November 07, 2008
A Reprieve for Private Companies and Other Nonpublic Entities
Since the implementation of FIN 48 — an accounting standard dealing with uncertain tax positions — numerous questions and issues have arisen. We'll answer some of them but first, here is a little background information.
As you know, companies generally try to reduce their tax liabilities and postpone paying their tax bills by claiming various tax credits, deductions and exemptions. However, the positions taken on tax returns may not ultimately be accepted by the IRS and other tax agencies. FIN 48 establishes accounting rules to handle uncertain tax positions.
It also requires organizations — both businesses and not-for-profits — to disclose information on financial statements about their potential tax liabilities and the financial risks they pose. While public companies already must comply with the rules, the Financial Accounting Standards Board recently proposed giving nonpublic entities a reprieve from FIN 48.
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Here are some frequently asked questions to help explain the new requirements.
Q: What is FIN 48 supposed to accomplish?
A: The underlying goals of FIN 48 are to:
- Standardize how companies address tax liabilities.
- Make it more difficult for companies to use hidden tax reserves to manage earnings.
In the past, companies often took different approaches when determining how to record tax liabilities and benefits of tax-saving positions. Some entities assessed the likelihood of a position being accepted in the case of a federal or state tax audit. Others also included the probability of such an audit. While still others simply recorded tax liabilities based on what was filed on their tax returns.
FIN 48 puts an end to this diversity by standardizing the accounting for all income tax positions.
Q: What are the requirements?
A: FIN 48 provides a consistent two-step process in evaluating an entity's tax position:
- Step One - Recognition. Your company's management should determine whether available evidence indicates that its tax position will be sustained in an audit. The evidence must indicate that there is more than a 50 percent probability that the position would be sustained. This is known as the more-likely-than-not standard.
- Step Two - Measurement. For tax positions that meet the requirements of step one, a company must measure how much of the tax benefit should be recognized. If a company determines that it is unlikely that their tax positions will be upheld, the tax benefits are reduced for financial reporting purposes — in other words, the book liability is increased.
Examples of areas in which FIN 48 might apply include: a shift of income between jurisdictions, including international transfer pricing or a decision not to file a tax return in one state.
Q: Is there a recommended approach?
A: A top-down approach is working well for some entities. This approach identifies uncertain tax positions by considering both current and deferred risks, as well as internal controls and processes, so that all potentially relevant positions can be identified.
In any event, companies should develop an action plan to address the adoption of FIN 48. The plan should include a phased approach as follows:
Phase 1 - Planning;
Phase 2 - Identification of all tax positions and the appropriate unit of account;
Phase 3 - Recognition and measurement and
Phase 4 - Accruing interest and penalties and determination of classification and disclosure.
Existing Sarbanes-Oxley control documentation can help reduce some of the effort in this area. Also, management should consult with the company's accounting firm to review general ledger and transaction processes for each open year and each tax jurisdiction.
Q: When do companies have to comply with the standards?
A: For public companies, FIN 48 went into effect for fiscal years beginning after December 15, 2007. For private companies, the FASB issued a proposed rule to defer FIN 48 for all private companies until fiscal years beginning after December 15, 2008. This decision was made at FASB's October 15 meeting and there is a 30-day comment period. (The previous effective date for non-public entities was for fiscal years beginning after December 15, 2007.)
Q: What are some negative effects?
A: As a result of FIN 48 requirements, companies may experience more volatility in their effective tax rate from quarter to quarter — potentially increasing their tax rate, while lowering earnings. In addition, FIN 48 will likely affect how tax planning strategies are accounted for in financial statements. More aggressive strategies could result in some of the benefit recognized as a FIN 48 liability instead of deferred tax.
Also, bank management should be more aware of each transaction and whether recognition of the tax benefit is likely to exceed 50 percent. If a tax benefit is likely to be denied in an audit, a reserve must be set aside as an unrecognized tax benefit. FIN 48 requires companies to disclose interest and penalties related to tax disputes and to provide a 12-month outlook on possible changes in their reserve.
Q: Will more IRS audits result?
A: One frequent question is whether increased disclosures will lead to additional audits from the IRS and other tax agencies. That remains to be seen.
In any case, your company should be careful when developing disclosure procedures so that your tax position is not compromised. To gauge your tax risk, your accountant might compare any unrecognized tax benefit to several numbers, including the company's total liabilities and market capitalization.
Moreover, there is some concern that the FIN 48 disclosures might provide tax authorities with a roadmap to a company's sensitive tax issues, especially the 12-month look forward disclosure. There has been discussion as to whether the IRS will attempt to obtain a company's FIN 48 work papers as part of its normal audit procedures.
Historically, the IRS requests tax accrual work papers from a taxpayer only for listed transaction situations and other limited and unusual circumstances.
Q: What's next?
A: While the first year of FIN 48 requires public companies to compile a list of uncertain tax positions, the AICPA suggests that subsequent years of disclosure could be even trickier.
Here are just a few going forward questions that should be addressed with your financial advisers:
- How should the company put together roll forward reconciliations with the deferred tax balance sheet items as of the end of the previous year?
- What kinds of disclosures are needed to add or remove tax items from the previous year's accounts?
- How are true-up adjustments handled?
- How will the business account for tax law changes and judicial developments?
Your company's goal should be to comply effectively with these requirements while minimizing any negative fallout. Consult with your accountants regarding the technical aspects of FIN 48 regulations and compliance in your company's situation.