This issue of BoardroomDirect® from PwC highlights income tax accounting issues on complex tax reporting systems, income tax accounting standards, and uncertain economic times.
When it comes to accounting, income taxes is one of the more challenging areas companies are required to address. Given the complexities of accounting for income taxes, over the past decade it has been the cause of numerous financial statement restatements. Further, the tax-related control issues have resulted in both significant deficiencies and material weaknesses being reported.
To address these issues, companies have increasingly dedicated significant time and resources to tax accounting specialization. Over the last several years, we've seen income tax accounting comprise more than 50% of a tax department's budgeted hours in many cases. The use of outside service providers for significant income tax accounting support is also a trend that has increased. Despite this concerted effort, companies still struggle with this area for a number of reasons:
Audit Analytics, an independent research company, completed a study in April 2012 that looked at initial public offerings (IPOs) since 2004. The study reported that 563 of 1,827 companies had to restate their earnings, with income tax-related items among the chief causes.
Given this complex environment with the need for seamless coordination and alignment among various corporate groups, two of the most frequent areas of focus for regulators are: (1) management assertions about unremitted earnings of foreign subsidiaries and (2) the impairment of deferred tax assets.
"Within these judgmental areas, we’ve seen regulators increasingly point to the need for enhanced transparency in financial reporting around the factors that influenced these judgments" said Ken Kuykendall, PwC's Global Tax Accounting Services Leader.
With the continued growth in foreign earnings, tax accounting assertions in this area are of increasing interest. The accounting standard essentially requires companies to record a liability for the tax cost of repatriating foreign earnings unless management asserts that it will indefinitely reinvest the undistributed earnings.
In assessing the potential tax reporting for foreign earnings, a key consideration focuses on a company's business plan for those earnings. The company must have a specific plan for reinvestment that details the evidence supporting its assertion. Factors to be considered include the company's overall business strategy, its financial plans, and the structure of its investments. In this analysis, cross-functional collaboration is imperative.
"The indefinite reinvestment assertion continues to be an area of deep interest by companies, regulators, investors, legislators, and the financial press," said Jennifer Spang, a PwC partner in the firm's national office. She observed that these groups have focused on this assertion in the past several years given the economic challenges facing a number of businesses. In such an environment, the availability of liquid funds becomes particularly significant, as well as the tax costs, which could limit the transferability of funds among entities within a group.
Disclosures in this area are important as well. The standard requires that companies disclose their unrecorded deferred tax liability or make a statement in their footnotes that it is impracticable to do so. We've seen a recent focus by the SEC staff where it questions whether it is impracticable to calculate the deferred tax liability for a particular company.
We have also seen some standard-setting activity in this area. The FASB recently issued a proposed standard regarding the disclosure of liquidity risk. As part of that proposal, the FASB would require narrative disclosure of the tax impact of transferring funds.
"Over recent years, investors have become aware that cash listed on a balance sheet may be available for application in the United States only after paying possible foreign withholding tax and U.S. tax if the foreign rate was less than the U.S. rate," said Karen Osar, an audit committee chair for Innophos Holdings and Webster Financial Corp. "Then it becomes a policy issue for management in discussion with the board regarding whether it is prudent to repatriate such cash or retain it overseas for future reinvestment."
The second major area where we see attention is the impairment of deferred tax assets. A realizability assessment of deferred tax assets is an ongoing evaluation that should be considered by companies on a quarterly basis.
Key to the accounting analysis is understanding the facts in a given situation and weighing that information based upon what is most objective. For example, reliance on projections, which are inherently subjective, in a case where cumulative losses exist can be extremely difficult and has often been questioned by the SEC staff. This area of income tax accounting is weighted more towards the past, which can be unique from other areas of accounting and may seem counterintuitive.
The decision of whether a deferred tax asset is impaired can require a company to work through a particularly challenging evaluation. The accounting model requires that companies make an assessment of the realizability of deferred tax assets at a jurisdictional level. This may be different than how management either strategically or operationally views the businesses.
The impact of impairment can be significant. A deferred tax asset may be built up over a number of years with a resulting substantial balance. On occasion the establishment of a valuation allowance has represented the largest one-off expense a company has ever recorded. A concern to companies is the perceived underlying message that an impairment of a deferred tax asset sends to the investor. While management may be optimistic about the future of the business, a valuation allowance can highlight some negative factors currently facing the company.
Some public company boards are adding income tax accounting issues to their agenda. Because of the complex tax reporting systems, income tax accounting standards, and uncertain economic times, all boards should consider doing a "deep dive" to understand income tax accounting risks. Some boards already cover topics in their agenda concerning taxes including: tax function resources, tax risk and corporate governance, cross-jurisdiction taxing authority enforcement, uncertain tax position management, the legislative landscape, and tax reform.
However, often times tax accounting has not been as high a priority on the agenda. In light of the financial statement risk, a basic understanding of key, high-stakes issues is important.