Uncertainties Created by FIN 48, Accounting for Uncertainty in Income Taxes

By Arthur J. Radin

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APRIL 2007 - In June 2006, FASB issued FASB Interpretation (FIN) 48, Accounting for Uncertainty in Income Taxes—An Interpretation of Statement of Financial Accounting Standards (SFAS) 109, Accounting for Income Taxes. The interpretation deals with the treatment of the liability for tax risks; that is, the uncertainty that a tax authority will audit a filed return and assess additional income taxes. This issue relates to the “cushion” that has traditionally been included in liabilities to record such exposures. This issue has been around longer than any of us. Don Bevis, the drafter of Accounting Principles Opinion 11, told me that in 1967, when the Accounting Principles Board (APB) was evaluating that opinion on income taxes, the APB discussed the “cushion” but did not deal with it.

The interpretation says in its summary that: “diverse accounting practices have developed resulting in inconsistency.” Such inconsistencies have arisen because neither APB 11 nor SFAS 109 has dealt with this issue. While FIN 48 might reduce inconsistency, this author believes it creates larger problems.
The interpretation creates two primary standards:

  • Uncertain tax positions should be recorded on a more-likely-than-not basis; that is, if there is a 51% chance that the position would not be sustainable on its merits, a liability should be recorded (paragraph 7a); and
  • It must be assumed that the taxing authority 1) will audit the enterprise, 2) will address the issue, and 3) will have all information available to the taxpayer (paragraph 7a and b).

Furthermore, according to FIN 48 (paragraph 7c), “Each tax position must be evaluated without consideration of the possibility of offset or aggregation with other positions.”

Under the interpretation, “uncertain tax positions” include all areas of tax reporting, including whether to file a return, the allocation of income among jurisdictions, timing of income or deductions, and the inclusion or exclusion of income.

I believe that the interpretation creates an accounting model that is economically inappropriate, that may overstretch certain GAAP concepts, and that is excessively difficult to apply. The assumptions that the tax authority will audit and examine the issue with all facts available to the taxpayer is clearly at odds with the experiences of all tax professionals and almost all taxpayers. In a letter to FASB dated August 30, 2004, from the U.S. Senate Committee on Governmental Affairs (FASB File Reference 1215-001), Senator Carl Levin (D-Mich.) stated, “In 2004, due to the limited resources and funding, the IRS audit rate for businesses dropped to just 2 audits for every 1,000 businesses.” While it is not necessary to determine the exact risk of a federal audit, any practitioner and most taxpayers will testify that the risk of audit is quite low, except possibly for very large corporations.

The application of FIN 48 to uncertain tax positions relating to the states and local taxing authorities is even more difficult. While all U.S. businesses must file income tax returns, it is frequently unclear whether a state or local return is required. In relation to audits by states and municipalities, the risk of audits is even lower. Furthermore, the interpretation requires the incorrect assumption that in an audit all positions taken will be challenged. That assumption is not supported by most professionals’ experience.

Because of the conflict between FIN 48 and common experience, issuers of financial statements and their auditors will be evaluating, and possibly providing for, liabilities that will never be realized. FIN 48 indicates that such liabilities can be reversed with accrued interest after the statute of limitations expires. According to FASB Statement of Concepts 6, Elements of Financial Statements, “The essence of a liability is a duty or requirement to sacrifice assets in the future.” These liabilities would not require the sacrifice of an asset, but rather a later reversal of the entry. Clearly, liabilities would be recorded with little chance of an actual obligation to pay.

Issues Relating to State and Local Taxation

As previously noted, all U.S. companies must file U.S. income tax returns, but whether a state or local return is required is not always clear. The filing of such returns is related to whether a company has nexus, in a particular jurisdiction. Often a company may have none of the elements of nexus, but the chance sale by a salesperson, or the temporary storage of inventory in a state, may trigger a state liability where no returns were previously required and none will subsequently be filed. Many times there is little chance that the state will audit and assess a liability. The author’s experience has shown that state authorities rarely raise an issue of temporary nexus. When asked, many tax professionals inform their clients that state laws are not clear, and they will also indicate that, on audit, the states are more likely than not to assess tax. In addition, should a taxpayer question counsel on this issue, the response will almost always be that the law requires filing. I also doubt that any state would admit ignoring temporary nexus.

I believe that in most instances described in the preceding paragraph, companies would opt to not file state income tax returns. FIN 48 requires that a financial statement issuer record the liability and accrue interest and penalties annually. The difficulty here is that if a return is never filed, the statute of limitations never expires and the exposure never disappears. In other words, once this potential liability is established, it may never be reversed. For the remainder of the company’s existence, this liability will remain recorded, with interest and penalties accrued each year. The result appears to be intended to enforce rarely used state laws, rather than good accounting. Because the enterprise might never have to pay this liability, the author believes that the recording of said liability is incorrect accounting treatment.

Other Issues with FIN 48

The requirement that “each tax position must be evaluated without consideration of the possibility of offset or aggregation with other positions” is also contrary to normal experience. Tax practitioners routinely deal with audit examinations where a number of issues are raised. The normal procedure is to work toward a settlement that reflects compromise on both sides and is satisfactory to both the taxpayer and the taxing authority. These settlements often have little to do with the merits of a given position and more to do with the need of both sides to settle. (An approach generally referred to as “splitting the difference.”) When issues are referred to an appeals agency, a compromise is usually obtained. The standard used in FIN 48, whether the position is more likely than not to be sustained on its merits, is rarely the position taken during negotiation, although of course both parties will claim that their position will be sustained. The attitude of all parties tends to be, “Let’s make a deal.”

Beyond the issue of the risk of audit and detection, the more-likely-than-not evaluation creates significant problems for an issuer of financial statements and the independent financial statement auditor. Those of us who have pressed attorneys for an evaluation of whether a legal exposure is more likely than not to ripen into a real liability can testify that such an evaluation generally cannot be obtained. The more-likely-than-not standard requires a 51% evaluation, whereas reality is much softer. We have all lost “slam-dunks,” won other matters, or have the matters dropped where we have felt that clients were liable. The interpretation requires the recording of a “feeling” rather than the recording of a real exposure. Followed literally, FIN 48 would require flip-flopping as professionals reevaluated their views as to an exposure.

The interpretation’s standard as to examination risk is based on premises that do not stand up to scrutiny:

  • Paragraph B19 indicates that “Some Board members believe that accounting for tax positions based on examination risk … is analogous to reporting accounts payable based … on the amount that would be ultimately paid if the creditor filed suit to collect the liability.” I don’t see why it is analogous; more significantly, I don’t see why a company should pay more than the creditor would be paid if litigation was instituted.
  • FASB expressly rejected the SFAS 5 concept relating to unasserted claims. FIN 48 (paragraph B20) states, “The Board does not believe that guidance is applicable to tax positions because a tax return is generally required to be filed based on the provisions of tax law.” I believe that the guidance in SFAS 5 as to unasserted claims is indeed appropriate. I do not believe that the fact that the law requires the filing of a return overcomes the risk of audit and detection.
  • Paragraph B21 of the interpretation refers specifically to paragraphs of Concepts Statement 6 as to the definition of a liability, but ignores the reference made earlier to a liability being a claim on assets.
  • Paragraph B22 appears to refer to the recent inclusion of Schedule M-3 in the federal corporate return and the requirement to disclose “reportable transactions” as the standard’s position on no assumption of examination risk. This position has logic if one is addressing large tax-shelter transactions, or a very limited number of transactions. Applying this logic to the vast number of uncertain tax positions does not hold up.

The interpretation’s explanation of the logic of the more-likely-than-not standard does not really lend any support. Paragraphs B27 to B32 reject other approaches. FASB had originally proposed a difference between “probable” and “more likely than not,” although the dictionary indicates that the definition of probable is “more likely than not.” Having dismissed the stated alternatives, the interpretation concludes it is correct.

The ability to evaluate exactly what is required to support “more likely than not” is not resolved to my satisfaction. The board states that a legal tax opinion is not required. Because many of the issues I have addressed in my career, especially relating to state and municipal taxation, do not fit in “relevant statutory or case law,” we are left with no method of determining more-likely-than-not. Tax professionals responding to the draft of the interpretation commented on this difficulty, resulting in a change from the draft to include: “When the past administrative practices and precedents of the taxing authority in its dealings with the enterprise, or similar enterprises, are widely understood, those practices and precedents shall be taken into account.” Because of the narrow definitions inherent in the preceding sentence, I believe it is unlikely to be useful unless the taxpayer’s tax professional has had experience with a number of clients with regard to that issue and taxing authority.

Moreover, I think the explanation in paragraphs A12 and A13 is based on a trivial example. A more substantive example, which I have encountered, is that an enterprise has not filed for many years in a particular state. What would be the attitude of the state? Many factors would enter, including who brought the issue to the state’s attention; the potential tax; and the state’s present revenue pressures. Obviously, a taxpayer would not necessarily have knowledge of these issues, some of which might change over time.

A Proposal to Resolve the Issue

Accounting professionals have been providing for uncertain tax positions for decades, using various approaches to the above scenarios. Generally, the future liability is discounted for the risk of audit and detection, then evaluated as to the most likely settlement. I have seen a liability recorded that would not be required under FIN 48: where an audit is expected and the experience of the taxpayer is that the auditor will not leave without some assessment and an amount is provided for such an audit, even though there is no issue that can be evaluated.

My recollection of income tax footnotes, over many years, is that one is more likely to see a take-back of an excessive reserve provided in prior years than one is to see a sudden additional provision for an audit. Although my experience is admittedly anecdotal rather than scientific, it supports the position that, historically, the accounting approaches to this issue in financial statements are not inappropriate.

I recommended a solution to FASB in my response to its exposure draft: using the methodology in Statement of Concepts 7, starting with paragraph 42 and with the example in Appendix A. While those paragraphs and the example relate to the evaluation of an asset rather than the evaluation of a liability, I believe that the technique is entirely appropriate for uncertain tax positions. Factors such as the risk of an audit, the risk of the item being challenged, and the possibility of settlement, could be built into the alternative percentage risks and then evaluated proportionately. As an audit is started or an item challenged, the risk weighting would be adjusted. The issues of recorded liabilities being reversed when the statute of limitations has run out, or eternal liabilities being recorded, would be eliminated.

After studying FIN 48, I have difficulty determining why FASB came to the conclusion it did. It would appear that one factor was the aforementioned letter from the U.S. Senate. This letter appears to stress the importance of income tax collection and not the appropriateness of financial reporting. It states:

If for financial statement purposes, a business were also allowed to consider this audit statistic [as indicated above] when assessing whether it was “probable” that questionable tax benefits would be sustained, the low probability of audit would consistently skew such reports. In addition, even companies audited by the IRS often work out settlements that may aggregate questionable tax positions with less questionable tax positions or allow benefits that would normally be prohibited.

I do not believe that easing the collection of taxes is a proper function of financial reporting. While, as a citizen, I agree that the tax laws should be enforced, the function of financial statements is to report economic events. The issue related to uncertain tax positions for a tax professional is not the enforcement of laws, but rather the requirement to enforce uncertain laws, a much more complex issue. To some extent, FIN 48 shifts to outside auditors yet another requirement to enforce uncertain laws. I do not believe that is an appropriate function for the profession.

Nothing I have said is intended to undercut the position that my firm, and every responsible tax professional I know, have undertaken to do the best possible job to ensure that clients follow the law and file appropriate returns. Some of us are more aggressive than others. The various applicable laws and cases do not make it easy, however, and not all of us agree on the proper approach on any particular matter.

Arthur J. Radin, CPA, is the managing partner of Radin Glass & Company LLP, New York. N.Y. He is a member of the NYSSCPA’s SEC Practice Committee and the Large and Medium-Sized Firms Practice Management Committee.




















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