Accounting For Uncertain Tax Liabilities

In Mel Brooks’ brilliant 1968 movie, “The Producers,” a timid accountant named Leo Bloom (played by Gene Wilder), off-handedly suggests that his client, Broadway producer Max Bialystock (played by Zero Mostel), could actually make more money by producing failures than hits. By overselling investment interests in truly bad plays, a short-running failure would leave the producer with excess cash, which he could theoretically pocket (instead of refunding), with no one the wiser. Of course, the one fly in the ointment, Bloom advises Bialystock, would be if the play were to succeed. In that instance, everyone would go to jail.

Undeterred by that seemingly remote possibility (in terms of the Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 5, Accounting for Contingencies, of course), Bialystock and Bloom happen upon the script for a terrible play, entitled “Springtime for Hitler,” which they produce as a musical—with an insipid director and a terrible leading actor. Alas, as so many improper accounting schemes have demonstrated, the play turns out to be “fools gold”—it's so bad it becomes a huge success, thereby proving the wisdom of the age-old aphorism, “beauty is in the eyes of the beholder.”

Trying to wrest benefits out of possible liabilities is not restricted to movies, or the Broadway stage, however. Many a legitimate accounting principle has been “tweaked” in an effort to produce results the principle never was intended to support, as evidenced by Enron, WorldCom, and their progeny.

One place where issues have arisen is in the area of uncertain future tax liabilities. In the past, companies that were understandably aggressive in their approach to the IRS concerning their potential tax obligations often took a defeatist approach in establishing their reserves for tax liabilities deemed likely to result when the IRS review finished.

Since overly large or excessively deficient reserves can have a material and direct impact on corporate bottom lines, some companies used the imprecision prevailing in estimating future tax liabilities to assist them in demonstrating better performance than actually occurred. As a result, audit committee members today must confront requirements imposed not only by the Sarbanes-Oxley Act of 2002, but by the new obligation to recognize, measure, and disclose the adequacy of their tax reserves that was established by Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”).

Since 1972, when the Securities and Exchange Commission first recommended that publicly held companies establish audit committees, the responsibilities of audit committees have been expanding. More recently, SOX resulted in regulations and rules strengthening the audit committee’s authority, improving its monitoring role, raising its membership requirements, and increasing its responsibilities.

It’s axiomatic that—for the marketplace to function effectively and freely—reliable, accurate financial data must be readily available to all investors. The role of the audit committee is crucial in ensuring the integrity of the financial statements on which investors rely and which are essential to the efficiency of our capital markets. These recent regulatory reforms have intensified the scrutiny of audit committees, whose role as the protector of investors’ interests now attracts substantially higher visibility and expectations. These developments also have resulted in an increase in the audit committee’s workload. Today’s audit committee faces the formidable challenge of effectively overseeing the company’s financial reporting process in a dramatically changed corporate governance environment.

The issuance in July 2006 of FIN 48, which became effective for fiscal years beginning after Dec. 15, 2006, created some anxiety and uncertainty in boardrooms and audit committees, especially as its effective date approached. The goal of FIN 48 is to reduce, through the use of consistent criteria, diversity in approaches to recognizing, measuring, and presenting income taxes for uncertain tax positions. The complexity of FIN 48, however, led to questions regarding its application and the major technical and practical consequences it holds for public companies. Its implementation is having significant consequences for many companies, most notably increased financial statement disclosure of uncertain tax positions.

As part of the transition to the new requirements, companies must review their outstanding reserves for open issues in prior years. Successfully ensuring ongoing compliance with FIN 48 will be time-consuming, requiring the efforts of a company’s tax and accounting professionals and, as appropriate, the assistance of external advisers. Companies need to consider whether their processes, policies, controls, and documentation are adequate.

The SEC recognizes the critical role that is played by audit committees in assuring the quality of public company financial disclosures. Nonetheless, many audit committee members have been understandably uncomfortable about the amount of time they have spent understanding their company’s tax issues, including accruals for tax exposure items. Now, because of FIN 48, companies and their auditors are going to be spending a great deal of additional time in this area, and audit committees need to figure out how to tap into the results of that additional scrutiny from much more than the perspective of the new rule. For example, the audit committee members will need to consider and resolve two fundamental questions when evaluating the company’s tax position:

How aggressive or conservative is the company with respect to the tax positions it takes in its returns? If the company has been aggressive, it’s potentially exposed to penalties and interest if tax authorities believe that what’s been done is not permitted. It also exposes a company to a certain amount of reputational risk. No member of an audit committee can be happy to learn the IRS has branded the company as a tax cheat. On the other hand, an excess of conservatism may result in the company paying far more in taxes than it’s legally obligated to pay. That’s poor stewardship.

How aggressive or conservative has the company been in accounting for the uncertain tax positions it has taken? Prior to FIN 48, there was no specific consideration of tax uncertainties in the accounting rules. As a result, there were varying practices employed to determine when losses or gains were required to be recognized. FIN 48 interprets SFAS No. 109, Accounting for Income Taxes, and makes it mandatory to evaluate tax positions in a two-step process: recognition and measurement. FIN 48 explicitly recognizes that there can be differences between tax positions taken in a tax return and amounts recognized in the financial statement.

The new requirements place a greater premium on management’s objectivity in recognizing gains or losses based on positions taken in connection with tax filings. Given the need for the audit committee to assess how the company has performed in this regard, the last thing any audit committee member should want is to find a significant discrepancy between what the company recognized and what the IRS and the courts ultimately allow. Neither would any audit committee want doubts raised about the independence of its external auditors because the audit firm has also furnished the company with tax advice. This leads to some new approaches on dealing with tax matters by audit committees.

Audit committee members should limit themselves to no more than three companies. Given the additional obligations imposed on audit committees as a result of FAS 109 and FIN 48, it should be apparent that members will need to expend considerable time and effort understanding tax treatment and the disparities, if any, between tax returns and financial reporting. By definition, this means there’s a limit to the number of audit committees on which any person can effectively serve.

Audit committee members need to devote time and energy to understanding the company’s tax returns, and the aggressiveness or conservatism of its tax positions. Audit committee members will, perforce, spend significant time with the key people employed in the key areas of the company, such as the CFO and controller, who are responsible (in the first instance) for the company’s decision whether to recognize gains or losses stemming from tax returns. In addition, audit committee members must be comfortable with the expertise and independence of the company’s external accounting, financial, and tax advisers.

In many circumstances, outside assessments of the tax returns should provide comfort for members of the audit committee. It is important that management’s positions on tax returns be carefully reviewed. Most audit committee members are not expert in taxation issues. Outside experts can provide a degree of comfort for the audit committee.

Consider developing a policy statement. It can be instructive and useful for a company to set forth in a policy statement what its practices are for determining tax positions and who will be involved in decisions about them. This will provide a guide for management that can avoid skewing approaches to meet the needs of any given reporting period.

“Tone at the top” cannot be overemphasized. Cultures of integrity, ethics and compliance, like charity, begin at home, and at the top. A corporation must have the right people in leadership positions—leaders who are truthful, transparent, and fair, just as they expect their agency and employees to be. Leaders must not only talk the talk, they must walk the walk.

An appropriate culture of compliance and ethics doesn’t simply happen. Directors, committee members, and senior executives aren’t born knowing or exuding it; it must continuously and repeatedly be taught, inculcated, and emphasized.

Audit committees should schedule periodic briefings on changes in the tax laws and the company’s policies with respect to its tax returns. Taxation issues are significant enough to warrant periodic briefings. In addition, the audit committee would do well to reassess the company’s policies, and how management is implementing them, regarding tax issues.

The right questions should be asked. Audit committees aren’t charged with deciding what the tax reserves should be, but rather with overseeing the process. This means that there are some critical issues audit committees should consider, including:

Who looked at the tax reserves?

What major issues were addressed?

What attention has been given to issues involving interest and penalties?

In what way have the proposed reserves changed from prior periods, and why?

Are there specific countries in which the company isn’t filing, where an argument could be made that a filing is required?

Are there states where an argument could be made that a filing is required but hasn’t been made?

What events, if any, have occurred since the date of the balance sheet?

What procedures does the external auditor employ to assess and evaluate the adequacy of uncertain tax reserves?

Are comparable competitors approaching their reserves in the same fashion? and

Has the IRS begun any review of the tax liabilities covered by the reserve, and if so, what indications has management received?*

Keep in mind that IRS revenue agents will review disclosures companies make in SEC filings. At a recent conference on FIN 48, IRS Chief Counsel Donald Korb reaffirmed the IRS’s position that its revenue agents will review SEC disclosures (see related Compliance Week article entitled, “Real Beneficiary Of FIN 48 May Be The IRS”). More to the point, he indicated that the IRS is likely to ask what a company’s reserves for its tax liabilities are before signing off on a settlement of tax claims. If a company has reserved a substantial amount for a tax liability, the IRS will be embarrassed if it settles for a smaller number, and then reads about the company returning the excess of its reserve. Excessive reserves may, therefore, result in higher IRS claims in settlement discussions.

Audit committees should ascertain whether their company’s tax exposure items would be DOA if discovered by tax authorities. Since IRS revenue agents will review corporate disclosures, one issue to consider is finding tax problems before the IRS. If one or more tax exposure items are unlikely to survive IRS scrutiny, the audit committee should consider, with the help of tax advisors, filing amended returns. In that way, a problem can be prevented from turning into a crisis, and a crisis can be prevented from turning into a catastrophe.

It’s important not only to do the right thing, but to be able to prove that you did. FIN 48 does not require extensive documentation of highly certain tax positions. And the SEC staff has said that companies do not need to provide supporting documentation for every last tax position. However, it’s always valuable to be able to demonstrate the care and thoughtfulness that was expended to get to the right result. This places a premium on good, although not excessive, recordkeeping.

In the movie “The Producers,” Messrs. Bialystock and Bloom failed to learn the critical accounting axiom—doing things straight up almost always avoids significant problems. In today’s environment, public companies and their audit committee members don’t want to become—or cause the companies they serve to become—a modern-day cautionary tale. One good way to avoid such a bad outcome is for audit committee members to understand what’s necessary to comply meaningfully with FIN 48—and to tackle their newly-imposed responsibilities with perspicacity and diligence.

*Many of these suggested questions were presented by Ray Groves at the Seigel & Associates Conference on FIN 48 (May 21, 2007).