In the world of material weaknesses, taxes are emerging as one of Corporate America’s weakest spots in the financial-reporting process.
In a Compliance Week analysis of 400 companies that reported material weaknesses in their most recent annual reports, one-third attributed problems at least in part to taxes. They get sympathy from tax experts who say it’s one of the most complex, manual, and rushed parts of the reporting process.
Taxes are tough because they’re subject to two separate reporting systems in a myriad of jurisdictions. First, companies file tax returns with federal, state, and local authorities in countries and localities all over the world. Then they process those figures for reporting into financial statements to satisfy capital-market requirements.
Shoulders
“Tax accounting attempts to reconcile two different sets of rules: one set of rules for tax and another set of rules for financial reporting,” says Allen Shoulders, director of Tax 404 Services for Ernst & Young. “The complexity is in paying taxes under one set of rules but reporting them under financial-reporting rules and reconciling those two areas.”
Add to that the numerous taxes companies pay to numerous taxing authorities, and the complexity grows “exponentially,” Shoulders explains.
Confounding the process more recently: corporate-tax accounting swept up in the perfect storm of Sarbanes-Oxley, a regulatory crackdown on abusive tax shelters, and a skilled workforce shortage. Combined, the three are breaking the backs of tax departments at public companies.
Shoulders says Ernst & Young has done some tracking of material weaknesses, and determined that nearly 400 companies have reported or announced some sort of material weakness related to taxes. “Tax has remained one of the top reasons for companies having material weaknesses,” he insists.
Into 2006, Shoulders said tax-related restatements are ahead of the pace observed in 2005, when more than 100 companies restated to correct material problems with tax figures.
What Help There May Be …
Financial Accounting Statement No. 109, Accounting for Income Tax, issued in 1992, gives companies a roadmap for how to take their various corporate tax filings and turn them into line items in the financials statements. But, due to the fractured nature of tax reporting, executing the details of compliance can be exceedingly difficult.
“FAS 109 on its face isn’t a terribly complex rule or pronouncement,” says Kenneth Leikam, managing partner for lead tax services at Deloitte Tax. “However, applying it to a company situation depends on the complexity of the organization. It’s not done at the top level of the organization but at every single subsidiary. It’s doing the calculations down at the entity level, and each entity may be doing business in different jurisdictions.”
Financial Interpretation No. 48, issued by the Financial Accounting Standards Board in June, adds a new wrinkle to the complexity. FIN 48 requires companies to take a more conservative view of their tax liabilities when reporting them in the financial statements. “It requires companies to analyze or re-analyze their tax exposures from the very beginning,” Leikam says.
And now that Sarbanes-Oxley’s Section 404 requires companies to assess the control they have over tax reporting, that adds another dimension to the complexity, Shoulders says. “SOX has brought a whole new way of looking at the tax department,” he says. “Prior to SOX, tax had not been an area that was required to be looked at from a process standpoint.”
Because of the numerous offline, manual calculations and judgments involved in tax work, and the numerous inputs from multiple, global entities, it’s tough for companies to assert that they have control over all those processes, says Tom Windram, managing director of national tax for RMS McGladrey, a tax and accounting firm.
Windram
“When you have large multinational corporations, you rely heavily on the knowledge of the people in those countries, but there’s no way to verify the information coming from foreign entities,” Windram explains. “It’s tough to convince the auditor you have control over that when you don’t really know what’s coming in.”
TAX TIPS
Below are some tips on what tax departments should consider to ensure compliance with SOX Section 404, according to Allen Shoulders, director of Tax 404 Services at Ernst & Young:
Implement policies to cover the 5 R’s – Roles, Responsibilities, Reconciliations, Roll-forwards, and Reviews.
Assign a tax representative to the company’s disclosure committee.
Engage in tax-control rationalization; rely on company-level controls to limit tax-control testing.
Develop an annual tax SOX 404 calendar.
Re-assess and standardize tax/provision reporting packages.
Build and maintain auditable work papers to support income-tax balances.
Designate a global tax-risk manager and/or a tax-accounting manager.
Develop and deploy a tax-technical training curriculum.
Consider tax-provision software.
Prepare and retain documentation with the assumption it will be viewed by a third party.
Source: Allen Shoulders, director of Tax 404 Services at Ernst & Young
That is resulting in greater appreciation up the corporate ladder for the need for more focus on the tax function, Shoulder says. “Many companies have gained a lot of appreciation of the risks they have every day with their tax departments,” he says. “The risks are not just in filing a return, but in having a financial reporting error that could affect the stock price.”
Getting Reporting Straight
More focus would begin with more people being trained in the endless intricacies of the various tax rules. In an already tight market for talent, companies not only are looking to hire more people with the right skills in the right places, but also looking around inside the organization for people who can help in the tax area.
“Sometimes we see companies drawing on the financial-reporting side of the house and working them into the tax side of the organization, including folks from internal audit,” Leikam says. “We have seen a pickup in training, both in the U.S. and abroad. We’ve seen companies take roadshows out to their subsidiaries to make sure they understand the importance” of the tax function.
They need better tools, too, the tax experts agree. There are several software tools on the market that can help with certain aspects of tax calculations and reporting, but no single system exists that automates the process to the degree that exists in other areas of accounting, Leikam says.
“There’s no magic bullet, nothing that puts full control around the organization,” he says. “Certainly there are tax compliance programs, but they’re all pieces. There’s no comprehensive solution to the entire tax area. The market would welcome it, but defining what it is would be tough. Each organization is so different.”
Terpening
Robert Terpening, a tax partner with tax consulting firm BDO Seidman, says the system in place simply is not designed to collect tax information. “It typically takes eight months to calculate and file a federal tax return,” he says. “If it took eight months to close the books, people would be up in arms. There are a lot of manual, offline calculations, and to be compliant you try to do them in a short period of time. That’s why it’s so difficult.”
Terpening doesn’t see much hope that the situation will get any easier for companies anytime soon. “At least in my career, I can’t imagine the tax code getting less complex,” he quips. “Whenever there’s a change in the law, there are people trying to figure out how to circumvent it. When you read the tax code, you wonder how people came to wording it in a certain way that they have. It’s typically because they thought someone would try to circumvent it in one way or another, or they already had tried to circumvent it.”
The key for coping, he says, is for companies to ramp up their staffing and resources. “Companies need to focus on getting more qualified people into the process and figure out ways to employ technologies to do the work more quickly and gather the information on a more timely basis,” Terpening says.
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