The Challenges of Transparency in Corporate Tax Departments
What Will the New Audit Documentation Requirements and FIN 48 Reveal to the IRS?

By Mark J. Cowan and Tom English

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OCTOBER 2007 - In the wake of the accounting scandals of recent years, standards-setters have aspired to improve financial reporting documentation and transparency. In particular, recent guidance with respect to section 103 of the Sarbanes-Oxley Act (SOX), “Auditing, Quality Control, and Independence Standards and Rules,” and FASB Interpretation (FIN) 48, Accounting for Uncertainty in Income Taxes, has put pressure on companies and their auditors to better articulate tax risks and exposures. At the same time, the IRS appears to be getting more aggressive in seeking access to tax accrual workpapers.

The confluence of these trends puts in-house corporate tax departments in a very difficult position. First, already overburdened tax departments will have to rise to the challenge of complying with the new documentation requirements. Second, the tax accrual workpapers, particularly with regard to tax exposures, must now be more detailed than ever. Should the IRS gain access to such workpapers, a company’s tax “secrets,” including aggressive tax positions and other tax “soft spots,” would be revealed. This disclosure would give the IRS the upper hand in audits and put corporate tax managers at a significant disadvantage.

What follows is a review of the efforts by accounting and auditing authoritative bodies to enhance documentation in the tax function, including the consolidated impact of guidance issued with respect to SOX section 103 and FIN 48; a discussion of how tax departments can cope with these new requirements; and an assessment of the risk posed by these new requirements in light of IRS policies on workpaper access.

Increased Audit Documentation Requirements

Historically, auditing rules for all companies were issued by the Auditing Standards Board (ASB), a private technical group created by the AICPA. Section 101 of SOX created the Public Company Accounting Oversight Board (PCAOB), a new private-sector, nonprofit corporation vested with the authority to issue auditing standards for companies that report to the SEC. Audits of companies that do not report to the SEC continue to be governed by the ASB’s standards.

The PCAOB issued Auditing Standard 3 (AS3), Audit Documentation, on August 25, 2004. The standard is effective for audits of financial statements for fiscal years ending on or after November 15, 2004. The standard was the result of SOX section 103(a)(2)(A)(i), which required the PCAOB to establish standards regarding audit documentation. It is one of the few specific items that SOX requires of the PCAOB, demonstrating the significance the law places on documentation and transparency. AS3 indicates that documentation includes “evidence obtained, and conclusions reached by the financial statement auditor” (para. 2). It requires the financial statement auditor to maintain documentation that has sufficient detail to allow “an experienced auditor, having no previous connection with the engagement to understand the nature, timing, extent and results of procedures performed” (para. 6) and “should include identification of the items inspected … [and] abstracts or copies of the documents” (para. 10). These items are to be maintained for outside reviewers such as “external inspection teams that review documentation to assess audit quality and compliance with auditing and related professional practice standards; applicable laws, rules and regulations” (para. 3).

Similarly, the ASB issued SAS 103, Audit Documentation (included in the AICPA Professional Standards at AU 339), effective for audits of all companies for fiscal years ending on or after December 15, 2006. It states that documentation “should include the identifying characteristics of the specific items tested” (AU 339.20). The documentation should demonstrate “the accountability of the audit team for its work by documenting the procedures performed, the audit evidence examined and the conclusions reached” (AU 339.8). Specific pieces of evidence should be included “if they are needed to enable an experienced auditor to understand the work performed and conclusions reached” (AU 339.6). If transferring a paper copy to another medium, “the auditor should apply procedures to generate a copy that is faithful in form and content to the original paper document” (AU 339.5).

While the above PCAOB and ASB standards are of recent vintage, financial statement auditors were already following similar procedures in practice up until the mid-1990s. In the 1990s, auditors began to stray from this detailed approach to documentation toward a more general policy in an effort to provide less detail for plaintiffs’ attorneys and to streamline audit files (e.g., auditors stopped identifying the specific invoices that had been tested). Compliance with these increased documentation requirements will return financial statement auditors’ documentation to pre-1990s levels and place greater demands on auditors and their clients. Audit files will have more detail about a client’s tax position, including potential tax exposures.

FIN 48

FASB issued FIN 48, Accounting for Uncertainty in Income Taxes, on June 13, 2006. FIN 48 interprets SFAS 109, Accounting for Income Taxes. FIN 48 is effective for fiscal years beginning after December 15, 2006. Once adopted, FIN 48 applies to all tax return positions taken by the company, including tax returns filed in prior years (para. 23). A full technical discussion of FIN 48 is beyond the scope of this article, but a detailed analysis can be found in Neil D. Kimmelfield, et al, “Accounting for Uncertainty in Income Taxes—The Effect of FASB Interpretation No. 48,” The Tax Executive, July–August 2006.

FIN 48 could represent a sea change in the way that companies report income taxes on their financial statements. While the basic framework of SFAS 109 remains the same, companies must meet a new threshold before they can report tax benefits on their financial statements. Under SFAS 109, companies would estimate the amount that would be reported on their income tax returns in current and future years and use that as a basis to report their current and deferred liabilities or assets. Diverse methods were then used to account for any additional tax that could become due because of aggressive tax positions. (See FIN 48, para. B2.)

While practice varied, many companies would use SFAS 5, Accounting for Contingencies, to determine whether a liability should be established for aggressive tax positions. Under the SFAS 5 approach, a liability had to be established only if it was “probable” that the company would owe additional tax as of the balance sheet date and such amount could be reasonably estimated. “Probable” means likely—generally a likelihood that is less than 100% but greater than 50%. In practice, most viewed an event as probable if it had a 75% or greater likelihood of occurrence. Larger companies that were regularly audited by the tax authorities would do an analysis showing their major exposure items and their chances of success with each. Corporate tax managers would then ensure that they maintained an additional tax liability at least equal to the added tax they would probably need to pay. Most companies would also provide for additional amounts, establishing a cushion against any unexpected fluctuations in their tax expense. Smaller companies that were not regularly audited by the tax authorities would often not do a detailed review of their tax exposure items.

Under FIN 48, SFAS 5 can no longer be used. Instead, tax benefits claimed (or to be claimed) on a tax return may only be recorded on the financial statements if it is “more likely than not” (a likelihood of more than 50%) that such benefits would be sustained on examination by the tax authorities or ultimately in court. This approach is the opposite of SFAS 5, under which a benefit claimed on a tax return was also generally claimed on the financial statement unless it was probable it would not be sustained on audit. Thus, unless the tax benefit was likely to be lost on audit, it was generally recorded. (For further detail on SFAS 5 analyses and pre–FIN 48 alternative views as to the proper recognition of tax benefits, see James R. Browne, “Financial Reporting for Uncertain Tax Positions,” Tax Notes, October 3, 2005.) Under FIN 48, a benefit cannot be claimed at all unless there is a more than 50% likelihood that it would be sustained on audit or in court.

In other words, under SFAS 5, a company generally reported a tax benefit unless it could establish that it had an approximately 75% chance of losing if the benefit was challenged (i.e., only a 25% chance of winning). Under FIN 48, a company reports no tax benefit unless it can establish it has a greater than 50% chance of winning if the benefit is challenged. In applying FIN 48, it is presumed that the position would be examined by the relevant tax authority and that such authority would have knowledge of the relevant facts (para. 7a).

Furthermore, per FIN 48 (para. 21), companies must annually disclose the gross amounts of unrecognized tax benefits and increases or decreases in the amounts during the year. The disclosures must include, in gross, the increases or decreases resulting from positions taken during current and prior years, settlements with tax authorities, and changes resulting from the closing of statutes of limitations. Even though this information will be provided in gross, it will provide more detail to investors and the tax authorities than in the past. (For an example of the presentation of these new disclosures, see FIN 48, para. A33.)

Under FIN 48, companies will need to apply more scrutiny to their tax positions than ever before. Smaller companies that are not regularly audited by the tax authorities, and thus did not worry about setting up a reserve for tax positions under SFAS 5, will be forced to critically evaluate their tax positions and exposures in detail—perhaps for the first time. (For further discussion of this issue, see William L. Raby and Burgess J.W. Raby, “Quantifying Uncertain Tax Positions,” Tax Notes Today, October 11, 2006.)

Larger companies that have historically performed an SFAS 5 analysis will need to apply even more scrutiny to document that their tax positions are more likely than not to be sustained. Because of the prior diversity in accounting for uncertain tax positions, the adoption of FIN 48 will affect companies in different ways. Some companies that used the SFAS 5 approach may see their tax liabilities increased upon adoption of FIN 48. Other companies may have, in the past, erred on the side of conservatism in recording tax benefits. Such companies may see their tax liabilities decrease upon adoption of FIN 48. (For a summary of some early FIN 48 disclosures, see, for example, Thomas Jaworski, “Tax Disclosures Week in Review: Time Warner, Others Foresee Sizable Effects from FIN 48,” Financial Reporting Watch, February 23, 2007.)

FIN 48 is likely to affect tax planning as well. Management is often concerned with whether the tax benefits resulting from proposed tax planning ideas can be recorded on the financial statements. Corporate tax departments will now need to run potential tax planning ideas or transactions through a FIN 48 analysis to determine the financial statement impact. This should be done when the transactions are being planned, in order to give management advanced warning of tax benefits that may not be recordable under FIN 48.

Consolidated Impact of AS3, SAS 103, and FIN 48

To support recognition under FIN 48’s “more likely than not” standard, a company must accumulate evidence to support its tax positions. FIN 48 (para. 5) indicates that the amount and type of evidence required are matters of judgment based on the particular facts and circumstances of the position. FIN 48 (para. B34) makes it clear that external legal tax opinions can serve as evidence that the more-likely-than not standard has been met, but such opinions are not necessarily required. In any case, evidence of some kind must be gathered and documented in order to conform to FIN 48 and SFAS 109. Presumably, this may take the form of legal memos prepared by a company’s tax department analyzing the facts and applicable tax law of various tax positions.

External auditors are likely to demand a substantial amount of evidence to support a company’s FIN 48 analysis. First, there will be uncertainty regarding how much evidence is required, given that FIN 48 allows for judgment in this area. Auditors will likely err on the side of requesting too much, rather than too little, support. Second, an auditor’s exposure has changed under FIN 48. Previously, when tax uncertainties were governed by SFAS 5, the auditor opined on a negative assertion: that the company did not have any unreserved tax exposures where it was probable additional tax would be due. Under FIN 48, the auditor is opining on a positive assertion: that the tax positions reported on the financial statements are more likely than not to be sustained. The auditor is put at a greater risk under FIN 48 and will therefore have a strong interest in obtaining substantial evidence to support the client’s assertion.

Once auditors have obtained the evidence, they must review it and, under the PCAOB and ASB standards previously discussed, document their review of this evidence. This documentation must be detailed enough to allow an audit professional with no prior involvement in the audit to determine, upon review of the workpapers, what audit work was performed, and assess the outcome of such work. Given the complexities of FIN 48 and the rigor of the new PCAOB and ASB documentation standards, it is likely that auditors will want to retain substantial documentation regarding the tax provision, such as legal memoranda in support of a client’s FIN 48 assertions.

In short, the confluence of AS3, SAS 103, and FIN 48 will result in tax accrual workpapers that are more detailed and informative than ever before. This poses two major challenges to corporate tax departments: 1) documenting the evidence the external auditors will demand in order to comply with FIN 48, and 2) assessing the risk that such documentation may be obtained by the IRS.

Improving Documentation

FIN 48 and the accompanying pressure on auditors to more fully document their work will put pressure on corporate tax departments to better assess, articulate, and document their tax positions. In this sense, FIN 48 adds to an already burdensome litany of new pressures on corporate tax departments.

The role of the corporate tax department has shifted significantly in recent years, and the stress of such changes has been evident. Over the past decade, corporate tax departments have evolved from cost centers, focused on efficiently complying with the tax law, to profit centers, focused on reducing the company’s effective tax rate. More recently, tax departments have had to adapt to the changing regulatory environment. On top of their normal tax compliance and planning functions, tax departments are now confronted with many new requirements, including compliance with the internal control requirements of SOX section 404, the newly expanded disclosure of book/tax differences on Schedule M-3 of the corporate tax return, IRS-mandated electronic filing of tax returns, and now FIN 48.

Compliance with SOX section 404 was particularly difficult for tax departments because of documentation concerns. In fact, in the first year of section 404 compliance, tax accounting was the second most reported reason for internal control material weakness disclosures. This is not surprising because, historically, tax professionals have not been overly concerned with standardized documentation practices. For example, many tax departments would use ad hoc “homegrown” spreadsheets to compute tax provisions and deferred tax amounts for year-end financial statement reporting. These and similar documentation issues became painfully clear as tax departments went through the first-year SOX internal control review. (For a detailed discussion of these issues, including best practices to address them, see Mark J. Cowan and Tom English, “Sarbanes-Oxley Section 404 and Mandatory E-Filing,” The CPA Journal, July 2006.)

To overcome the historic problems they have encountered in tax accounting, tax departments will need to train their personnel not just in the technical requirements of FIN 48, but in proper documentation techniques as well. This is an area where the internal audit department can help. For years, some public accounting firms have required tax professionals to participate in one or more financial statement audits. While some of this cross-fertilization may have been driven by staffing needs or state CPA licensing requirements, this effort also helped tax professionals gain an understanding of good documentation practice. This same practice is in place in many internal audit departments for management trainees. Many management development programs involve rotating management trainees through various departments, including internal auditing. This experience provides the trainee with an overview of the company and knowledge of good internal control practices. In-house tax professionals could benefit from such a practice. New hires would benefit from an internal audit stint that would ultimately provide a pool of tax professionals with the tools necessary to meet SOX internal control and documentation requirements and the FIN 48 documentation that the external auditors will require. This, of course, assumes that the tax department can spare new hires for such an assignment. Furthermore, internal audit departments can conduct sessions for tax professionals on documentation, or otherwise consult with the tax department on good documentation practice.

IRS Policy on Access to Workpapers

Once tax departments have successfully implemented FIN 48 and external auditors have complied with the new PCAOB and ASB documentation directives, the tax accrual workpapers will be very detailed—and a tempting target for IRS auditors. To properly assess the risk this scenario poses, it is necessary to understand the IRS’s position on requesting tax accrual workpapers. “Workpapers” can refer to both audit workpapers maintained by the external auditor and in-house documents supporting the tax accrual. For purposes of this discussion, any internal documents are assumed to have been provided to the external auditors as part of their SFAS 109/FIN 48 review. Internal documents that are not provided to the auditors raise certain attorney-client or work-product privilege issues beyond the scope of this article. That is, such documents may, in certain circumstances, be entitled to greater protection from IRS scrutiny. Given the discussion above on FIN 48 and auditor documentation requirements, however, it can safely be assumed that the most critical and revealing documents relating to the tax accrual have been reviewed by the auditor—and are thus subject to the rules discussed below.

The U.S. Supreme Court, in U.S. v. Arthur Young & Co. [465 U.S. 805 (1984)], recognized that the IRS has broad powers to examine tax accrual workpapers. In Arthur Young, the IRS was attempting to gain access to tax accrual workpapers prepared by the auditors of Amerada Hess Corp. The Court noted that communications between a taxpayer and its independent auditor were not privileged or covered by any sort of a work-product privilege. Auditors work for the public and, unlike attorneys, do not act as advocates for their clients. In fact, the Court noted that making accrual workpapers reviewed by the independent auditor confidential would make it appear that the auditor was an advocate for the client, weakening public confidence in the auditor’s independence and the perceived accuracy of the financial statements.

While Arthur Young made it clear that the IRS had broad authority to examine tax accrual workpapers, in practice the IRS requested such workpapers only in unusual circumstances. The IRS exercised restraint, perhaps out of fear of protests from industry and accountants that would result if the IRS began to routinely request tax accrual workpapers.

The restraint exercised by the IRS in the years after its victory in Arthur Young has begun to fade. In 2002, the IRS changed its policy and indicated that it would be more aggressive in requesting workpapers (see IRS Announcement 2002-63, 2002-2 C.B. 72). Between 1984 (when Arthur Young was decided) and 2002, the IRS requested tax accrual workpapers less than a dozen times. Since 2002, however, the IRS has requested tax accrual workpapers 92 times (Jesse Drucker, “Tax Battle: IRS vs. Textron,” Wall Street Journal, June 20, 2006, quoting Deborah M. Nolan, commissioner of the IRS Large and Mid-size Business Division.)

This acceleration in workpaper requests is largely driven by the government’s focus on tax shelters. The IRS, much like the PCAOB, ASB, and FASB, has been on a transparency campaign of its own. The target of this campaign has been corporate tax shelter activity. The detailed book/tax reconciliation in Schedule M-3, tax shelter (so-called “listed transaction”) disclosures, and mandatory electronic filing of corporate tax returns are examples of IRS attempts to streamline their audits and more readily identify aggressive tax shelter activity. Access to detailed tax accrual workpapers would give the IRS yet another powerful weapon in its audit arsenal.

The IRS’s current policy on requesting tax accrual workpapers is incorporated in the Internal Revenue Manual (IRM) section 4.10.20. The complete policy (including special rules relating to tax returns filed prior to July 1, 2002) is available online at
/irm/part4/ch10s23.html. The IRS divides the workpaper universe into three categories and then designates policies applicable to each one, as shown in the Exhibit.

At least for the time being, the IRS will request the tax accrual workpapers (presumably including the new FIN 48 materials) only if the taxpayer is engaged in a tax shelter (listed transaction or similar transaction), or under “unusual circumstances.” IRM elaborates on the unusual circumstances standard, indicating that the IRS should look to the taxpayer’s records as the primary source of needed information. The tax accrual workpapers should be requested only when the facts required for the audit are not available from the taxpayer’s records or third parties. Even then, only the relevant portions of the workpapers should be requested. Any request for workpapers under the unusual-circumstances standard must be approved by a higher-level IRS official. For example, in the case of an audit conducted by the IRS’s Large and Mid-size Business Division, the director of field operations must approve the request (IRM

Responding to taxpayer fears, IRS Chief Counsel Donald Korb indicated that safeguards were in place to prevent the IRS from broadening the scope of the unusual-circumstances test. Korb indicated that the IRS’s policy was designed to discourage taxpayers from engaging in tax shelter transactions. If the taxpayer engaged in a tax shelter, the IRS would request the workpapers. If not, the IRS would only request the workpapers in unusual circumstances. If the IRS were to get more aggressive in seeking workpapers from all taxpayers, the incentive to avoid tax shelter transactions would disappear. (See Thomas F. Carlucci, et al, “The Perfect Storm Gathers,” The Tax Executive, November–December 2005.)

Despite the restraint of current IRS policy and the reassurances by Korb, there is still cause for concern. First, the acceleration of workpaper requests in recent years suggests that the IRS may be pushing its policy as far as possible. Second, current IRS policy and Korb’s comments were made prior to the release of FIN 48. Since then, IRS officials have been sending mixed signals, sometimes indicating the IRS will stay the course with its policy of restraint and at other times indicating that its workpaper policy may be under review. With the new analysis and detail required by FIN 48, the IRS will clearly be tempted to be more aggressive in making workpaper requests.

Third, the IRS is clearly willing to take taxpayers to court in support of its workpaper requests, at least in the tax shelter arena. United States v. Textron, Inc. is currently pending in the U.S. District Court for Rhode Island. In this case, the IRS has accused Textron of engaging in several listed transactions and is therefore seeking all of Textron’s tax accrual workpapers. The outcome of this case may help define the parameters of the IRS’s power in this area, clarify whether any sort of work product privilege can apply in the tax accrual area, and shed further light on the how the IRS is implementing its workpaper policy. (For more on Textron, see Christopher M. Netram, “Summons Enforcement Action Filed for Tax Accrual Workpapers,” Tax Notes Today, May 2, 2006.)

To minimize the risk of IRS access, experts traditionally advised corporate tax departments to provide independent auditors only with summary information about their tax exposures (e.g., Thomas F. Carlucci, et al, “The Perfect Storm Gathers,” The Tax Executive, November–December 2005). The hope was that if the auditor was not provided significant detail, then confidentiality could be maintained, Arthur Young would not apply, and the work-product and attorney-client privileges would therefore be more likely to apply. Auditors’ reduced documentation practices in the 1990s, previously discussed, aided in this strategy. This approach is no longer feasible under FIN 48.

The AICPA professional audit standards instruct financial statement auditors to consider lack of documentation access or existence when forming an opinion on the financial statements. In general, client-imposed limitations on access to material information will result in significant report modifications, including the potential for a disclaimer of opinion (AU 508.24). These standards apply to all audits (both public and private) because AU 508 was adopted by the PCAOB as part if its interim standards. As noted above, auditors have more exposure in light of FIN 48 and will likely not settle for mere summary schedules in support of the client’s FIN 48 assertions.

More Disclosure, More Risks

The recent PCAOB and ASB documentation standards and FIN 48 should result in more accurate financial reporting, more useful information to auditors and investors, and better management of tax risks. At the same time, these new rules create compliance headaches for already overburdened corporate tax departments. Tax departments should consider using the experience of their internal audit departments to deal with this issue. The internal audit function is uniquely situated to provide assistance in this area because it involves internal control, tax, documentation, and audit standard expertise.

A more troubling problem, and one less easy to address, is that the new rules result in tax accrual workpapers that can provide the IRS with precise directions to the company’s tax exposures. While the IRS has historically restrained itself, it has been more aggressive recently in requesting tax accrual workpapers. With so much detail now required, the IRS may be tempted to be even more expansive in its scope.

Corporate tax departments are in a bind. They must provide their auditors with the tax exposure information required by FIN 48 in order to ensure an unqualified opinion. Withholding information from the auditors to keep it safe from IRS scrutiny is clearly not an option. Corporate tax departments need to keep this risk on their crowded radar screens, monitor IRS activity and the Textron case, and collectively urge the IRS to maintain its historic restraint.

Mark J. Cowan, JD, CPA, is an assistant professor of accountancy, and Tom English, PhD, CPA, is a professor of accountancy, both at Boise State University, Boise, Idaho.




















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