Beware the tax GAAP.

No, that's not a typo. I am referring to the "tax GAAP," an increasing difficulty in establishing and maintaining best practices regarding tax accruals arising from the headlong collision of taxation and financial reporting.

The pace of change in tax law and financial reporting has left the business of tax accruals a mess. Some companies try to migrate to software that integrates with general ledger systems and tax returns, but software vendors are struggling with the pace of change too. Some vendors have added financial reporting to remain competitive, but it certainly adds to their challenges. Many companies continue to rely on tax provision templates and general ledger downloads, but those "offline" processes are difficult to keep current, and even more difficult to audit. Throw in the constant changes in state income and franchise taxes, and the goal of a stable system seems like a cruel joke.

Let's face it: Some companies continue to struggle with creating FASB Accounting Standards Codification 740 tax provisions. The reason is not rocket science: It is because of the dynamic status of tax law, the ever-changing nature of reporting and auditing, and the constantly shifting business environment and economy. It's tough to set up best practices when the system is constantly in flux.



The pace of federal legislation that affects taxation has been breathtaking over the past few years. The states have been busy too, with a plethora of legislation and tax-framing court cases. Don't forget foreign tax laws if your clients or company have foreign investments. Numerous regulations also have been issued (or sometimes worse, not issued) that implement and interpret legislation. Forms have been created with their related instructions; case law is still evolving with respect to earlier laws; and there is even talk of repealing laws recently passed.

When organizations are operating with lean staffing to reflect the challenging economy, accommodating that pace of change is nearly impossible. In addition to the general tumult of the tax environment, a few developments deserve special attention.

Consider Internal Revenue Service access to tax provision work papers. The IRS has always had access to the tax reconciliation work papers that reconcile the differences between balances in the financial statements and those on the tax return. The IRS had maintained a policy of restraint with respect to tax accrual papers, except in certain circumstances. That policy of restraint seemingly has changed. In IRS Announcement 2010-09, the IRS said that it had the right to compel the production of taxpayer risk assessments and reserve amounts, citing United States v. Arthur Young and a series of cases up to U.S. v. Textron Inc.

Also consider the migration from the "realistic possibility" standard to the "more likely than not" standard for recording tax positions. American Institute of CPAs Statement of Standards of Tax Services No. 1 previously relied on the one-in-three likelihood embodied in the realistic-possibility standard. For tax return purposes, IRC Section 6662(d)(2)(B) used a "substantial authority" standard that roughly correlated to 40 percent likely to be sustained. FASB Interpretation No. 48 initiated the "more likely than not" (greater than 50 percent) likelihood of being sustained for financial reporting purposes. That standard was low-hanging fruit for Congress, so IRC Section 6694 was modified to uphold the more-likely-than-not standard (Small Business and Work Opportunity Tax Act of 2007), and then back to the substantial authority standard (Tax Extenders and Alternative Minimum Tax Relief Act of 2008) to harmonize the tax preparer standard with the taxpayer standard.

If you combine a road map like that imposed by FIN 48/ASC 740 with legal precedent established under case law, the inevitable happens - Schedule UTP. IRS Announcement 2010-9 stated that the IRS intended to continue its restraint toward tax accrual work papers, but it indicated a requirement to disclose uncertain tax positions on Schedule UTP. Once the IRS imposes these disclosures, states surely will follow suit, perhaps with some specific states requiring documentation on positions.

Treasury Regulation 1.6662-4(d) stipulates the documentation level necessary to support the substantial authority standard. For tax positions, the tax accrual work paper for each uncertain position should identify the facts and circumstances giving rise to the UTP, as well as the law applicable to those facts and circumstances. FIN 48 essentially creates a path for the IRS to examine each uncertain position identified in a tax accrual. Access to work papers enables the IRS to focus its risk-based examination approach on just those transactions that companies were required to document under FIN 48.

The big development in financial reporting and auditing was the aforementioned FIN 48. FIN 48 creates a single model to address uncertainty in income tax return positions, and FAS 109, as modified by FIN 48, was codified into the ASC as ASC 740. When it comes to income taxes, ASC 740-05-5 states that there are two basic principles in this area, each of which considers uncertainty through recognition and measurement criteria:

Recognize the estimated taxes payable or refundable on tax returns for the current year as a tax liability or asset; and,

Recognize a deferred tax liability or asset for the estimated future tax effects attributable to temporary differences and carry-forwards.

ASC 740 prescribes the threshold a tax position is required to meet before being recognized in financial statements. That standard also provides guidance on derecognition, measurement, classification, interest and penalties, and accounting in interim periods, among others. ASC 740 applies to all tax positions, and covers tax return positions considered "routine," as well as those with uncertainty. The guidance is also applicable to pass-through entities, non-taxable entities, and entities whose tax liability is subject to a 100 percent credit for dividends paid.

A two-step approach is used for evaluating tax positions. The first step, recognition, occurs when an enterprise concludes that a tax position, based solely on its technical merits, is more likely than not to be sustained upon examination. Measurement is the second step, which is addressed if the requirement for recognition has been satisfied. The benefit of a tax position is the largest amount of benefit, determined on a cumulative probability basis, that is more likely than not to be realized upon ultimate settlement.

Another issue at play - that may not have had full effect yet, but could soon - is convergence with International Financial Reporting Standards. As the U.S. awaits a final Securities and Exchange Commission decision, the rest of the world is busy at convergence. If convergence eventually occurs in the U.S., changes to policies and procedures, and more education for staff, boards of directors, and investors, are inevitable.



For companies with subsidiaries abroad, IFRS challenges may already exist. Since most other countries are somewhere along the path to convergence with IFRS, many subsidiaries are already facing convergence issues for in-country reporting. IFRS may necessitate another "set" of foreign books with which there must be translation and consolidation procedures. The ability to extend ASC 740 to foreign subsidiaries can be challenging for many reasons, from the complexity of foreign tax laws to cultural differences. Some companies rely on a decentralized approach out of the necessity of relying on in-country tax and financial accounting expertise. As a result, incorporating disciplined ASC 740 evaluations of tax positions can be difficult in a multinational context.

Now try auditing those provisions. The Public Company Accounting Oversight Board issued Release No. 2010-006 on Sept. 29, 2010. That report included tax accruals as one of the areas deemed problematic in its inspections. The concern was largely focused on the accurate reporting and net realizable value of tax assets in an adverse economic environment. That report states: "Further, estimates made by issuers regarding the recoverability of deferred tax assets as well as the outcome of uncertain tax positions might require significant management judgment, which increases the risk of material misstatement, particularly in times of economic distress."

Inspection teams observed deficiencies that included firms' failures to:

Evaluate whether issuers placed appropriate weight on forecasts of taxable income in light of the uncertainty created by an adverse economic environment and the existence of recent losses;

Adequately test reductions in issuers' deferred tax asset valuation allowances; and,

Test the reasonableness of the assumptions used by issuers in estimating tax contingency reserves.

Relying on an external auditor is not an option. The PCAOB affirms Interpretation 101-3: "In cases where the client is unable or unwilling to assume these responsibilities (for example, the client does not have an individual with the necessary competence to oversee the non-attest services provided, or is unwilling to perform such functions due to lack of time or desire), the [AICPA] member's provision of these services would impair independence. Furthermore, under ET 101-3 provisions (also adopted by the AICPA after the board adopted its interim standards), when tax services are provided by the auditor, the engagement team has the responsibility to make a determination as to whether management has carried out its responsibilities under ET 101-3 and to document the work performed in making that determination. The standard is quite clear that, if management has failed to carry out its responsibilities, an independence violation exists. Consequently, the auditor would be unable to render an opinion."

As demonstrated, tax accrual is problematic to create, maintain and audit. The persistent problematic state leads to difficulties in completing the tax accrual in a timely fashion, in staff workload compression, and in expensive processes.



With all this legal and regulatory cacophony, tax function best practices are imperative, albeit difficult. Best practices should be policies, procedures and systems designed to repeatedly accomplish, or exceed, performance expectations with the minimum cost to establish and operate.

One way to approach best practices for the tax function is to use proven quality improvement processes. Usually those processes include planning, analysis, implementation/integration, monitoring, and feedback of some type. A good first step is to set goals for the process. Below are several goals to consider for the tax accrual process:

Prepare an ASC 740-conforming tax provision for the year-end (or month/quarter) on a timely basis;

Contemplate incorporation into a high-quality system of internal control that is readily adaptable to a Sarbanes-Oxley-compliant environment;

Be easy to audit, facilitating auditor compliance with SAS 109 and 110;

Be informed by best practices in tax department operations (benchmarking);

Communicate clearly and timely with all stakeholders in the project - no "surprises;" and,

Accomplish these goals while minimizing the overall cost of implementing ASC 740 best practices, the costs of preparing the tax accrual within the constraints imposed by the above goals, and the cost of auditing the tax accrual.

Good project management skills are needed to move forward. The current tax process should be documented, along with the desired state driven by the above goals and dimensions of success. A gap analysis will identify opportunities for improvement and guide the development of the process. An improvement team can identify alternatives, and evaluate those alternatives as they relate to the vision of the desired state for the tax function. These may include outsourcing elements of the tax accrual process, decentralizing some elements of the process, enhancing internal human resources, and acquiring tax provision systems.

Be sure to include flexibility. You can rest assured that the "tax GAAP" arising from our turbulent tax, financial reporting and business environment will continue at a brisk pace for the foreseeable future.


Edward R. Jenkins Jr., CPA, is managing member of Jenkins & Co. LLC in Spring Grove, Pa., an instructor of business at Pennsylvania State University — York, and a member of the Pennsylvania CPA Journal Editorial Board. Reach him at Reprinted with permission from the Pennsylvania CPA Journal, a publication of the Pennsylvania Institute of CPAs.

Register or login for access to this item and much more

All Accounting Today content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access