MHM Messenger 6-12: Accounting for Uncertainty in Income Taxes

March 2012
MHMMessenger
M AY E R H O F F M A N M C C A N N P. C . – A N I N D E P E N D E N T C PA F I R M
A publication of the Professional Standards Group
Accounting for Uncertainty in Income Taxes
Accounting for income taxes is very much in the
public spotlight in 2012 as sweeping tax reforms
are taking center stage in election-year issues, and
standard-setters are reconsidering the accounting
rules for private companies. Taking the initiative in
these challenging times, the Financial Accounting
Foundation (FAF) selected “accounting for uncertainty
in income taxes” as the standard for its first postimplementation review. This standard was originally
issued as FASB Interpretation No. 48 (FIN 48), and it
has been widely faulted for:
1.not providing a commensurate amount of value
compared to the cost to implement,
2.raising the risk of adverse economic consequences
by providing a “roadmap” that leads tax authorities
to risky tax positions, and
3.for reflecting a standard-setting bias toward large
public companies.
In separate attempts to evaluate the concerns, the
FAF completed its review in January, and Congress
held hearings in February and March on the interaction
of tax policy and financial accounting rules and the
special challenges faced by smaller and closely-held
businesses.
How will your business be affected?
The FASB’s response to the FAF indicates that a
broad re-examination of FIN 48 is not warranted at
this time, but the FAF’s findings will be considered
when exploring potential differences for private
companies and resolving differences between US and
international accounting standards. To help companies
sort through the issues, this Messenger highlights
the FAF’s findings and provides helpful background
information on the reporting requirements, related
regulatory developments, and special challenges for
smaller and nonpublic entities.
1. FAF’s findings and areas for improvement
The FAF is the FASB’s parent organization, and its
post-implementation review (PIR) process is designed
to determine whether an accounting standard is
accomplishing its stated purpose. Overall, the FAF’s
report concludes that FIN 48 has resulted in improved
consistency and reporting of income tax uncertainties,
and the benefits to investors generally outweigh the
costs to preparers of applying the standard. But the
report also notes there is room for improvement,
mainly in meeting users’ needs for information that is
comparable across companies and predictive of actual
settlements and future cash flows.
Importantly, the report observes that smaller
companies incur more significant implementation
costs than public companies. These costs include
additional audit fees, external legal and accounting
expertise, and costs of documenting existing tax
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positions. The FAF’s research also confirms that
private companies and not-for-profit entities believe
FIN 48 demonstrates a standard-setting bias toward
large public companies. These findings may reflect
the fact that the effective date for pre-Codification
standard FIN 48 (which was issued in 2006 and took
effect with the 2007 year-end financial statements of
calendar-year public companies) was delayed twice
for nonpublic companies to give the FASB time to
develop additional guidance for not-for-profit entities
and pass-through entities, such as partnerships and
closely-held companies.
The report contains a number of recommendations
that might address the concerns identified in the
review, including:
• more outreach to financial statement users during
the early deliberation phases of a standard-setting
project,
• inclusion in future standards of a more detailed
statement of costs and benefits, and
• consistent policies and procedures for re-exposure
of new standards, including disclosures as well as
recognition and measurement.
2. Regulatory developments
Many of the concerns about the risk of adverse
economic consequences have arisen as a result of the
use of the accounting information by tax authorities,
including the Internal Revenue Service — which
is phasing in required disclosures about uncertain
tax positions on IRS Schedule UTP. More recently,
additional concerns have been raised about the tax
reforms being advocated as campaign issues for
the 2012 election year. Some fear these reforms will
benefit large public companies more than closely-held
private companies.
CEOs, accountants and Congressmen are all trying
to assess the potential effects of the combined
accounting and tax changes and the prospects for
adverse economic consequences or changes in tax
strategies. Here are a few key points to consider:
• IRS Schedule UTP requires disclosures of
uncertain tax positions. The IRS’s tax reporting
requirements took effect after FIN 48 was
finalized. Under the schedule’s extended phasein period for corporations, companies with total
assets of $100 million or more were required to
begin filing Schedule UTP starting with 2010 tax
years. The total asset threshold is reduced to $50
million starting with 2012 tax years and $10 million
starting with 2014 tax years.
• The IRS has indicated it will consider whether to
extend the Schedule UTP reporting requirement to
other entities, such as pass-through entities or taxexempt organizations. Some companies fear that
the risks of adverse economic consequences will
increase if foreign or state tax authorities decide
to require similar information in the future. For
more information, see www.irs.gov/businesses/
corporations/article/0,,id=221533,00.html.
• The House Ways and Means Committee is trying
to understand if the accounting rules affect how
businesses evaluate or respond to tax policy.
The Committee held a hearing in February to
discuss the interaction of tax policy and financial
accounting rules for publicly traded companies,
and it held a second hearing in March to focus
on the challenges faced by small and closelyheld businesses that must confront “tremendous
complexity” in accounting and in dealing with the
various choices of legal entities.
• The choices of entities for small and closely-held
businesses include C corporations (these entities
are taxed at the entity level and again at the
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individual taxpayer level when dividends are paid),
and pass-through entities, such as partnerships
and S corporations, (these entities do not pay
entity-level taxes but are taxed separately at the
individual taxpayer level). For more information,
see the announcements for the hearings on the
Interaction of Tax and Financial Accounting on
Tax Reform and the Treatment of Closely-Held
Businesses in the Context of Tax Reform.
3. Special challenges for smaller and nonpublic
entities
Today’s smaller and nonpublic companies face
challenges in both taxes and financial reporting.
Although FIN 48 took effect in 2009 for privately-held
companies with calendar year-ends, the application
of the standard still presents challenges for many
nonpublic entities for a variety of reasons, including
the following:
• Users of the financial statements of nonpublic
entities may have different information needs
compared with investors in public companies.
• The effects on earnings and cash flows of the
various tax reforms being considered now add
to the complexities and economic uncertainties
for smaller and non-public entities. The potential
reforms reflect ideas ranging from consolidating
existing pass-through rules into a “unified passthrough regime” to making it easier for closely-held
C corporations to convert to pass-through status,
or even subjecting some existing pass-through
entities to double taxation as C corporations.
The FAF’s recommendations relate primarily to the
first of these challenges. It remains to be seen if the
FASB will address the other challenges. If the effects
of the legislative and regulatory changes indicate the
environment has changed significantly, then perhaps
the FASB might reconsider the need for a broad-scale
re-examination of the standard. If not, then perhaps
the Board might consider changes of a more limitedscope, perhaps in subsequent discussions with the
IASB and/or proposed Private Company Standards
Improvement Council (PCSIC). (For a discussion of
the PCSIC, see MHM Messenger 13-11.)
• Smaller companies typically do not have in-house
tax expertise and resources.
Background Information
• The internal controls at smaller and nonpublic
entities may not be as robust or well-documented
because they are not subject to Section 404 of the
Sarbanes-Oxley Act.
Overview of FIN 48
• Smaller companies may not be subject to tax audits
as often as larger companies, with the result that
they have less audit experience to use as a basis
for forming their judgments about the likelihood of
sustainability on tax examinations.
• The effects on earnings and cash flows of the
disclosures that are required (or may soon be
required) by IRS Schedule UTP can be difficult to
predict.
The guidance in FIN 48 was developed to address
the diversity that had developed over the years
in the recognition, measurement and reporting of
uncertainties related to income tax positions. Highlights
of the basic requirements:
• The term “tax position” is defined broadly. It includes
the characterization of income on a tax return or
a decision to exclude reporting taxable income
on a tax return. It also includes the deductions or
credits taken or expected to be taken in an income
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tax return, a decision not to file an income tax
return or to classify transactions or entities as
tax exempt, and an allocation or shift of income
between jurisdictions, such as transfer pricing.
• As noted in the FAF’s report, FIN 48 does not
purport to represent the best estimate of income
tax cash flows. Instead, it uses a benefitrecognition approach. This approach requires
the use of a more-likely-than-not (MLTN)
recognition criterion and a measurement
methodology based on cumulative probability.
• The basic principle is that an entity can
recognize in the financial statements the
effects of a tax position when the probability is
more likely than not (greater than 50 percent)
that the position will be sustained based on its
technical merits upon examination by the tax
authority. In making the MLTN assessment, an
entity must presume that the tax position will
be examined by a taxing authority that has full
knowledge of all relevant information.
• If the uncertain tax position does not meet the
MLTN threshold, then no benefit is recognized.
Some accountants refer to this as the “cliff
effect.” A tax position with a 45 percent chance
of success is not recognized at all, while a tax
position with a 55 percent chance of success
is recognized and measured.
• The benefit to be recognized is the largest
amount (calculated on a cumulative probability
basis) that is more likely than not to be realized
on the ultimate settlement of the tax position,
even though this may differ (and often does
differ) from the amount actually settled.
Insights from the FAF’s review
To evaluate the effectiveness of FIN 48, the FAF
conducted research, surveys, questionnaires, and
interviews. Although the results are not statistically
valid, an analysis of the responses provided these
insights:
• Is the objective achieved? Overall, most
investors have been using the information
required by FIN 48 since the standard was
implemented. The types of usage differ: some
use it to predict the effects on future earnings
or cash flows; others use it to assess how
aggressive managements are in their income
tax strategies.
• Is it decision-useful? On balance, FIN 48
provides useful information for decisionmaking, but there are common threads of
dissatisfaction among preparers and users of
financial statements. Preparers generally feel
too much judgment is required to recognize
and measure tax uncertainties, with the result
that the information is not comparable across
entities and the amounts recognized do not
represent amounts expected to be settled.
Investors believe the information is useful for
some purposes, but it may not be a reliable
or verifiable predictor of risks from income tax
uncertainties.
• Is it operational? Preparers and accounting
firm practitioners are generally able to apply
the accounting standard, but this may entail
considerable discussions between the two due
to the level of judgment involved. For users,
small differences in judgments can lead to
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significantly different outcomes that impede
the comparability of financial statements
across entities. Further, the information may
be incomplete because of FIN 48’s required
assumption that a taxing authority has full
knowledge of the facts and issues and will judge
each uncertain tax position on its technical
merits. As a result, users may need to adjust
the reported amounts for an estimate of the
results of the settlement process, meaning the
amounts that will actually be paid to a taxing
authority following a tax audit.
• Any unexpected changes? The FAF found
FIN 48 has resulted in changes, but the
changes were not unexpected. Examples:
1.Companies required additional resources,
and this resulted in the hiring of additional
tax specialists, greater use of advisors from
law or accounting firms, and increased
levels of coordination between tax and
other functions.
2.Some
companies
adopted
more
conservative tax strategies, but it was
difficult to attribute this entirely to FIN 48.
3.Although companies did not observe any
unexpected changes in the behavior of
tax authorities, smaller entities continue to
be concerned about the “roadmap effect,”
meaning reduced leverage in negotiating
settlements with tax authorities. This tends
to be a concern for smaller companies
because they have fewer tax jurisdictions
to aggregate and therefore the disclosures
may make it more difficult to mitigate the
risk pertaining to any single tax jurisdiction.
• Any economic consequences? The study
did not identify any significant volatility in stock
prices or effects on valuations of entities as
a result of FIN 48. But the report notes that
it is too soon to determine the economic
consequences of IRS Schedule UTP (Form
1120, Uncertain Tax Position Statement).
Preparers are concerned that Schedule UTP
may result in adverse tax audit and settlement
consequences,
especially
for
smaller
companies.
For more information
If you would like additional information about
accounting for uncertainty in income taxes or
the FAF’s reports and post-implementation
reviews, please contact Andy Burczyk of MHM’s
Professional Standards Group or your MHM
service professional. You can reach Andy at
[email protected] or 913-234-1670.
The information in this MHM Messenger is a brief summary and may not include all the details relevant to your situation.
Please contact your MHM service provider to further discuss the impact on your financial statements.
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