Income Credit, and the Premium Tax Credit for those who buy medical coverage through a government exchange.

Also, the Payroll Tax Credits, the Employee Retention Credit, and the Paid Sick Leave and Paid Family Leave Credits, would be extended too. Assuming the bill is enacted, we'll cover all the tax provisions in the next program.

The good news is that most of these changes don't impact 2020 tax returns that we're preparing now. They're scheduled to become effective for 2021, and will of course impact tax planning for this year. We'll have to see if the final measure includes a provision exempting some 2020 unemployment benefits from gross income. Stay tuned.

WILLIAMS: Barbara discusses the new IRS guidance on the Employee Retention Credit, initially created by the CARES Act.

WELTMAN: The IRS has provided more guidance in Q&A format on the Employee Retention Credit to supplement the FAQs posted after its creation by the CARES Act. The CARES Act made the credit applicable to qualified wages paid after March 12, 2020 and before January 1, 2021. The Consolidated Appropriations Act 2021 extended the credit through June 30, 2021.

The new guidance, which is very extensive, only deals with the credit for calendar quarters through the end of 2020, but it reflects the retroactive changes in CAA impacting the credit.

The credit is 50% of qualified wages up to $10,000 per employee. So the maximum credit is $5,000 per employee. Qualified wages include qualified health plan expenses. But the credit can only be claimed by an

Video Transcript

4. ARPA, Tax Program Extensions, Deductibility Under CAA, and More

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t employer that experienced a full or partial suspension of operations or a significant decline in revenue.

It's the definition of these terms that is the focus of the latest guidance. How do you determine if you're an eligible employer? Did you in fact experience a significant decline in revenue? Was there a full or partial suspension of operations?

WILLIAMS: There has been some confusion about essential businesses operating, when a government order required non-essential business to suspend operations. Can an essential business be considered to have a full or partial suspension due to a government order?

WELTMAN: The guidance makes it clear that an employer that operates an essential business is not considered to have a full or partial suspension of operations if the government order allows all of the employer’s operations to remain open.

But an employer that operates an essential business may be considered to have a partial suspension of operations if more than a nominal portion of its business operations are suspended by governmental order.

Remember back last spring when medical practices couldn't perform elective surgeries? They may qualify for the credit if they can show that more than a nominal amount of their operations, literally, were suspended.

Nominal means either the gross receipts from the portion of the business operations is not less than 10% of total gross receipts, compared to the gross receipts of the same calendar quarter in 2019; or the hours of service performed by employees in that portion of the business is not less than 10% of the total number of hours of service performed by all employees in the employer’s business, compared to the number of hours of service performed by employees in the same calendar quarter in 2019.

WILLIAMS: But what about claiming the credit?

WELTMAN: The new guidance explains how to claim the credit to access funds in anticipation of the credit. As you know, and probably have been doing for clients eligible for the credit,qualified wages are reported on Form 941 and they don't have to deposit the taxes to the extent equal to the credit. If the amount to be deposited is less than the credit, the employer can file Form 7200 to obtain an advance of the credit.

The guidance makes it clear that the change in CAA that eliminated the bar to the credit for businesses that received a loan under PPP is retroactive, which means some employers are now eligible for the credit for the applicable part in 2020 even though they initially thought that they couldn't claim it.

But self-employed individuals can't take the credit with respect to net earnings from self-employment and household employers can't claim it because they're not in a trade or business.

One more thing, if the American Rescue Plan Act of 2021 is enacted, more guidance on changes to the Employee Retention Credit will be needed.

WILLIAMS: Turning to other matters, income and losses from business activities always present interesting questions for taxpayers and the IRS. One of these is constructive dividends. Barbara explains.

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t WELTMAN: Before the corporate tax rate dropped to 21%, it was common practice for some corporations to zero out income by distributing compensation to owners. The owners pay tax on their comp while the corporation deducted and avoided corporate income tax. But paying out comp always raises the issue of whether it is compensation for work performed, or a disguised dividend. We had the case of an asphalt paving company with three shareholders with differing ownership interests. At the end of the year, the corporation distributed what it called management fees to them.

The corporation never declared a distributed dividend to these shareholders. The tax court said the management fees were disguised dividends.

WILLIAMS: Barbara explains why.

WELTMAN: To give you an example of the gross receipts versus taxable income for one year in issue, the corporation grossed nearly $26 million, but reported taxable income of about $141,000. The main reason for the discrepancy, the deduction of the management fees.

The court said they were disguised dividends because the deduction for compensation cannot exceed what's reasonable for services performed. And here it could not be shown that the management fees were paid purely for services.

What's more, the fees were nearly pro rata to the shareholders percentage of ownership, and the fees were paid as a lump sum at the end of the year. Further, the deduction for the management fees left the corporation with very little taxable income. Bottom line, the management fees were disguised non-deductible dividends.

WILLIAMS: Speaking of deductions, when businesses are starting up, it is sometimes hard to know when the operations begin, so that expenses become deductible, and are not merely treated as startup costs. Barbara gives us an example.

WELTMAN: We had a case involving a taxpayer who owned a poor piece of land on the edge of the world's largest evaporative salt plant. For seven years, she tried various endeavors to grow crops and raise animals as her business. She tries to raise chickens for meat and then for egg production, but wild dogs destroyed most of the flock. She tried to grow watermelons, squash, peppers, and other items, nothing worked. She deducted her costs, but the tax court disallowed them. The reason, without the production of something, there's no business in existence. Here it was in the startup phase and never launched. Her farming activities never moved beyond the initial experimentation and investigation into an operating business.

WILLIAMS: So there was no question that the farmer was determined to make a profit and that farming was not a hobby, but that's another argument for curtailing deductions.

WELTMAN: We had a case involving a different taxpayer with a different situation. Here a highly skilled entrepreneur and banker who had grown up in a family of farmers and ranchers bought land to run a cattle farm. It ran at a substantial loss, which he used to offset his sizable banking income. The only problem for most of the years in issue, there was no cattle. He argued that the property was also a tree farm. The tax court held that this was a hobby and not a business.

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t The court ran through the nine factors used to distinguish a hobby from a business, assessing the results it was a hobby. He kept limited books and records. Didn't have a business plan. Didn't change methods of operation to improve the outcome or otherwise conduct the activity in a business-like manner. He took considerable personal pleasure in the activity and because of his day job as a banker, he couldn't put in a lot of time into it. Here was a hobby.

Remember until 2025 losses from a hobby activity are not deductible at all, and there's no carry over.

WILLIAMS: One last item of business income or loss to touch upon is discharge of indebtedness. Barbara shares with us a problem that clients should be aware of now if they’re terminating their businesses due to problems created by COVID-19.

WELTMAN: We had a case where a partnership was operated in which one partner made significant infusions of cash. At some point, the partners agreed that their business should cease operations.

At that time they walked away, but the IRS said, "Not so fast." The cash infusions amounted to loans to the partnership that were effectively discharged when the business closed. The partners were not called upon to repay their respective shares of the loans. This resulted in discharge of indebtedness income to the partners.

WILLIAMS: But why weren’t the cash infusions contributions to capital rather than loans?

WELTMAN: There were several reasons why the court viewed the cash infusions as loans, rather than contributions to capital. Focusing on the substance rather than the form of the transaction, the facts support loan treatment. The parties intended to treat the money as loans, the balance sheet on Form 1065 listed the cash infusions as note payable, the K-1s did not report any initial capital account balances. There was no evidence that the business could have obtained loans from third parties.

WILLIAMS: Barbara told us of the flexibility introduced by the Consolidated Appropriations Act, 2021, into FSAs for 2021, making mid-year election changes and more, but can employees recruit unused funds?

WELTMAN: You've often heard that the main feature of FSAs is “use it or lose it.” This has been modified somewhat by the ability of plans to offer grace periods or carry overs if they want as provided by CAA. In a note to a member of Congress, the IRS made it clear that even if a child didn't attend summer school in 2020 because of the pandemic, the employee could not recoup the 2020 salary reduction contribution to the dependent care FSA. But this note obviously was generated before CAA and the permissible carry overs. Still it's good information for the future. One thing to keep in mind this year, if applying allows for mid-year elections, they're prospective only. An employee may be able to opt in or change the contribution amount, but only for the balance of the year after the election is made.

They can provide flexibility with respect to carry overs of unused amounts from 2020 and 2021, extend permissible periods for including claims for planning years ending in 2020 and 2021, allow for special post-termination reimbursements for health FSAs in 20 and 21, and provide a carry over for dependent care assistance plans when a dependent ages out during COVID-19.

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t WILLIAMS: Barbara discusses employers and if they have to amend their plans to permit the carry-overs or take other actions.

WELTMAN: Employers may, but are not required to allow for a carry over or a grace period for mid-year changes, and other CAA rule changes. The IRS has provided guidance for employers amending their health FSA, or dependent care assistance plans ending in 2020 or 2021.

The notice makes it clear that an employer sponsored cafeteria plan on a calendar year ending December 31, 2020, which has a health FSA can amend the plan now to allow employees to be reimbursed for medical expenses incurred through December 31, 2021. The notice points out that as a practical matter, the carry over and the extended grace period provide the same relief to employees even though a plan can only offer one or the other.

Both options allow all unused benefits remaining in 2020 and 2021 to be made available for 2021 and 2022 respectively.

WILLIAMS: And how does the post-termination option interact with COBRA?

WELTMAN: Termination, as you know, is an event allowing a former employee to opt for COBRA if the company is subject to COBRA. If an employer allows an employee who ceases to be a participant because of termination of employment or certain reduction in hours to be reimbursed for expenses incurred after the termination or reduction in hours through access to the amount of salary reduction contributions that have been made as of the date, the employee ceased being a participant. Well, this event constitutes a COBRA qualifying event subject to notice requirements.

Here's an example, if an employee elected to contribute $2,400 to a health FSA and was terminated from the job on January 31, after making $200 in salary reduction contributions, and as a result of the termination was no longer permitted to contribute to the health FSA, other than by electing COBRA continuation coverage. The employer may allow the employee to request reimbursement up to $200, or the employee may elect COBRA continuation coverage to have access to $2,400 by paying the applicable COBRA premium of $200 per month on an after-tax basis.

Generally, a calendar year plan for 2020 must be amended by December 31, 2021. A non-calendar year plan for 2020 must adopt amendments by December 31, 2022.

WILLIAMS: Another thing added by CAA was the broadening of eligible expenses that educators can deduct. Barbara explains.

WELTMAN: As you know, educators can claim an above the line deduction for so-called classroom expenses up to $250 per year. This dollar limit has not been changed, although it may be adjusted for inflation in the future.

What's new is that costs incurred after March 12, 2020 for personal protective equipment, disinfectant and other supplies to prevent the spread of COVID-19 in the classroom, are treated as eligible expenses. The IRS has clarified what items fall into this category. They include disposable gloves, hand soap, paint, or chalk used to guide social distancing, air purifiers and other items recommended by the CDC.

The IRS has made it clear that if married couples are both teachers, the total deduction is up to $500. The IRS also made it clear that the cost of covered related items are in addition to regular classroom related items, such as books, supplies, and other non-athletic supplies for the courses of

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t instruction in health and physical education, computer equipment including related software and services, other equipment and supplementary material used in the classroom. The dollar limit applies to all eligible items COVID related or not.

WILLIAMS: CAA didn't change the basic rules for the tax treatment of damages. Barbara discusses a recent case dealing with this, but first she reviews the general rules for the tax treatment of damages.

WELTMAN: There's a hard and fast rule when it comes to the tax treatment of damages. Only amounts received for personal physical injury or sickness are excludable from gross income. So damages for non-physical personal injury, such as defamation as well as punitive damages for any reason are fully taxable. Damages for emotional distress are excludable only if they result from physical injury or illness.

WILLIAMS: But isn't it sometimes difficult to determine the cause of emotional distress?

WELTMAN: In a recent case, an employee developed shingles, a painful illness and got into hassles with her employer who let her go. She sued for back pay and other damages. She claimed she suffered emotional distress. The tax court would not let her exclude the damages attributable to emotional distress. The shingles did not cause the emotional distress so the damages were taxable.

Even though emotional distress can manifest itself in physical conditions, the emotional distress must result from the physical condition for damages to be excludable.

WILLIAMS: And what about a malpractice award from attorneys who mishandled a personal injury case?

WELTMAN: A taxpayer filed a personal injury lawsuit against the hospital after she sustained injuries from seeking knee replacement surgery. An admitting clerk put her in a broken wheelchair. The attorney she engaged to represent her retired, so she used another attorney in the firm. She lost; the court granted summary judgment to the hospital. She then filed a malpractice claim against the attorneys saying they breached their duty of care to prosecute her claim that her injuries were caused by the hospital's negligence.

The attorney settled with her for $125,000 and sent her a 1099-MISC. She didn't report the payment claiming it was a personal physical injury. The tax court rejected her claim.

For damages to be tax free there must be a direct causal link between them and the personal injuries sustained.

The nature of the claim is determined by reference to the terms of the agreement. Here the damages resulted from legal matters, not physical, personal injury, and the agreement made it clear. The agreement said it was for the purpose of compromising and settling the disputes between the parties, the taxpayer and attorneys. She didn't sustain physical injuries as a result of the attorney's actions or inactions.

SURRAN: There has been a lot of attention focused on charitable giving. The pandemic has increased the needs of many, and tax rules have been changed by the CARES Act and CAA. But before we get to some developments related to charitable giving, Barbara reminds us of the new rules for charitable deductions.

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tWELTMAN: For 2020 and 2021, individuals who don't itemize can deduct up to $300 in

cash contributions to charity. The charity doesn't have to be related to COVID-19 relief.

For 2020 returns that we're preparing now, the $300 cap applies to tax unit. So the same limit is for singles and joint filers. However, CAA changed this rule for 2021, allowing up to $300 per taxpayer, meaning up to $600 on joint returns.

The CARES Act had increased the AGI limit for cash donations to 100%, instead of the usual 60%. This higher limit must be elected and it doesn't apply to carry overs. So if you have a carryover from 2019, it's limited to 60% of AGI. The usual ordering rules for claiming itemized charitable contributions apply. The 100% of AGI limit applies for both 2020 and 2021.

WILLIAMS: In the past, Barbara told us about a couple who took a charitable deduction, by donating their house to charity. Barbara gives us an update on the case.

WELTMAN: A couple in Maryland bought property with a house on it. They wanted to tear it down, so they could build a bigger one. They allowed a charity called Second Chance, which is a training program to disassemble the house for salvageable components. What remained would be demolished by their builder. They deducted $675,000, which the IRS disallowed. They claimed the deduction based on the value of the entire house.

However, in a refund suit, a district court disallowed the deduction because they didn't donate the land as well.

It was not a donation of the entire interest in the property. While Second Chance may have become the contractual owner, the taxpayers remained record owners, no transfer to Second Chance was recorded.

This is so even though the donation agreement said Second Chance got and I quote, "The right title and interest in the house." And even if the interests were severable, there was no qualified appraisal. What's new, now the fourth circuit has affirmed the district court's decision.

WILLIAMS: On the income side, there are social security benefits, which may be tax-free or includable in gross income at 50% or 85%. Barbara elaborates as to how the filing status of married filing separately impacts the taxation of benefits.

WELTMAN: Whether social security benefits are tax-free or includable in gross income at 50% or 85% depends on the taxpayers' other income, including tax-free interest. You need to run through a computation to arrive at an adjusted base amount. The 85% rate applies if MAGI plus one half of social security benefits exceeds the base amount.

But there's a special rule for married persons filing separately. If they don't live apart from their spouses for the entire year, they're automatically subject to the 85% rate, regardless of the amount of their benefits and their income.

WILLIAMS: But is this constitutional?

WELTMAN: A taxpayer in Louisiana, a community property state, challenged the treatment of social security benefits for married persons filing separately, arguing it violates due process and equal protection that the treatment for married filing separately is discriminatory, but the tax court rejected this argument. He wanted to use one half of the base amount to figure the taxable portion of his social security benefits. But the legislative language

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t shows that Congress intended to treat married couples as a unit to prevent windfalls that might otherwise result from filing separately.

SURRAN: Earlier in the program we discussed the constant updates from the IRS and new guidance. But in one situation, the IRS’s informal guidance on rewards achieved by buying gift cards created a situation where most of the $310,000 benefits were not taxable. In the case of Anikeev v. Commissioner (TC Memo 2021-23) the IRS looked to impose a tax on the gains from rewards earned via an American Express credit card rewards program.

A taxpayer found a way to maximize benefits in an extreme and very creative way. Barbara Weltman discusses rebates, another type of payment that may or may not generate taxable income.

WELTMAN: Nearly 50 years ago, the IRS ruled that credit card rewards and similar programs were not taxable income. They were merely reductions in the purchase price of goods and services.

Over the years there hasn't been any issue about these rewards programs. In fact, frequent flyer miles haven't been taxed in part because it would be administratively difficult to do, but also because they're viewed as a reduction in the purchase price of tickets. But there are situations where rewards programs are taxable.

We had a recent case where a couple, not only obtained gift cards through American Express as rewards program, but cleverly and aggressively used the program to get reloads and money orders to the tune of over $310,000 in two years. The program had earned a 5% reward for the $6.4 million in purchases the couple made in those years. They used the rewards to buy visa gift cards, reloadable debit cards and money orders. They use the visa gift cards, debit cards, and money orders to pay down the credit card statements, allowing them to buy more purchases to get more rewards. The tax court said they were circular transactions that amounted to accessions to wealth taxable.

So just to be clear, using the American Express card to buy Visa gift cards, transactions generating rewards is okay, but reloading those cards and buying money orders is akin to cash transactions, not the purchase of goods and services.

SURRAN: The basic research credit has not been impacted in any way by tax legislation in the past year or so. The research credit is permanent and certainly during COVID-19 many businesses have engaged in research activities that may entitle them to the credit.

Some businesses are responsible for taxes, making plans and changing policies so that they can qualify for tax breaks that reduce their costs. Small businesses may even be able to use the credit as an employment tax reduction rather than as an income tax offset. Barbara Weltman talks about the research tax credit and limits on eligibility.

WELTMAN: To claim the credit the business must engage in research activities. The language in the code makes it clear that no credit can be claimed for any research funded by a grant contract or otherwise by another person.

We had a case recently involving an S-corporation. Looking at the arrangement, the tax court denied the credit for research that was paid 100% by another company. The S-corporation retained no substantial rights in the research it performed.

WILLIAMS: So what are qualified research expenses?

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t WELTMAN: At least 80% of research must constitute elements of a process of experimentation and not physical components of a product being developed or improved.

This definition came into play where a corporation claimed the research credit with respect to the development of a tanker and dry dock conducted by a shipbuilding subsidiary. The tax court denied the credit. The court said that the 80% rule is not met simply because the elements differ from products previously developed.

The corporation was merely providing supervisory or support services and wasn't engaged in the research itself. So the activities of the corporation did not constitute elements of a process of experimentation.

WILLIAMS: The research credit is not just for large corporations. Small businesses may also benefit from it. Barbara explains.

WELTMAN: A lot of R&D is conducted by small businesses. In fact, there's a special tax rule for small businesses. Instead of using the research credit as an offset to income tax up to $250,000 can be used to offset payroll tax liability. This selection is helpful to startups that may not have the income tax burden against which the regular research credit can be used. This payroll tax credit is claimed on Form 8974, which is attached to Form 941, not to the income tax return.

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Segment Five – Government / Not-for-Profit

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rofit 5. Newly Appointed GASB Chairman

Joel Black – A New Era

Segment Overview:

Field of Study:

Recommended Accreditation:

Reading (Optional for Group Study):

Running Time:

Video Transcript:

Course Level:

Course Prerequisites:

Advance Preparation:

Expiration Date:

Accounting – Governmental

June 12, 2022

Work experience in government accounting or auditing, or an introductory course in government accounting.

None

1 hour group live 2 hours self-study online

Update

”The Big Three: Taking a Comprehensive Look at Financial Reporting”

“Project Pages”

“Financial Reporting Model Improvements”

“Proposed Statement of the Governmental Accounting Standards Board Financial Reporting Model Improvements”

See page 5–12.

See page 5–22.

35 minutes

For the first time in FAF’s history, new GASB and FASB chairs started their terms at the same time. On July 1, 2020 Joel Black was appointed the new chairman of GASB. He talks to us about his background and what led him to the GASB. He also shares the challenges of taking office during a pandemic, his transition and collaboration with his predecessor Dave Vaudt and current FASB chairman Rich Jones, “The Big Three” projects the GASB is currently working or conducting research on, and what the future holds for the GASB.

Learning Objectives:

Upon successful completion of this segment, you should be able to: lˆ Identify the relief and resources provided by the GASB

during the pandemic and currently, l Understand the “Big Three” projects and the changes

included in each one, l Recognize the proposed changes in the financial reporting

model and how it differs from GASB 34, and l Determine the changes in the current concept statement on

the Note Disclosures project.

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Outline

A. GASB Standards

i. Recognized as authoritative by l State and local governments l State Boards of Accountancy l AICPA

B. Joel Black - A Career In The Making

i. Partner in charge of an audit practice l 95% allocated to serving state

and local governments

ii. AICPA’s representative to GASAC l GASB’s advisory council l AICPA’s state and local

government expert panelist

C. Observations & Lessons Learned

i. Structured & regimented process

ii. Use or improve existing processes l Ensure high level performance

iii. Consistency of dialogue was appreciated by stakeholders

iv. Strained government resources

v. Education of new standards & implementation

vi. Small government hardships l Provide them with more

resources

vii. Evolution & use of technology

I. GASB Mission and New Leadership

A. GASB Relief & Resources

i. Postponing effective dates for certain authoritative guidance l GASB Statement 95

ii. Following a “scoop and toss” approach

iii. New accounting issues due to the pandemic l Technical bulletin issued l Addressing common questions on

CARES Act funding

iv. Emergency toolbox

B. GASB in 2021

i. The Big Three Projects l Financial reporting model

v Exposure draft l Revenue and expense recognition

v Preliminary views l Footnote disclosure

v Concept statements

ii. Other projects l Risk and uncertainties l Renaming project

C. Organizational Changes

i. New director of research and technical activities l Transitioning from Dave Bean to

Alan Skelton

ii. Use of technology

D. Risk and Uncertainties Project

i. Useful information and essential information added to disclosures

E. Renaming Project

i. Existing name - comprehensive annual financial report l Acronym CAFR l Highly offensive racial slur

directed towards black South Africans

ii. Proposed name - annual comprehensive financial report l Acronym ACFR

II. GASB Current Resources & Plans for 2021

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eA. Leveraging Technology & the GASB

Evolution

i. Impact on GASB’s mission

ii. Outreach & communication

B. GASB’s Mission & Technology

i. Financial reporting for governments l From paper to pdf l Different way of reporting in the

future

“It's not necessarily our place to dictate to the marketplace how it consumes financial reports, but it's important for us to understand...”

— Joel Black

C. GASB’s Outreach & Communication

i. Going beyond comment letters

ii. Short videos of l Projects l Small pieces of proposed

standards v Inform the public v Direct them to exposure

drafts v Educate the public on

particular topics v Provide instant access for

feedback & comments

III.GASB Maximizing Technology Use

A. Financial Reporting Model

i. Re-examines GASB 34

ii. Changes in the governmental fund financial statements

iii. Creates consistency

iv. Reduces complexity

B. Revenue Recognition

i. Broader project

ii. Provides guidance for l Exchange transactions

v Revenue or expenses l Non-exchange transactions

v Distinguish between exchange & non-exchange transactions

C. Revenue Recognition Project - Other Changes

i. Transaction are now called A and B l Instead of exchange and non-

exchange

D. “A” Transactions

i. Previously considered exchange transactions

ii. Provide guidance

iii. Follow FASB’s performance obligation model

IV. “Big Three” Projects – Financial Reporting & Revenue

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A. Previous Concept Statement Describes

i. Who are the notes for

ii. What is their purpose

iii. What should be included

iv. Which is essential information

B. Current Concept Statement Describes

i. What is essential information?

ii. What would a user do?

iii. How would the information be used?

iv. Is the information l Significant? l Nice to know? l Essential?

V. “Big Three” Projects – Note Disclosures

A. Dave Bean’s Impact

i. Significant on l GASB l Governmental Accounting &

financial reporting

B. Chairman’s Actions

i. Creation of two positions l Assistant director

v Currently open l New director - Alan Skelton

C. Director’s Role - Focal Points

i. Leadership

ii. Passion for the GASB l And its mission

iii. Technical ability

D. Pre-agenda Project Interest

i. Capital assets project l Infrastructure

v Improvement on state and local government reporting

E. FASB & GASB Chairman Collaboration

i. Same mission on accounting & financial reporting l Different sectors l Different user needs l Different responsibilities

ii. Two separate boards

F. Diversity, Equity & Inclusion Offer

i. Different perspectives

ii. Balanced views from l Preparers l Auditors l Users

iii. Different l Socioeconomic backgrounds l Cultural backgrounds l Heritages

VI. Transition and Focus for the Future

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l As the Discussion Leader, you should introduce this video segment with words similar to the following:

“In this segment, Joel Black talks to us about his background and what led him to the GASB; he also shares the challenges of taking office during a pandemic, his transition, “The Big Three” projects the GASB is currently working or conducting research on, and what the future holds for the GASB."

l Show Segment 5. The transcript of this video starts on page 5–19 of this guide.

l After playing the video, use the questions provided or ones you have developed to generate discussion. The answers to our discussion questions are on pages 5–7 to 5–9. Additional objective questions are on pages 5–10 and 5–11.

l After the discussion, complete the evaluation form on page A–1.

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5. Newly Appointed GASB Chairman Joel Black – A New Era

1. Joel Black was appointed as GASB chairman on July 1, 2020 and immediately began the process of learning GASB’s operations. What were Mr. Black’s main observations? Do you agree with Mr. Black’s assessments? Why or why not?

2. The GASB Board provided relief and resources to stakeholders during the pandemic. What were the relief and resources provided during this time? Did your organization take advantage of such relief?

3. GASB has plans to forge ahead on new projects in 2021. What are the main projects GASB is intending to accomplish in 2021? What impact will these projects have on your role and your organization?

4. Per Joel Black, the use of technology is going to be key to GASB’s evolution and how it communicates with stakeholders. What are the issues associated with the use of technology? Do you agree with GASB’s approach?

Discussion Questions

You may want to assign these discussion questions to individual participants before viewing the video segment.

Instructions for Segment

Group Live Option

For additional information concerning CPE requirements, see page vi of this guide.

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s5. GASB’s Revenue and Expense

Recognition and the Financial Reporting Model projects currently have proposals out for comment. What is GASB looking to learn from these projects? How have these projects impacted the accounting and financial reporting for your entity?

6. GASB’s Note Disclosures project is expected to result in a final Concept Statement on the Disclosure Framework in mid-2021. What changes do you and your organization expect as a result of the project results and subsequent Concepts Statement?

7. Joel Black is currently reviewing several future topics for GASB to focus on. What are some of the areas GASB may turn its attention to in the near future? Will these areas impact your organization?

Discussion Questions (continued)di

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Discussion Questions (continued)

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Suggested Answers to Discussion Questions

5. Newly Appointed GASB Chairman Joel Black – A New Era

1. Joel Black was appointed as GASB chairman on July 1, 2020 and immediately began the process of learning GASB’s operations. What were Mr. Black’s main observations? Do you agree with Mr. Black’s assessments? Why or why not? l Structured & regimented process at

GASB to ensure that everything is considered and everything goes along at a certain pace to keep everything moving forward.

l GASB continues to use or improve existing processes to ensure high level performance.

l Consistency of dialogue by GASB was appreciated by stakeholders.

l Strained government resources called for GASB assistance.

l Education of new standards & implementation.

l Small government hardships require they be provided with more resources.

l Evolution & use of technology. l Participant response based on

personal/organizational experience.

2. The GASB Board provided relief and resources to stakeholders during the pandemic. What were the relief and resources provided during this time? Did your organization take advantage of such relief? l Postponing effective dates for certain

authoritative guidance (e.g., GASB Statement 95).

l Following a “scoop and toss” approach to defer all standards not required to be immediately implemented.

l Responding to new accounting that arose due to the pandemic; including addressing common questions on CARES Act funding.

l Issued emergency toolbox (i.e., uncommon topic areas due to the pandemic e.g., employee

terminations, going concern issues etc.).

l Participant response based on personal/organizational experience.

3. GASB has plans to forge ahead on new projects in 2021. What are the main projects GASB is intending to accomplish in 2021? What impact will these projects have on your role and your organization? l The Big Three Projects

V Financial reporting model project K Exposure draft issued in

spring 2020 V Revenue and expense recognition

K Preliminary views issued in summer 2020

V Footnote disclosure K Review Concept statements to

evaluate footnote disclosures to see what should be included in the footnotes to the financials.

l Other Projects V Risk and uncertainties disclosure

project V Renaming project.

l Participant response based on personal/organizational experience.

4. Per Joel Black, the use of technology is going to be key to GASB’s evolution and how it communicates with stakeholders. What are the issues associated with the use of technology? Do you agree with GASB’s approach? l Leveraging Technology

V Consider the impact on GASB’s mission

V How to use technology for outreach & communication

l GASB’s Mission & Technology v Financial reporting for

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Suggested Answers to Discussion Questions (continued)

paper to electronic to a different way of reporting in the future

l GASB’s Outreach & Communication v Going beyond comment letters v Produce short videos of

k Projects k Small pieces of proposed

standards b Inform the public b Direct them to exposure

drafts b Educate the public on

particular topics b Provide instant access for

feedback & comments. l Participant response based on

personal/organizational experience.

5. GASB’s Revenue and Expense Recognition and the Financial Reporting Model projects currently have proposals out for comment. What is GASB looking to learn from these projects? How have these projects impacted the accounting and financial reporting for your entity? l Financial Reporting Model Project

v Re-examines GASB 34 v Changes in the governmental fund

financial statements v Creates consistency v Reduces complexity

l Revenue Recognition Project v Broader project v Provides guidance for exchange

transactions & nonexchange transactions

v Distinguish between exchange & non-exchange transactions

l Revenue Recognition Project - Other Changes v Transactions are called A and B

instead of exchange and non-exchange

v “A” Transactions k Previously considered

exchange transactions k Provide guidance k Follow FASB’s performance

obligation model l Participant response based on

personal/organizational experience.

6. GASB’s Note Disclosures project is expected to result in a final Concept Statement on the Disclosure Framework in mid-2021. What changes do you and your organization expect as a result of the project results and subsequent Concepts Statement? l The disclosure project was designed

to look at footnote disclosures as a whole.

l The concept statement is the first step in the overall project.

l GASB performed research into the footnotes, and what's required in the footnotes – what do people use and why do they use it?

l Previous Concept Statement Describes v Who are the notes for? v What is their purpose? v What should be included? v Which is essential information?

l Current Concept Statement Describes v What is essential information v What a user would do v How the information would be

used v Is the information

k Significant? k Nice to know? k Essential?

l Participant response based on personal/organizational experience.

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Suggested Answers to Discussion Questions (continued)

7. Joel Black is currently reviewing several future topics for GASB to focus on. What are some of the areas GASB may turn its attention to in the near future? Will these areas impact your organization? l Pre-agenda project interest

v Capital assets project and infrastructure

v Improvement on state and local government reporting

l Participant response based on personal/organizational experience.

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1. The standards established by the Governmental Accounting Standards Board (GASB) are:

a) recognized as authoritative by state and local governments and the AICPA.

b) recognized as authoritative only by state and local governments.

c) NOT recognized as authoritative by State Boards of Accountancy.

d) NOT recognized as authoritative by any state/local governmental or private entity.

2. Prior to becoming GASB Chairman, Mr. Black:

a) focused his practice solely on clients in the private sector.

b) was NOT experienced in the standard setting process.

c) was an audit partner with many state and local government clients.

d) had experience with only large city government clients.

3. Which of the following relief measures and/or resources was provided by GASB during the pandemic?

a) Speeding up of effective dates for certain authoritative guidance

b) Issuance of technical bulletins

c) Completely eliminating any proposed standard

d) All of the above

4. GASB’s Financial Reporting Project Model:

a) was issued in spring of 2020.

b) was issued in the summer of 2020.

c) will result in a Concept Statement issued in 2021.

d) will require GASB to review foot note disclosures.

5. The proposed new model for governmental funds:

a) used the modified accrual system.

b) does not make significant changes to governmental fund financial statements.

c) is a lot more complex than the modified accrual basis.

d) seeks to create consistency.

6. GASB’s Revenue Recognition Project:

a) is a narrowly focused project.

b) would require a performance obligation model for exchange transactions.

c) provides NO distinction between exchange and non-exchange transactions.

d) focuses only on exchange transactions.

7. GASB’s proposed Concept Statement on the Disclosure Framework contains information on:

a) who the footnote disclosures are for.

b) the purpose of footnote disclosures.

c) what is considered essential information in the footnote disclosures.

d) what should be included in footnote disclosures.

You may want to use these objective questions to test knowledge and/or to generate further discussion; these questions are only for group live purposes. Most of these questions are based on the video segment, a few may be based on the reading for self-study that starts on page 5–12.

5. Newly Appointed GASB Chairman Joel Black – A New Era

Objective Questions

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8. With respect to Management’s Discussion and Analysis (MD&A), GASB’s financial reporting model:

a) requires that the basic financial statements be preceded by MD&A.

b) eliminates the need for the MD&A section.

c) leaves the decision to include MD&A up to the discretion of management.

d) requires the MD&A section to have 3 sections.

9. GASB’s proposed Concept Statement on the Financial Reporting Model describes unusual or infrequent items as transactions or events that are:

a) unusual in nature only.

b) infrequent in occurrence only.

c) unusual in nature and frequent in occurrence.

d) unusual in nature or infrequent in occurrence.

10. For a government with total revenues of $75 million or more, the effective date of GASB’s proposed Concept Statement on the Financial Reporting Model is:

a) June 15, 2022.

b) June 15, 2024.

c) June 15, 2025.

d) left to the discretion of the government entity

Objective Questions (continued)

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Self-Study Option

Reading (Optional for Group Study)

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THE BIG THREE: TAKING A COMPREHENSIVE LOOK AT FINANCIAL REPORTING

l In order to ensure adherence to NASBA guidelines regarding self-study, the CPA Report and CPA Report Government/Not-for-Profit Self-Study Professional Education Centers are no longer available. Customers should contact their company administrators for information on taking course exams and receiving CPE credit for the courses.

l Customers may contact Kaplan Financial Education at cpesupport@kaplan.com to obtain certificates previously earned through the CPA Report Self-Study and CPA Report Government/Not-for-Profit Self-Study Professional Education Centers.

l Customers interested in the self-study format of the CPA Report can find information on Kaplan Financial Education's self-study libraries at Online Accounting CPE Courses.

CPA Report Gov/Not-for-Profit Update

Source: https://www.gasb.org/jsp/GASB/Page/GASBSectionPage&cid=1176168865291

The GASB is either actively working on or conducting research on three interrelated projects that will allow the Board to take a comprehensive look at financial reporting for state and local governments.

Of these three efforts, two are on the current technical agenda:

l Financial Reporting Model Reexamination, and

l Revenue and Expense Recognition.

The third, the Note Disclosures Reexamination, was recently added to the Board’s pre-agenda research.

Work on "The Big Three" began with the Financial Reporting Model Reexamination. The project was added to the current agenda after two years of research. In late 2016, the Board issued an Invitation to Comment

(ITC) in this project. Here, the Board is evaluating—and asking for your input at each stage along the way—what the model should ultimately look like. While the existing model remains effective in most respects, recent Board research identified that there are potential areas for improvement. These are the areas the Board is asking for your input on at the ITC stage.

As the direction is determined for the reporting model, the Board also will look at how revenue and expense should be recognized within that model in the Revenue and Expense Recognition project. This project is designed to develop a comprehensive application model for the recognition of revenue and expenses that arise from nonexchange, exchange, and exchange-like transactions, including guidance for exchange transactions that have not specifically been addressed in the current literature.

As the model is being determined, the question becomes: What disclosures need to be made to offer a complete understanding

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of the financial model and the related recognition concepts? The objective of the pre-agenda research on the Note Disclosures Reexamination is to evaluate whether currently required note disclosures are sufficiently meeting the informational needs of users of state and local government financial reports. The research should provide the Board with the information necessary to determine whether additional or revised guidance is needed.

The timing of the interrelated projects is staggered to allow the Board to work on them in unison so they can be issued consecutively—and in as timely a manner as possible. The time horizon for completion of these efforts is relatively lengthy, however. The anticipated timing for completion of the Financial Reporting Model Reexamination alone is late 2021. The Board looks forward to your input as these activities progress.

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Source: https://www.gasb.org/cs/ContentServer?c=GASBContent_C&cid=1176163289827&d=&pagename=GASB%2FGASBContent_C%2FProjectPage

Financial Reporting Model—Reexamination of Statements 34, 35, 37, 41, and 46 and Interpretation 6 Project Description: The objective of this project is to make improvements to the financial reporting model, including Statement No. 34, Basic Financial Statements—and Management’s Discussion and Analysis—for State and Local Governments, and other reporting model-related pronouncements (Statements No. 35, Basic Financial Statements—and Management’s Discussion and Analysis—for Public Colleges and Universities, No. 37, Basic Financial Statements—and Management’s Discussion and Analysis—for State and Local Governments: Omnibus, No. 41, Budgetary Comparison Schedules—Perspective Differences, and No. 46, Net Assets Restricted by Enabling Legislation, and Interpretation No. 6, Recognition and Measurement of Certain Liabilities and Expenditures in Governmental Fund Financial Statements). The objective of these improvements would be to enhance the effectiveness of the model in providing information that is essential for decision-making and enhance the ability to assess a government’s accounting and to address

certain application issues, based upon the results of the pre-agenda research on the financial reporting model.

………..

FINANCIAL REPORTING MODEL—PROJECT PLAN

Background: Statement 34 was the culmination of 15 years of research, deliberation, and due process. In Statement 34, the GASB established the present blueprint for state and local government financial reporting—the format and measurement focus of the basic financial statements, certain related notes to the financial statements, and required supplementary information including management’s discussion and analysis (MD&A). Among its many features, Statement 34 introduced government-wide financial statements containing accrual information—which notably included the reporting of infrastructure, other capital assets, and long-term liabilities—for activities previously reported only on a modified accrual basis in the governmental funds. Statement 34 also required a narrative MD&A to precede the financial statements, added the presentation of the original budget to the budgetary comparison schedule, introduced major fund reporting in the governmental and enterprise funds, and added note disclosures related to capital asset and long-term liability activity during the reporting period.

PROJECT PAGES

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Statement 34 was first effective for periods beginning after June 15, 2001. Most provisions of the Statement became effective in three phases, beginning with the largest governments. Up to an additional 4 years were allowed for Phase 1 (annual revenues of $100 million or more) and Phase 2 ($10 million to $100 million) governments to retroactively report existing infrastructure assets. Phase 3 governments (below $10 million) were allowed to report general infrastructure prospectively.

The financial reporting model has a pervasive influence over the effectiveness of financial reporting by state and local governments and the ability of that reporting to achieve the objectives of financial reporting. As a result, the GASB decided that it was important, as part of its commitment to maintaining the effectiveness of its standards, to reexamine the current financial reporting model now that it has been in place for a sufficient time. The pre-agenda research showed that most of the components of the financial reporting model are effective; however, the research identified several areas for potential improvements.

In conjunction with this project, the efforts to develop recognition concepts for information presented in governmental funds will be continued. The Board’s conceptual framework project on recognition was put on hold pending reexamination of the financial reporting model. Feedback to the Preliminary Views issued in June 2011 included recommendations that recognition concepts for governmental funds should be developed in conjunction with a reexamination of the financial reporting model.

Accounting and Financial Reporting Issues: The project is considering the following issues:

Management’s Discussion and Analysis (MD&A)—Explore options for enhancing the financial statement analysis component, consider the elimination of requirements that are boilerplate and no longer necessary for understanding the financial reporting model, and clarify guidance for presenting currently known facts, decisions, or conditions that are expected to have a

significant effect on financial position or results of operations.

Governmental Fund Financial Statements—Explore a conceptually consistent measurement focus and basis of accounting and develop a presentation format for governmental fund financial statements consistent with the measurement focus and basis of accounting. In conjunction with this project, the conceptual framework project on recognition of element of financial statements was recommenced.

Proprietary Fund and Business-Type Activity Financial Statements—Evaluate operating indicator alternatives in conjunction with evaluating the guidance for the separate presentation of operating and nonoperating revenues and expenses.

Budgetary Comparisons—Explore the appropriate method of communication (either as basic financial statements or required supplementary information) for budgetary comparison information and consider whether and, if so, which budget variances should be required to be presented.

Other Issues—As appropriate and in conjunction with other topics, explore options that would permit more timely financial reporting or that would reduce complexity overall, such as presentation of special and extraordinary items and major component unit information.

Project History:

l Pre-agenda research approved: August 2013

l Research results reported to the Board: July 2015

l Added to current technical agenda: September 2015

l Task force established? Yes

l Deliberations began: October 2015

l Task force meeting held: June 2016

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l Invitation to Comment cleared: December 2016

l Comment period: January–March 2017

l Deliberations on new issues for Preliminary Views began: December 2016

l Public hearings and user forums held: April–May 2017

l Task force meeting held: September 2017

l Redeliberations began: October 2017

l Preliminary Views approved: September 2018

l Comment period: September 2018–February 2019

l Deliberations on new issues for Exposure Draft began: October 2018

l Public hearings and user forums held: March 2019

l Redeliberations began: June 2019

l Exposure Draft approved: June 2020

l Comment period: July 2020–February 2021

Current Developments: An Exposure Draft of a proposed Statement was approved in June 2020. The comment period ends February 26, 2021. Public hearings and user forums are scheduled for March and April 2021.

Work Plan:

Board Meetings Topics to Be Considered

January–February 2021: Comment period continues.

March–April 2021: Public hearings and user forums.

May 2021–January 2022: Redeliberate issues based upon due process feedback.

March 2022: Discuss first draft of a final Statement.

April 2022: Discuss preballot draft of a final Statement.

June 2022: Discuss ballot draft of a final Statement and consider for approval.

For minutes please visit https://www.gasb.org/cs/ContentServer?c=GASBContent_C&cid=1176163289827&d=&pagename=GASB%2FGASBContent_C%2FProjectPage

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Notice to Recipients of This Exposure Draft

Source: https://www.gasb.org/jsp/GASB/Document_C/DocumentPage?cid=1176174965673&acceptedDisclaimer=true

The GASB is responsible for (1) establishing and improving standards of state and local governmental accounting and financial reporting to provide useful information to users of financial reports and (2) educating stakeholders—including issuers, auditors, and users of those financial reports—on how to most effectively understand and implement those standards.

The due process procedures that we follow before issuing our standards, concepts, and other communications are designed to encourage broad public participation. As part of that due process, the GASB is issuing this Exposure Draft setting forth a proposed Statement on financial reporting model improvements.

We invite your comments on all matters in this proposed Statement. Because this proposed Statement may be modified before it is issued as a final Statement, it is important that you comment on any aspects with which you agree as well as any with which you disagree. To facilitate our analysis of comment letters, it would be helpful if you explain the reasons for your views, including alternatives that you believe the GASB should consider.

All responses are distributed to all Board members and to staff members assigned to this project, and all comments are considered during the Board’s deliberations leading to a final Statement. Only after the Board is satisfied that all alternatives have adequately been considered, and modifications have been made as considered appropriate, will a vote be taken to issue a final Statement. A majority vote of the Board is required for adoption.

Summary

The objective of this proposed Statement is to improve key components of the financial reporting model. Those changes would (1) improve the effectiveness of the financial reporting model in providing information that is essential for decision making and assessing a government’s accountability and (2) address certain application issues.

Management’s Discussion and Analysis

This proposed Statement would continue the requirement that the basic financial statements be preceded by management’s discussion and analysis (MD&A), which is presented as required supplementary information (RSI). This proposed Statement would require that the information presented in MD&A be limited to the related topics discussed in five sections: (1) Introduction, (2) Financial Summary, (3) Detailed Analyses,

(4) Significant Capital Asset and Long-Term Debt Activity, and (5) Currently Known Facts, Decisions, or Conditions. This proposed Statement would continue the requirement that MD&A provide an objective and easily readable analysis of the government’s financial activities based on currently known facts, decisions, or conditions, and present comparisons between the current year and prior year, with a focus on the current year, in order to assist users with understanding why balances and results changed. This proposed Statement also would emphasize that the analysis provided in MD&A should avoid any unnecessary duplication by not repeating explanations that may be relevant to multiple sections and that “boilerplate” discussions should be avoided by presenting only the most relevant information, focused on the primary government. Finally, this proposed Statement would continue the requirement that information included in MD&A distinguish between that of the

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FINANCIAL REPORTING MODEL IMPROVEMENTS

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primary government and its discretely presented component units.

Unusual or Infrequent Items This proposed Statement would describe unusual or infrequent items as transactions and other events that are either unusual in nature or infrequent in occurrence. Furthermore, governments would be required to display unusual or infrequent items as the last presented flow of resources prior to the net change in resource flows in the government-wide, governmental fund, and proprietary fund statements of resource flows.

Application of the Short-Term Financial Resources Measurement Focus and Accrual Basis of Accounting in Governmental Funds

This proposed Statement would require financial statements for governmental funds to be presented applying the short-term financial resources measurement focus and accrual basis of accounting. This measurement focus and basis of accounting would report elements of financial statements from a short-term perspective that is uniform across governments.

Recognition using the short-term financial resources measurement focus and accrual basis of accounting would be based on whether items arise from short-term or long-term transactions and other events. Balances, inflows of resources, and outflows of resources from short-term transactions and other events would be recognized as the underlying

transaction or other event occurs. Balances, inflows of resources, and outflows of resources from long-term transactions and other events would be recognized when payments are due, with the exception that any item associated with long-term debt issued for short-term purposes would be recognized as a short-term transaction. Interfund balances and transfers would be recognized as short-term events.

Presentation of Governmental Fund Financial Statements

This proposed Statement would require that the short-term financial resource flows statement for governmental funds be presented using the current and noncurrent activity format. That format would report inflows of resources and outflows of resources related to the purchase and disposal of capital assets and the issuance and payment of long-term debt separately from other activities in governmental funds.

This proposed Statement also would require that the governmental fund balance sheet be titled “Short-Term Financial Resources Balance Sheet” and the governmental fund resource flows statement be titled “Statement of Short-Term Financial Resource Flows.” The captions used in the governmental fund financial statements would be assets, deferred outflows of resources, liabilities, deferred inflows of resources, fund balances, inflows of resources from current activities, outflows of resources from current activities, and net flows from noncurrent activities.

Presentation of the Proprietary Fund Statement of Revenues, Expenses, and Changes in Fund Net Position

This proposed Statement would require that the proprietary fund statement of revenues, expenses, and changes in fund net position continue to distinguish between operating and nonoperating revenues and expenses. Operating revenues and expenses would be defined as revenues and expenses other than nonoperating revenues and expenses. Nonoperating revenues and expenses would include (1) subsidies received and provided,

(2) revenues and expenses related to financing, (3) resources from the disposal of capital assets and inventory, and (4) investment income and expenses.

In addition to the subtotals currently required in a proprietary fund statement of revenues,

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expenses, and changes in fund net position, this proposed Statement would require that a subtotal for operating income (loss) and noncapital subsidies be presented before reporting other nonoperating revenues and expenses. Subsidies would be defined as

(1) resources received from another party or fund to keep the rates lower than otherwise would be necessary to support the level of goods and services to be provided and

(2) resources provided to another party or fund that results in higher rates than otherwise would be established for the level of goods and services to be provided.

Budgetary Comparison Information

This proposed Statement would require governments to present budgetary comparison information using a single method of communication—RSI. Governments also would be required to present (1) variances between final budget and actual amounts and (2) variances between original and final budget amounts. An analysis of significant variances would be required to be presented in notes to RSI rather than in MD&A.

Effective Date The requirements of this proposed Statement would be effective based on a government’s total annual revenues in the first fiscal year beginning after June 15, 2022. Governments with total annual revenues of $75 million or more would be required to apply the requirements of this proposed Statement for fiscal years beginning after June 15, 2024. Governments with total annual revenues of less than $75 million would be required to apply the requirements of this proposed Statement for fiscal years beginning after June 15, 2025. Earlier application would be encouraged.

How the Changes in This Proposed Statement Would Improve Financial Reporting

The proposed short-term financial resources measurement focus and accrual basis of accounting would result in information provided by governmental fund financial statements that is more comparable across governments. Governments would recognize transactions on a conceptually consistent basis and over a uniform recognition period. The proposed requirements for the presentation of governmental fund financial statements would make the short-term nature of their information more evident and understandable and would more clearly differentiate them from the perspective presented by the government-wide financial statements. Financial statements presented applying the short-term financial resources measurement focus and accrual basis of accounting would reflect the amount of fund balance at period-end that is available for spending in the next period using a standardized approach, which may or may not be restricted for specific purposes, as well as fund balance that is legally or contractually required to be maintained intact. The proposed requirements for MD&A would improve the quality of the analysis of changes from the prior year, which would enhance the relevance of that information. They also would provide clarity regarding which information should be presented in MD&A. The proposed requirements for the separate presentation of unusual or infrequent items would provide clarity regarding which items should be reported separately from other inflows and outflows of resources.

The proposed definition of operating revenues and expenses and description of nonoperating revenues and expenses would replace accounting policies that vary from government to government, thereby improving comparability. The proposed addition of a subtotal for operating income (loss) and noncapital subsidies would improve the relevance of information provided in that statement.

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The proposed requirement that budgetary comparison information be presented as RSI would improve comparability, and the inclusion of the specified variances and variance analyses would provide more useful information for making decisions and assessing accountability.

How the Board Considered Costs and Benefits in the Development of This Proposed Statement One of the principles guiding the Board’s setting of standards for accounting and financial reporting is the assessment of expected benefits and perceived costs. The Board strives to determine that its standards address significant user needs and that the costs

incurred through the application of its standards, compared with possible alternatives, are justified when compared to the expected overall public benefit. The Board believes that the expected benefits that would result from the implementation of this proposed Statement— more comparable, consistent, relevant, reliable, and understandable information—are significant and justify the perceived costs of implementation and ongoing compliance.

The proposed effective date provisions would allow governments with total annual revenues of less than $75 million to implement one year later than governments with total annual revenues of $75 million or more, thereby enabling the former to reduce implementation challenges by benefitting from the implementation experiences of the latter. In addition, certain decisions made by the Board are intended to mitigate the costs associated with the proposed Statement by not requiring additional information that some stakeholders requested. For example, this proposed Statement would not require presentation of a schedule of government-

wide expenses by natural classification, nor does it include additional requirements for either the presentation or disclosure of debt service fund information or for the presentation of either a government-wide or a governmental funds statement of cash flows.

Table of contents and footnotes were omitted from this article. For the full version, please visit https://www.gasb.org/jsp/GASB/Document_C/DocumentPage?cid=1176174965673&acceptedDisclaimer=true

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Table of contents and footnotes were omitted from this article. For the full version, please visit https://www.gasb.org/jsp/GASB/Document_C/DocumentPage?cid=1176174965673&acceptedDisclaimer=true

June 30, 2020

INTRODUCTION 1. The objective of this Statement is to improve key components of the financial reporting model.1 The purposes of the improvements are (a) to enhance the effectiveness of the financial reporting model in providing information that is essential for decision making and assessing a government’s accountability and (b) to address certain application issues identified through pre-agenda research conducted by the Governmental Accounting Standards Board (GASB).

STANDARDS OF GOVERNMENTAL ACCOUNTING AND FINANCIAL REPORTING

Scope and Applicability of This Statement

1. This Statement establishes or modifies existing accounting and financial reporting requirements related to the following:

a. Management’s discussion and analysis

b. Unusual or infrequent items

c. Presentation of governmental fund financial statements

d. Application of the short-term financial resources measurement focus and accrual basis of accounting in governmental funds

e. Presentation of the proprietary fund statement of revenues, expenses, and changes in fund net position

f. Information about major component units in basic financial statements

g. Budgetary comparison information

h. Financial trends information.

The requirements of this Statement apply to the financial statements of all state and local governments.

2. This Statement supersedes National Council on Governmental Accounting (NCGA) Statement 1, Governmental Accounting and Financial Reporting Principles, paragraphs 44,

Management’s Discussion and Analysis

1. The basic financial statements should be preceded by management’s discussion and analysis (MD&A), which is required supplementary information (RSI). MD&A should provide an objective and easily readable analysis of the government’s financial activities based on currently known2 facts, decisions, or conditions. The financial managers of governments are knowledgeable about (a) the transactions and events that are reflected in the government’s financial report, (b) the fiscal policies that govern its operations and decision making, and (c) other conditions that may have a significant effect on financial position or results of operations. MD&A provides financial managers with the opportunity to present both short-term and long-term analyses of the government’s activities.3 MD&A should be written in a manner that can be understood by users who may not have a detailed knowledge of governmental accounting and financial reporting. MD&A also should include explanations and interpretations that help users understand the information provided.

2. MD&A should discuss the current-year balances and results in comparison with the prior year, with emphasis on the current year. This analysis should be fact based and should discuss the activities that have a

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PROPOSED STATEMENT OF THE GOVERNMENTAL ACCOUNTING STANDARDS BOARD FINANCIAL REPORTING MODEL IMPROVEMENTS

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positive and negative impact on the government’s balances and results in comparison with the prior year. The analysis should assist users in understanding why balances and results reported in the current year’s financial statements changed from the prior year rather than just the amounts or percentages by which they changed. The use of charts, graphs, and tables is encouraged to enhance the understandability of the information.

For the full exposure draft please visit https://www.gasb.org/jsp/GASB/Document_C/DocumentPage?cid=1176174965673&acceptedDisclaimer=true

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SURRAN: Standards setting is a conscious, methodical process, purposely designed as such to ensure thorough review and adequate time for comments and stakeholder feedback, before standards become U.S. generally accepted accounting principles (GAAP).

The standards established by the Governmental Accounting Standards Board (GASB) are recognized as authoritative by state and local governments, state Boards of Accountancy and the AICPA.

Standard setting is overseen by the Financial Accounting Foundation (FAF) and the collective mission of the Financial Accounting Standards Board (FASB), GASB and FAF is to

“Establish and improve financial accounting and reporting standards to provide useful information to investors and other users of financial reports and educate stakeholders on how to most effectively understand and implement those standards.”

For the first time in the FAF’s history, new GASB and FASB chairs started their terms at the same time. On July 1, 2020 Joel Black was appointed the new chairman of GASB and we have the pleasure of having him with us this month. He shares with us the challenges of taking office during a pandemic, the projects he is overseeing and what the future holds for GASB. But first, we asked him to give us a synopsis of his background and what led him to the GASB.

BLACK: I do have to say that anything that I say is really my views and my experiences and my perspectives and not those of the full board. Any kind of decisions by the board are done through due process and formal votes of the entire board.

I'll start by saying, I'm very honored and excited to be part of the GASB family, our mission, what we do to improve financial reporting for state and local governments me: I'm just very excited to be a part of it. I've spent my career in government accounting, but it has been with CPA firms.

I was with KPMG for 12 years and then a regional firm in the South for the past 16 before I joined the GASB.

Even though I was the partner in charge of the audit practice at my firm when I left, I still, over my career, including when I left, spent 95 plus percent of my time serving state and local government clients.

So my clients range from state governments and their agencies to larger cities and counties, down to very small towns, every type and size of government in between. So I've just been involved with GASB standards my whole career. In addition to performing as an auditor of financial statements and sometimes I prepare for my clients, I've been involved with the standards setting a lot. I was the AICPA's representative to the GASAC, which is the GASB's advisory council.

I served on the AICPA state and local government expert panel. So I've been involved with the GASB process beyond just using the standards for many years.

Video Transcript

5. NFP Organizations – Current Challenges, Internal Controls & More

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t With a career like that, that's been dedicated to government accounting and to using the GASB and being involved with the GASB to actually have the opportunity to serve on the board is one that I'm just extremely honored to have and excited about.

WILLIAMS: Starting last spring, Joel had a virtual transition period during which he worked closely with former chair David Vaudt. He discusses what he learned during that time and how that shaped his initial priorities.

BLACK: Dave was kind enough to spend a lot of time with me. It was all virtual, it all is in this world, and the board was extremely busy his last few months of his term, trying to get a lot of projects completed or two significant milestones because two board members were rolling off.

It was a very busy time, but he spent a lot of time with me. I think one of the things that I really learned was that I had some knowledge of how the GASB operated and saw the output. But then being involved and being behind the scenes and seeing the kind of structured regimented process that they go through to make sure that everything is considered and everything goes along at a certain pace to keep everything moving forward was really informative.

I learned a lot about that and how the organization can then continue to use those processes and improve them at times, but continue to use that so that we continue to perform at a high level.

WILLIAMS: During the first three months of his term, Joel conducted a listening tour with about three dozen leading stakeholders to better understand their perspectives and concerns. He shares with us the major things he learned.

BLACK: One of the main things I heard was about the dialogue itself. Dave Vaudt opened up that dialogue a lot, he really emphasized that during his term. As I was listening and going through and meeting all of our stakeholders, I was hearing that they really appreciated that, the consistency of that, the routineness of that dialogue. It’s going to be very important for me to continue that and that initial listening tour wasn't just something that happened at the beginning, but will be a continuous process for me and for us as an organization.

Another thing we heard a lot about was the pandemic. This was back in the summer, so the pandemic, our government's resources were strained. They continued to be so, and so we heard a lot about that and listened to how we can help in providing whatever help we could during that time. That's going to continue to be something that's important to our governments as the resources will continue to be strained.

I heard about education. I think that we do and I heard that we do a good job of educating as new standards come out about how to implement them. But I think there are other things that we can educate more on such as why we exist, maybe why we do the projects we do and how that process works, not so much just about the output.

One thing I heard about that was probably not new news and isn't a new problem, but small government. Small governments, which I had several clients that were small government, so I understand the hardships that changes and new standards have on them. I've continued to hear from our stakeholders that small governments can use more resources and use more help, is there any relief we can provide to small governments?

Then finally, I would say it's evolution, that we need to be sure to continue to evolve. And in today's world, a lot of that has to do with technology. How do we use technology in our outreach, in our

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t interactions, in our processes? But also how is technology affecting us, affecting governments, and affecting our mission?

WILLIAMS: Starting a new role in the midst of a pandemic is not making the task any easier. During Joel’s transition, the Board provided relief and resources to stakeholders, from an accounting perspective. But what did that look like and what other relief and resources may the Board need to provide going forward? Joel elaborates.

BLACK: We did hear this a lot by listening to our governments, they are being asked to do more with less. They don't have access sometimes to all their resources, although they're coping just like everybody is pretty well and figuring out how to operate in this environment. But certainly, for several years, there's going to be pressure on budgets and government resources are going to be pulled in different directions. Even finance departments, accounting departments are going to have some resource strains and constraints put on them. If there's help we can provide, we want to try to provide that.

What that's looked like for us up to now has been first and foremost, we postponed effective dates for standards that were not yet effective. So we issued GASB statement number 95 back in the spring. I think we did it in the fastest time we've ever issued a GASB standard from beginning to end was six weeks. That’s extremely fast for us.

What we decided to do in that time was to take what we call the scoop and toss approach. Meaning, we scooped up every standard, anything that wasn't yet required to be effective and we tossed it into the future, mostly 12 months, although some standard, including our lease standard were pushed out 18 months. We’ve gotten a lot of good responses from that.

Governments appreciated the relief, they appreciate being able to focus on what they just normally do without having to implement something new. As of now, we're not hearing a big call for further relief, for further postponement, but it's something that we continue to listen to our stakeholders about.

Another thing we were getting lots of questions about new accounting issues that are popping up in governments because they're dealing with the pandemic. Primarily, many of them related to the CARES Act funding back in the summer.

We issued what we call a technical bulletin, which was the first time we'd done that in many years, which was something that the staff actually produces and the board just doesn't disagree with its issuance. We answered in that technical bulletin, six common questions about the accounting for the CARES Act funding.

Another thing we did to answer some of those kinds of common questions was we put on our website what we call the emergency toolbox. This was not new guidance, but it was a listing of topic areas that maybe aren't as commonly incurred by most normal governments, but because of the pandemic, they might be having to address those issues that they aren't familiar with, but that for which we already have existing accounting, such as no employee terminations or going concern issues, those kinds of things, things don't come up commonly. We listed them out and then we have linkable references to the appropriate accounting guidance for those topics.

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t WILLIAMS: Shifting the focus to the future, Joel gives us his insights as to what 2021 looks like for the GASB, both organizationally and in terms of its standard setting activities.

BLACK: We have what we call our big three projects that are long-term projects that have made significant progress up to now and we'll continue with those.

One of those is the financial reporting model project. We issued an exposure draft for it back in the spring, so it's pretty far along back in the summer. The revenue and expense recognition project is the second of the big three, and that one we issued, is not quite as far along, but we issued preliminary views back in the summer as well.

So both of those are our documents that are out there that we're looking for public comment on. We gave an extra-long comment period because of the pandemic, which was through the end of February. So from there, when we receive all of those comments, we then will evaluate those comments. Then we are having a series of public hearings and user forums in March and April that we had planned to go across the country in different places and hear from different stakeholders and users.

But for now we're going to have them all virtual. So we look forward to a lot of feedback on those two projects this year, in 2021 and evaluating that feedback, and then figuring out how those projects move forward.

The third of our big three is the footnote disclosure project. The first major step in that was to re-look at what we call our concept statements, which really guide the board and its future deliberations and future pronouncements.

It's not necessarily a direct requirement to external parties, but that concept statement has already gone through our full due process. We're in the final deliberations of it now, so a concept statement will be issued this year on footnote disclosures. Then we will use those concepts to then evaluate footnote disclosures, past, and present, and future to see what should be included in the footnotes to the financials.

A couple of other small, we have a number of practice issues we're dealing with too. I'll just mention two very briefly. One is our risks and uncertainties disclosure project, which I think is important. Then a project to rename the comprehensive annual financial report. So those are a couple of projects that are fast tracked and underway during 2021.

From an organizational perspective, I guess I'll talk about two things. First of which is, we recently named a new director of research and technical activities. We have David Bean who has been our long time director at the GASB. Has been the director for over 30 years.

He's retiring at the end of March and we recently announced his replacement, Alan Skelton, and we're excited about that. So bringing Alan in, getting him on board, getting him involved in everything in the organization is going to be a high priority and a big change for us as an organization in 2021.

The other thing I would say is that using technology for which I think I have some plans for us to try some new things, to try to go beyond just the formal comment letters on our proposed changes and new standards being our main source of input, but trying to use technology, trying to figure out ways to get input into those projects from people that maybe have not responded in the past.

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t WILLIAMS: Joel Black elaborates further on the risk and uncertainties and the renaming of financial reporting projects and what prompted those changes.

BLACK: The risks and uncertainties project is one that didn't necessarily come about by the pandemic, but I think has fast-tracked it in the pandemic. And if you just hear that name, risks and uncertainties, it sounds like it could be pretty broad.

We think there is going to be some useful information, some essential information added to the disclosures is to limit it, put a fence around what we're considering for that project.

Not to say we won't evaluate other risks later at some future project, but this project is going to be concentrated on just a few things. These are disclosures that actually already exist in the FASB world, but the GASB has never required these disclosures.

And so things like concentrations, vulnerabilities due to concentrations or some different financial flexibility things that you may be a little unique to the government environment are potential disclosures that we're considering as part of that project.

The renaming project is something we felt was important because the comprehensive annual financial report has been in our financial reporting for governments’ environment for a long time. That's a document most people are used to, and we knew normally call it the acronym CAFR by how that is pronounced. But it recently came to our attention that when you say it that way, say CAFR as it sounds, it's actually a highly offensive racial slur directed towards black South Africans.

So we undertook a project to consider how to deal with that. We don't want to be offensive to anybody. We're part of a broader global community, it's important for us to not be offensive to anyone. Due to this, we looked into it, is it education about not using the acronym or do we need to rename it?

Tentatively so far, the board has decided that renaming is the way to go and actually has a proposed name of Annual Comprehensive Financial Report or ACFR, which are the same four words, just jiggled around a little bit. Which we think will emphasize to people that's not changing what's between the covers. That all the information in there is the same information, we're not changing those requirements. We're just changing around the name for this important purpose so that we're inclusive and not offensive. That's where that project is and where it's going and why it exists.

SURRAN: Joel Black discusses how leveraging technology is going to be critical to the GASB’s evolution and how it will impact the outreach the GASB conducts with stakeholders.

BLACK: There's a lot that you can go into right with technology. I look at it in two buckets, if you will. One is, how is technology impacting us in our mission? The other is, how do we use technology for that outreach and for that communication.

So when you consider both, there's a quote I use a lot and it's been out in publications, the staff are probably tired of hearing me say it, but I use it a lot and I used it at my prior firm too.

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t It comes from Bill Gates who said that “we always overestimate the change that will occur in the next two years, but underestimate the change that will occur in the next 10 years. Don't be lulled into inaction.”

So it's important for me, I live by that in a way. Change is driven a lot of ways by technology, and that's just the world that we live in now. But if you look at and say, "Let's look at how technology is impacting our mission.

Financial reporting for governments and all entities really has largely been consumed by the users in much the same way for the past 50 plus years. We get paper reports, those were replaced with PDF reports, which are electronic paper, and that's how that information was consumed.

I have to imagine that at some point, maybe not in the next two years, but definitely within the next 10 years, that that consumption of financial information is going to be different. It's going to look different, it's going to feel different and technology is going to make that different than it is now. That’s something that we have to pay attention to, that we have to be involved with. It's not necessarily our place to dictate to the marketplace how it consumes financial reports, but it's important for us to understand how they are consuming it and what impact if any, that have in our standards.

On the idea of how we even use technology to interact. Like I said before, going something beyond the comment letters, for example, an idea that I have that we may try as we've been producing short videos that were direct and advertise projects we have, and maybe take general small pieces of a proposed standard and tell the public about that, and then direct them towards the exposure draft, for example, for them to then provide comments.

But could we take those little videos, break out the potential new standard into more chunks, educate on a particular topic that we're interested in feedback on. Then at the end of the video allow for a clickable link where somebody could just go ahead and type their comments or their response to what that proposal was or that small piece of it was.

And that will be input to us as opposed to having to then wait for them to understand the full impact of the whole standard and write one big comprehensive comment letter.

Now, maybe that won't work. Maybe you have to understand, especially for bigger projects, the bigger picture before you can talk about each piece of it. That's an example of something that I would like to try.

SURRAN: The GASB is currently working or conducting research on three major projects, also known as “The Big Three”, which include Financial Reporting Model Reexamination, Revenue and Expense Recognition and Note Disclosures.

The GASB’s “Big Three” projects have two proposals recently out for comment; Revenue and Expense Recognition and the Financial Reporting Model, providing a lot of opportunities for stakeholders to share their views coming up this spring.

The Note Disclosures project was recently added to the Board’s pre-agenda research.

Joel Black talks about what the Board is looking to learn from these projects and how they potentially impact accounting and financial reporting for state and local governments.

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t BLACK: Those are big comprehensive projects, but I'll take them each and talk about them at a pretty high level. But I actually, I see a common theme between both of them. The financial reporting model, for those of us who've been around GASB 34, 20 years ago really changed the government financial reporting model, and this is a re-examination of that. I think what you will see is this not going to change that drastically, but that we've considered these to be targeted improvements.

The area that's changing the most is the governmental fund financial statements. Those are changing significantly. If you're used to modified accrual and what those governmental fund financials have done in the past, it was really this series of accounting rules that maybe there wasn't a logical flow through of all of it, but is rules that built on entails. We say, it's a series of accounting conventions. If you grew up with it like I did, you know them, you understand them.

It makes sense to you or you're just used to them, but to new accountants coming into governmental accounting, it's harder to learn. It doesn't make sense. The same transaction It's treated different ways at times because of the way these rules were cobbled together in a way over years.

I think the new model for governmental funds as proposed would create a lot more consistency, reduce that complexity, make it be such that new complex transactions might come around, it'll just be easy for them to float through and for us to understand how they should be accounted for in the governmental funds.

Revenue and expense recognition is almost even broader. It is a broader project that for those of you who are used to the GASB, what we consider now to be exchange transactions, number one, don't have a lot of guidance about how to account for exchange transactions, revenue, or expenses.

Number two, distinguishing between exchange transactions and non-exchange transactions has always been really difficult.

Both of those things are major reasons this project exists, problems we were trying to solve. I think under the preliminary view, what you will see is, we've taken that exchange versus non exchange, and we've made a new distinction between the two.

Right now we're not even using names, we're calling them A and B transactions to try to distinguish that this is new. Again, it's taking any type of transaction and is it you need these criteria to be A or these criteria to be B. Take value out of it that sometimes leads to different people coming to, or same similar people coming to different conclusions about whether something's exchange or non-exchange. So I think that's one thing, this problem, this project is trying to solve.

Then the other is then taking what we call the A transactions, which are a lot of what you would previously or currently considered to be exchange or falling into A transactions, we're going to provide some guidance on how to account for those. As proposed, would be a performance obligation model similar to what the FASB did with their revenue recognition project relatively recently.

So that's the major thing, but again, it's about consistency, taking some of these complicated transactions, being able to account for them from government to government view like we're getting them the same every time. And you did ask, what are we looking for? That's what we're

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t proposing. What we're looking for to answer the question is we want input. These are public comment documents, that was our objective; did we achieve it right? Do you know of transactions? Could you run transactions through them? Does it make sense to you? Do the words on the page allow you to understand what we were trying to do? Or is it problematic? You have transactions that I wouldn't know how to do this under your proposal.

David Bean, who's our longtime director, routinely says, "All knowledge does not reside in Norwalk, Connecticut," and that's very true, and that's what we're looking at.

WILLIAMS: The first result of the third project, Note Disclosures, is expected to be a final Concept Statement on the Disclosure Framework in mid-2021. Joel shares with us how this project fits in with the other two we mentioned and what the next steps will be after the Concepts Statement.

BLACK: The disclosure project, because it was one of the big three, is really meant to look at footnote disclosures as a whole, and so the concept statement is kind of the first step in this overall project. And so it was really the board did a lot of research into the footnotes, and what's required in the footnotes, and what do people use? Why do they use it? I think a board at the time a couple of years ago decided that they really needed to re-look at their concept of what should be in the footnotes might need to be changed. That’s the concept statement that will be issued in the coming months is that. It's describing who the notes are for, what's their purpose and what should be in there, which is essential information.

That's what the prior concepts said, that's what this concept said, but this concept statement is trying to define what essential means. What is it that a user would do? How would they be using the information? Is it significant to them? Is it nice to know? Or is it essential to know? That’s what we're really trying to define.

Then we would take that concept and apply it to other footnotes, to footnotes that passed, or that are out there now. Do they meet this kind of new requirements? So that would be a next project if the board decides to keep going with it, would be to look at those. But certainly for current projects now that have disclosure requirements potentially, or future projects, this new concept statement would dictate what is being considered by our board and future boards when they're considering potentially new disclosures.

WILLIAMS: The GASB has just announced a new director of research and technical activities, Alan Skelton, taking over for Dave Bean, who retired at the end of March. Joel discusses Dave’s contribution over his 30-year career, Alan’s role and the transition.

BLACK: Thirty years is a long time and Dave, his impact on the GASB and governmental accounting really can't be overstated. He's done more to improve government accounting and financial reporting than anybody I can think of.

He did that for so many years with integrity, and humility, and charm, and grace. He was a great leader. He really has been the heart of what we call the GASB family.

So he's hard to replace, and so when I knew I was going to replace him, that he was retiring, it became important to me to not have maybe one person that replaces him, so we actually added a position of an assistant

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t director, which we will fill now that we filled the director position so that we can spread some of those responsibilities out among several people in the leadership of the GASB and not just have one person do all of it.

So from there, knowing that I was spreading out, I really focused for the director, what's important? What are the most important parts of what Dave did and of that position that I want the new director to have? I focused on leadership, a passion for the GASB and our mission, and then technical ability.

Alan has been the state accounting officer for the state of Georgia for the past, almost 10 years. He has public accounting experience before that. He's been in governmental accounting for most of his career too. He brings that. Leadership-wise, he really has a passion for leading his staff, for developing his staff. So I think from a staff leadership perspective, he's proven to be a great leader and I think he's a great fit for us. He and I talked a lot about our vision for the GASB's evolution, so that leadership and strategy, strategic planning, and looking toward the future in our evolution, he and I share a lot of the same passion for that, which was the second thing, passion for our mission.

If you talk to Alan for very long, he's been involved with the GASAC, our advisory council for several years as the vice chair, he has a real passion, he's been involved in what we do. He's provided input into the GASB for many years, so he really has a passion for governmental accounting and our mission. And as the state accounting officer for the state of Georgia, he's been using our standards. He has significant practical experience with a very complicated government in using our standards. So he brings that perspective and that kind of technical perspective to our standard setting process. So we're really excited to have Alan on.

WILLIAMS: As Joel looks beyond the current state of the GASB, he shares with us what’s on the horizon and what he keeps a particularly keen eye on.

BLACK: We have several projects on our, what we call our pre-agenda research activities list. So these are things that we're researching to be potential projects for our technical agenda.

I would say the one I am the most keenly aware of and interested in is our capital assets project, in particular within that, infrastructure. There’s a lot that we could do to improve how that is reported for our state and local governments. I'm really interested in progressing and it's a big project. We’ll take our time, but I think that's the one in particular I'm paying attention to.

SURRAN: For the first time in the Financial Accounting Foundation’s history, new GASB and FASB chairs have started their terms at the same time. Joel discusses his relationship with FASB Chair Rich Jones and the commitment they both have to work together.

BLACK: Rich and I talk routinely, at least weekly, if not more often, so it's been great learning on the job with him. We're going through the transition the same way, similar transitions and our organizations have very similar missions.

Basically the same mission about accounting and financial reporting just for different sectors. And because we're in different sectors, we have different user needs and different responsibilities, and that's why we have

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t two separate boards, but a lot of the times some of the issues are the same.

I think the boards have always, and it's important for Rich and I both that we continue to do this, work together when it makes sense to work together. And that can be a lot of times, whether it be leases or dealing with a LIBOR transition, things like that. These are issues where we have a lot of commonality. The staff continues to work together, have work together when we have common projects, and it's important for Rich and I that we continue to do that.

WILLIAMS: Diversity, equity and inclusion, is another very important topic. Joel gives us his insights as to why it is so critical.

BLACK: I think that as a standard setter and that generally accepted part of it, the due process we go through. This is something that we've been pretty good at. And I say pretty good at because that inclusion, getting multiple different perspectives has always been important in standard settings, so that we're getting a balanced view from preparers, from auditors, from users who often have competing objectives, but trying to balance all of that.

So it's been important as we set standards to consider that. So when we get input, when we get feedback, we are used to making sure we have different perspectives included. But I think we can go beyond that as an organization and as a society, making sure that we have even more different perspectives, not just preparers, auditors and users, but different socioeconomic backgrounds, different cultural backgrounds, different heritages, all of those things do impact still what we do.

I think it's important for us to try to be achieving that. And how we do that, we're working on, we're working on getting better. It's always something we're trying to do, but we're, like many companies going through a process of, is there a way we can do it better? Is there a way we can provide education on inclusivity? Is there a way we can be more equal and get all those perspectives? And that's what we're trying to work through and set a strategy for, and move forward with.

SURRAN: Joel Black concludes our segment and leaves us with a few key takeaways.

BLACK: Key takeaways, I guess number one, thank you. I'm excited to be here. I'm excited to be at the GASB. And maybe number two, we look forward to your input. I look forward to dialoguing with everybody, all of your members, everybody participating. Please let us know what you think about our project. Please let us know what we can do to help in the pandemic, et cetera. So open dialogue, Dave Vaudt was really good at that. I want that to continue. That's going to be important for us as an organization.

In some ways it's more efficient to dialogue now because we don't have to get on planes to do it, but in some ways not meeting in-person, I don't want that to create barriers. So I'm just hopeful that we can in whatever way it looks like that we can keep the dialogue going routinely. So I look forward to working with all of you and hearing from all of you.

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Evaluation Form

Please rate the segments on the April 2021 issue 5 = Excellent, 4 = Very Good, 3 = Good, 2 = Fair, 1 = Poor

Please comment on each segment you used. (Attach additional pages if needed.)

I. Segment

Overall Speakers Format Content Topic

1. Structuring Equity Compensation _____ _____ _____ _____ _____

2. Current Expected Credit Losses – What You Need to Know _____ _____ _____ _____ _____

3. Human Capital, Management Oversight & Disclosure – Is Your Board Ready? _____ _____ _____ _____ _____

4. ARPA, Tax Program Extensions, Deductibility Under CAA, and More _____ _____ _____ _____ _____

5. Newly Appointed GASB Chairman Joel Black – A New Era _____ _____ _____ _____ _____

Segment 1:__________________________________________________________________

Segment 2:__________________________________________________________________

Segment 3:__________________________________________________________________

Segment 4:__________________________________________________________________

Segment 5:__________________________________________________________________

Suggested Topics to be covered in future volumes (please comment):

_______________________________________________________________________________

_______________________________________________________________________________

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rm Please rate the discussion leaders 5 = Excellent, 4 = Very Good, 3 = Good, 2 = Fair, 1 = Poor

II. Discussion Leader

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Segment 1: ___________________ ___________________ ___________________ Discussion Leader’s name

Segment 2: ___________________ ___________________ ___________________ Discussion Leader’s name

Segment 3: ___________________ ___________________ ___________________ Discussion Leader’s name

Segment 4: ___________________ ___________________ ___________________ Discussion Leader’s name

Segment 5: ___________________ ___________________ ___________________ Discussion Leader’s name

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A. By Citation

Accounting Standards Update – see: ASU

ASU No. 2014-09 June – 2

ASU No. 2016-02 June – 2

ASU No. 2016-13 April – 2

ASU No. 2017-02 October – 1

ASU 2018-08 July – 2

FASB or Financial Accounting Standards Board – see: ASU

IRS Notice 2020-29 July – 4

IRS Notice 2020-32 January – 2

IRS Notice 2020-50 August – 3

IRS Notice 2020-51 August – 3

IRS Notice 2020-65 December – 4

IRS Rev. Proc. 2016-47 December – 1

IRS Rev. Proc. 2020-20 June – 3

IRS Rev. Proc. 2020-23 October – 4

IRS Rev. Proc. 2020-46 December – 1

IRS Rev Proc 2020-51 January – 2

Ivison v. IRS June – 4

Simmons v. United States June – 4

SSARS No. 25 December – 1

Statement on Standards for Accounting & Review Services – see: SSARS

Tibble v. Edison August – 4

B. By Topic

Accounting, diversity in December – 2

American Rescue Plan Act (ARPA) April - 4

ASC Topic 326, FASB's reasons for issuing April – 2

ASC Topic 606, implementation of Jan. – 4; July – 2

ASC Topic 606, PPP loans and July – 2

ASC Topic 718 August – 1

ASC Topic 842, implementation of July – 2

ASC Topic 842, pandemic and October – 1

Auditor's report, revised May – 4

Automobile depreciation September – 3

Big data, finance and January – 4

Bitcoin and Ethereum December – 3

Index

Note: At the request of several subscribers, this Index reflects the most recent 11 months of CPAR programming rather than the current calendar year.

May 2020 – April 2021

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Blockchain, tax implications of December – 3

Bonus depreciation, IRS special rule on May – 3

Bankruptcy, COVID-19 and September – 1

Brand licensing, ethics and January – 3

Businesses, effect of COVID-19 on September – 2

Business Interest Expense Limitation, IRC Sec. 163(j) May – 3

CAA, disaster relief and February – 4

CAA, tax relief and February – 4

CAMs, auditor independence and

CAMs, inventory observation challenges October – 2

CARES Act May 1; May – 2; June – 3; June – 4; Feb. – 1

CARES Act and NOLs June – 4

CARES Act, charitable contribution deductions and July – 4

CARES Act, not-for-profits and February – 5

CECL, COVID-19 and April – 2

Chapter 11 September – 1

Common Reporting Standard (CRS) November – 2

Consolidated Appropriations Act 2021 (CAA) Feb. – 4; April - 4

COVID-19, challenges companies face due to May – 2; Aug. – 1; Sept. – 2

COVID-19, economy and August – 1

COVID-19, FATCA and June – 3

COVID-19, IAASB Audit Implications of July 1

Critical audit matters – see: CAM

Current Expected Credit Losses (CECL) April – 2

Cybersecurity, internal audit and January – 1

Data security and privacy November – 3

Debt Instruments, significant modifications of October – 4

De minimis use rule November – 1

Depreciation, IRS Sec. 704(c) and May – 3

Digital assets, tax implications of December – 3

Dirty Dozen Tax Scams and COVID-19 September – 3

Distributions & loans, CARES Act August – 3

Diversity, equity and inclusion (DEI) December – 2

Dodd-Frank Act, transparency and October – 4

Dodd-Frank Act, whistleblower complaints and September – 4

Earnings management, reasons to perform September – 4

Economic Aid Act Feb. – 1; Feb. – 2

Economy, COVID-19 and May – 1

Elder Care, CPAs role in July – 3

Elderly, financial abuse of July – 3

Electronic Code, IESBA and June – 1

Employee and employer donations, special August – 3

Employee Retention Credit April - 4

Employee stock options April – 1

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Employee stock ownership plan (ESOP) November – 4

Environmental, social and governance (ESG) issues Oct. – 4; April - 3

Estate planning, importance of July – 3

Ethics, tax planning and August – 2

ETSC, definition of November – 4

Executive compensation, COVID-19 and Aug. – 1; Oct. – 2

FASB & GASB Chairman Collaboration April - 5

FASB, pandemic and February – 3

FATCA, Common Report Standard and November – 2

Families First Coronavirus Response Act (FFCRA) May – 1; June – 4

Fiduciary litigation, key issues August – 4

Financial Accounting Standards Board (FASB) June – 2

Financial statements, COVID-19 and August – 1

Five-year lookback rule November – 1

Flexible Spending Account (FSA) April - 4

Foreign Account Tax Compliance Act (FATCA) June – 3

Forms W-8 and W-9, information reporting and June – 3

Fraud triangle October – 2

FTE Safe Harbor February – 2

Funding programs, CARES Act May – 1

Global Forum on Transparency and Exchange of Information November – 2

Going concern analysis October – 2

Going concern considerations February – 5

Goodwill impairment, COVID-19 and October – 1

Governmental Accounting Standards Board (GASB) April - 5

Hardship extension, FATCA and June – 3

Health care plans, guidance on July – 4

H.R. 6408, SOS America Act July – 4

Human capital April - 3

IESBA Technology Project August – 2

Income tax returns, extension for 2019 May – 1

Internal audit and internal controls, difference between November – 3

Internal auditing, COVID-19 and January – 1

Internal auditing, technology and January – 1

Internal controls programs, advantages and disadvantages of November – 3

Internal controls, not-for-profits and February – 5

Internal controls, risk assessment and November – 3

International Accounting Standards Board June – 2

International Code of Ethics for Professional Accountants June – 1

International Ethics Standards Board for Accountants June – 1; Aug. – 2

International Auditing and Assurance Standards Board May – 4; July – 1

International Ethics Standards Board for Accountants – see: IESBA

International standards, benefits of July – 1

International Standard for Review Engagements 2400 December – 1`

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IRC Section 409A April – 1

IRC section 501(c)(6), tax-exempt status and February – 1

IRS Form 941X, existing and revised October – 3

IRS Notice 2020-69, purpose of GILTI under November – 1

KAMs, CAMS vs. May – 4

Lease-based donation , special tax breaks for August – 3

Licensing, impact of technology on January – 3

Materiality, auditor's judgment on May – 4

Medicaid Waiver Program June – 4

National Adult Protective Services Association (NAPSA) July – 3

Next generation internal auditing December – 2

Next Generation Internal Audit study, 2020 January- 1

No Action Letter, SEC and September – 4

Non-Compliance with Laws and Regulations (NOCLAR) June – 1

Not-for-profits, finance and accounting challenges for February – 5

OSHA, whistleblower complaints and September – 4

Pandemic, Standard Setters’ Response to July – 2

Payroll tax deferral Oct. – 3; Dec. – 4

PPPFA, New criteria to qualify for forgiveness under July – 2; July – 4

PPP loan forgiveness, deductability of expenses for January – 2

PPP loan obligations January – 2

PPP, changes to February – 4

PPP, second draw Feb. – 1; Feb. – 2

Preparer tax identification number (PTIN) June – 4

Principal-Agent problem April – 1

Privacy, social media and January – 4

Public interest entity (PIE) June – 1

Qualified retirement plans November – 4

Qualified opportunity zones, tax benefits of August – 3

Regulation S-K April - 3

Retirement plan regulations, changes to February – 4

Safe harbor approach, the May – 3

SSARS No. 25, purpose of December – 1

SBA Funding Programs May – 1

SBA PPP loans July – 2; Sept. – 1

SBA, second program February – 1

Schedules K-2 & K-3 September – 3

SECURE Act Aug.- 3; Nov. – 4

Simplification Initiative June – 2

Small Business Reorganization Act of 2019 Sept. – 1

Social credit model January – 4

SOX, whistleblower complaints and September – 4

State and local taxes, limit on deductibility of September – 1

Stock options, primary forms of April – 1

Strength, weaknesses, opportunities and threats (SWOT) analysis December – 2

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Sustainability Accounting Standards Board (SASB) Oct. – 4; April - 3

Sustainability, long-term April - 3

Task Force on Climate-related Financial Disclosures (TCFD) October – 2

Tax Cuts and Jobs Act – see: TCJA

TCJA, IRC Section 118 and October – 4

Technology, GASB and April - 5

Transit card reimbursement, IRS views on May – 3

Triggers, single vs. double stock option April – 1

Trusts and estates, final regulations for November – 1

Uniform Prudent Management of Institutional Funds Act (UPMIFA) February – 5

Valuation analysis, COVID-19 and September – 2

Virtual currencies, valuation of December – 3

Whistleblower complaints September – 4

Working remotely May – 2

W-2 reporting & deferral, IRS guidance on December – 4

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Group Attendance and CPE Recordgr

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d Company __________________________________________________ Date __________________

Segment Title _______________________________________________________________________

Location of Seminar _______________________________________________________________

SS# Name State Hours Earned

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I hereby certify that the above individuals viewed this portion of CPA Report, participated in the group discussion, and earned the recommended hours of CPE credit.

Discussion leader _______________________________ Date completed ____________

All CPE hours listed are recommended. They are developed in a manner consistent with AICPA guidelines. Since CPE requirements vary by state and/or professional organization, we suggest you contact the appropriate organization for information about their requirements.