Dig Deep To Ensure FIN 48 Tax Compliance

Calendar year-end companies preparing to close the books should be digging deep into tax documents today to comply with a new tax-reporting rule that effectively goes into force with the end of fiscal 2007, according to recent professional accounting guidance blessed by the Securities and Exchange Commission.

Financial Interpretation No. 48, which becomes effective in the first fiscal year beginning after Dec. 15, 2006, requires companies to take a closer look at all their unresolved tax positions with tax authorities and report them on their financial statements with a new level of candor. Companies must assess each outstanding tax position as it proceeds through reporting to tax authorities and, for any position less than 51 percent likely to be approved, to establish a percentage of likelihood that the position will survive any challenge mounted by tax authorities.

Although the interpretation goes fully into effect with year-end 2007, companies are required to make related disclosures in their interim reporting periods, according to a discussion paper issued by the SEC Regulations Committee of the American Institute of Certified Public Accountants and approved by SEC staff.

Salus

In fact, companies should be tallying up their FIN 48 effect now, says Larry Salus, senior manager at True Partners Consulting, to comply with SEC Staff Accounting Bulletin No. 74. SAB 74 mandates that companies disclose at the end of the current year the effect of any significant change in accounting policy that they expect to adopt in the following year.

“Even though this is being adopted for 2007, [regulators] are saying you have to have those disclosures ready to go on Jan. 1,” Salus says. “It’s been a real scramble for a lot of companies trying to get this all in place right now.”

The AICPA committee discussion paper says companies are confused about exactly what to disclose (and when to disclose it) because the SEC staff traditionally has required interim-period disclosures when companies are adopting a new accounting standard. For the purposes of FIN 48, that means calendar-year companies would include disclosures in their first 10-Q of 2007.

The AICPA committee, however, points out that FIN 48 “does not require (or permit) retrospective application. Accordingly, when a company first adopts FIN 48 in a quarter, it is unclear how to approach the initial disclosure of information that relates to annual periods.”

The AICPA committee met with SEC staff in September to hash out a solution, which the committee maps out in its discussion paper. The disclosure list focuses on what companies should disclose as of the date of adoption and what they should disclose in interim periods following adoption.

The guidance says companies need not provide an itemized list of unrecognized tax benefits in the first 10-Q of 2007, but should provide a total dollar figure for unrecognized tax benefits as of the date of adoption. Companies also should have a dollar figure attached to the total amount of unrecognized tax benefits that, if recognized, would affect the company’s effective tax rate.

Further, the guidance says companies are not required to provide a tabular reconciliation of unrecognized tax benefits in interim periods, but are required to disclose any material changes as they occur. For example, if a company has a material change in unrecognized tax benefits because of tax positions taken in a current period or a prior period, those must be disclosed in each interim period. Companies also should disclose any material settlements with tax authorities or any change in unrecognized tax benefits that occur because the applicable statue of limitations has passed.

Preferability Letter?

As companies prepare to adopt FIN 48, they may want to rethink how they have classified interest and penalties on the income statement, Salus says. For example, companies may have reported interest and penalties as an operating cost, but now would prefer to lump it into taxes, or vice versa.

Such a change in classification typically would require a “preferability letter,” in accordance with Financial Accounting Statement No. 154, Accounting Changes and Error Corrections. That’s a process in which a company has to take its case to the external auditors and get their blessing on such a change to secure a letter of preferability.

Q & A

An excerpt from SAB No. 74 follows.

QUESTION 1: Does the staff believe that these filings should include disclosure of the impact that the recently issued accounting standard will have on the financial position and results of operations of the registrant when such standard is adopted in a future period?

INTERPRETIVE RESPONSE: Yes. The Commission addressed a similar issue with respect to SFAS No. 52 and concluded that “The Commission also believes that registrants that have not yet adopted SFAS No. 52 should discuss the potential effects of adoption in registration statements and reports filed with the Commission. The staff believes that this disclosure guidance applies to all accounting standards which have been issued but not yet adopted by the registrant unless the impact on its financial position and results of operations is not expected to be material. Management’s Discussion and Analysis (“MD&A”) 4 requires registrants to provide information with respect to liquidity, capital resources and results of operations and such other information that the registrant believes to be necessary to understand its financial

condition and result of operations. In addition, MD&A requires disclosure of presently known material changes, trends and uncertainties that have had or that the registrant reasonably expects will have a material impact on future sales, revenues or income from continuing operations. The staff believes that disclosure of impending accounting changes is necessary to inform the reader about expected impacts on financial information to be reported in the future and, therefore, should be disclosed in accordance with the existing MD&A requirements. With respect to financial statement disclosure, generally accepted auditing standards specifically address the need for the auditor to consider the adequacy of the disclosure of impending changes in accounting principles if (a) the financial statements have been prepared on the basis of accounting principles that were acceptable at the financial statement date but that will not be

acceptable in the future and (b) the financial statements will be restated in the future as a result of the change. The staff believes that recently issued accounting standards may constitute material matters and, therefore, disclosure in the financial statements should also be considered in situations where the change to the new accounting standard will be accounted for in financial statements of future periods, prospectively or with a cumulative catch-up adjustment.

QUESTION 2: Does the staff have a view on the types of disclosure that would be meaningful and appropriate when a new accounting standard has been issued but not yet adopted by the registrant?

INTERPRETIVE RESPONSE: The staff believes that the registrant should evaluate each new accounting standard to determine the appropriate disclosure and recognizes that the level of information available to the registrant will differ with respect to various standards and from one registrant to another. The objectives of the disclosure should be to (1) notify the reader of the disclosure documents that a standard has been issued which the registrant will be required to adopt in the future and (2) assist the reader in assessing the significance of the impact that the standard will have on the financial statements of the registrant when adopted. The staff understands that the registrant will only be able to disclose information that is known.

The following disclosures should generally be considered by the registrant:

A brief description of the new standard, the date that adoption is required and the date that the registrant plans to adopt, if earlier.

A discussion of the methods of adoption allowed by the standard and the method

expected to be utilized by the registrant, if determined.

A discussion of the impact that adoption of the standard is expected to have on the financial statements of the registrant, unless not known or reasonably estimable. In that case, a statement to that effect may be made.

Disclosure of the potential impact of other significant matters that the registrant believes might result from the adoption of the standard (such as technical violations of debt covenant agreements, planned or intended changes in business practices, etc.) is

encouraged.

Source

SAB No. 74 – Disclosure of the Impact that Recently Issued Accounting Standards Will Have on the Financial Statements (Securities And Exchange Commission)

The AICPA guidance says companies can make a one-time change in their classification of interest and penalties without securing a letter of preferability, and the SEC staff agreed with that position.

Both parties point out, however, that the release from a preferability letter is a one-time event upon adoption of FIN 48. “After the adoption of FIN 48, the SEC staff agreed that a preferability letter is required for a material change in a registrant’s accounting policy regarding the classification of interest and /or penalties on income tax contingencies,” the AICPA committee said in its document.

Analysis Today

The year-end disclosure that companies need to make to comply with SAB 74 won’t be lengthy, but must be carefully thought out, Salus says. “That disclosure is very high level. It’s not detailed, but you’re probably going to have to put a number in there. If you have to put a number in there, it means you have to compute that number now, before you issue your 10-K.”

Robason

Randy Robason, a regional managing tax partner with Grant Thornton, says the year-end disclosure could assert that a company doesn’t have enough information yet to assess the impact of adopting FIN 48, but that raises a credibility problem. “You have to disclose the number in the first quarter,” he explains. “Since the year-end and first-quarter reporting are so close together, it would be very odd to say ‘We don’t know what the impact is,’ and turn around a month later and say ‘The impact is …’”

Robason says there’s an even more compelling reason to do careful analysis around the year-end disclosure. “In the period you adopt FIN 48, you have to consider the entire impact and book the entire impact in the first quarter,” he says. “If there are any changes after that, unless they are due to a change in facts, you have the potential to have restatements. You have to get it right the first time.”

The market is lagging in doing the analysis necessary to get a good FIN 48 figure into year-end disclosures, Robason warns, partly because of confusion over who is responsible for implementing it. “When the pronouncement came out, most tax people thought the auditors would deal with it, but the auditors thought it was a tax issue,” he says. What’s more, the analysis must take place among various tax professionals with expertise in state, local, federal, and international taxes, as well as with taxes related to compensation and benefits.

Now that crunch time has arrived and the detailed disclosures in the early part of 2007 will overlap the traditional tax filing season, “there’s a huge shortage of resources to help get this adopted in a timely fashion,” Robason says. “For the next year, I would say most tax people in the U.S. will be sold out.”

Robason contends that the market still hasn’t fully grasped the depth of analysis required to comply with FIN 48. “It doesn’t apply to just uncertain positions,” he says. “It applies to all positions, even if they’re certain. You still have to document why they’re certain and why you came to the conclusion. You have to go down the balance sheet for every item in the income statement and ask ‘What could be in here?’ and ‘How did I conclude it’s certain?’ You might only need three or four sentences, but you still have to have them.”

SEC Deputy Chief Accountant Scott Taub disputed the notion that FIN 48 requires such a line-by-line analysis. “Some are saying FIN 48 is being used to say you need an analysis of every position,” he said at a recent conference of the American Institute of Certified Public Accountants. “This just doesn’t make sense.”

Calling FIN 48 “blissfully principles based,” Taub said obvious positions require no new analysis. “We don’t need to make things harder than they really are.”

For uncertain positions, Robason says, companies need to provide additional analysis and judgment to attach a percentage figure to their level of certainty. “There’s nobody I know of that can tell you what 60 percent certain is, or what 70 percent certain is,” he says. “That’s not something we deal with in this industry.”

Future Implications

FIN 48 was intended to make companies’ uncertain (some would say aggressive) tax positions more transparent to readers of financial statements. Critics say it simply gives the Internal Revenue Service a roadmap to audit a company’s aggressive positions, because it forces them to document where they suspect they are treading on thin ice.

Now that they are required to expose their uncertainties, would it be easier to just abandon tax positions that are less than 51 percent certain of being sustained, to spare the grief of new financial reporting requirements?

Joffe

“It would strike me that if companies are compelled to create a roadmap for the IRS about where they’ve been aggressive on positions, companies might be more compelled to be conservative,” says Steven Joffe, senior managing director for FTI Consulting.

The decision will depend on a company’s appetite for scrutiny from its external auditors, IRS auditors, and perhaps potential litigants, Joffe says. It also may depend on how the market reacts if financial statements begin to portray some companies as more aggressive than others.

“Certainly in the 1990s, companies threw as much on the wall as possible to see what would stick,” he says. “But that was a situation where it had to be discovered first. It’s a whole different situation now that it’s listed in financials. It’s not about being discovered. It’s there. It would strike me there’s going to be so much more effort and tension, it will make companies more conservative in their tax positions.”