Income tax accounting

Income tax accounting continues to be a "leader in the clubhouse" on lists that no one wants to lead, such as the number of restatements and Sarbanes-Oxley material weaknesses. The topic continues to be a troublesome area for companies both large and small.

Why the issues in this area? The reasons are numerous. The rules that must be followed come from multiple sources, including new disclosure requirements proposed by the FASB (see our In brief). A thorough understanding of the financial accounting rules can only go so far; to ensure you "get it right" in this area, the appropriate understanding of tax technical rules must also be obtained. Generally speaking, the expertise in these two areas may not always reside in the same professionals, so the income tax accounting arena also necessitates strong communication amongst multiple professionals due to the sheer complexity of the issues at hand.

Income tax accounting incorporates highly judgmental areas, such as valuation allowance assessments, as well as certain areas which have very prescriptive rules (e.g., intraperiod allocation, valuation allowance balance sheet classification). It requires the use of estimates and assumptions, which can be challenging for professionals to determine, and can result in the need for difficult judgments to be made at various points in time. In addition, there is generally a "timing difference" in terms of when professionals focus on certain aspects of income tax accounting. For example, although the year-end financial reporting function is a critical aspect in the year-end reporting timeframe, the income tax return for that same year is not generally a priority until several months after year-end.

In addition to the "everyday" complexities of income tax accounting, when acquisitions or divestitures occur, additional complexities often materialize in the areas of intraperiod allocation, permanent reinvestment assertions, and valuation allowance assessments.  Simply put, no transaction is "complete" without a comprehensive assessment of the income tax accounting guidance.

"Getting it right" in income tax accounting takes time, effort, coordination, appropriate resources and relevant knowledge. Without all of these critical pieces to the puzzle, the risk of a reporting issue is heightened, as is evidenced by the many restatements and material weaknesses in this area.
Chad Kokenge, Partner

Impacts to companies:

  • In a transaction environment, income taxes play a critical role in valuation, tax technical and financial reporting processes. Since income taxes cascade through virtually all transaction-related work streams, communication and coordination amongst financial reporting and income tax personnel is paramount to successful transaction integration. 
  • The ability to forecast a prospective effective tax rate post-acquisition, something considered to be a "must-have" by many tax directors, can only be done with appropriate consideration of the "day one" acquisition accounting impacts of income tax accounting.
  • Integrating acquired companies into pre-existing income tax accounting policies and procedures can be a challenge, and only appropriate planning can ensure an effective and timely integration.
  • The ongoing changes to tax regimes and tax laws require a continuous assessment of the latest law changes, in order to timely record the income tax accounting impacts of those law changes in the appropriate interim period.

What companies should do:

  • Develop an integrated plan for both financial accounting needs and income tax needs for any contemplated transaction, and ensure that all constituents are aware of the many work streams that naturally develop from a transaction, and how individual topic-specific work streams interact with other work streams.
  • Consider the need to reassess understanding of the latest income tax accounting rules for business combinations. Although changes went into effect in 2009, for many who have been out of the M&A space, these changes can be a surprise.
  • Establish a plan on the front end of a transaction that is aimed at integrating the acquired business into the Company's overall income tax accounting policies and practices. This can only been done with a detailed understanding of the target company's current practices.