Transcript Slide 1

Common Traps for Tax Related
Restatements and Material
Weaknesses
December 16, 2011
Presenter: Wayne Hoeing, JD, CPA
Partner, Clifton Gunderson, LLP
Overview
• Since the passage of Sarbanes-Oxley, tax issues continue
to be a major cause of material weaknesses and
restatements
• 27% of US GAAP failures related to tax accruals and
deferrals according to a recent survey by Audit Analytics
(404 Dashboard Year 6 Update, October 2010)
• For further reading, see Deloitte’s 2011 publication,
“Material weakness and restatements, Is tax still in the
hot seat?”
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Top Tax Material Weaknesses
• Inadequate staffing and technical expertise
within the company
• Ineffective review and approval practices relating
to tax
• Inadequate processes to effectively reconcile tax
accounts
• Lack of documentation regarding tax provision
• Improper treatment/recording of tax expense
and accruals
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Situations Creating Tax Risks
• Poor communication/data sharing
• Business combinations
• Net operating losses and tax credits
• Stock-based compensation
• State taxes
• Foreign taxes
• Valuation allowances
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Basics of ASC 740
(formerly FAS 109)
• Current income tax provision (benefit)
• Deferred income tax provision (benefit)
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Identify book-tax temporary differences
Identify NOL and tax credit carryforwards
Determine the tax rate to measure assets/liabilities
Consider the need for a valuation allowance
• Presentation and disclosure
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Calculating Current Income Taxes
• Calculate current income tax using the
“regular” tax system after adjusting book
income for temporary and permanent
differences
• Alternative minimum tax (AMT) systems must
be considered
• Multistate and international tax calculations
required for material jurisdictions
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Examples of Permanent Differences
• Tax-exempt revenues
• Nondeductible expenses
 State, municipal interest
 Life insurance proceeds
 Domestic dividends
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Life insurance premiums
Nondeductible goodwill
Penalties and fines
Political contributions
50% of meals, entertainment
Club dues
Lease inclusion amount
Certain related-party interest
Obligations under buy-sells
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Examples of Temporary Differences
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Book & tax depreciation differences
Bad debt reserves
Inventory uniform capitalization
Estimated warranty reserves
Bonus accruals not paid within 2 ½ months
Deferred revenue book-tax differences (tax rules
generally provide for lesser deferral than GAAP)
• Stock compensation expense
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Deferred Tax Items –
Documentation and Reversals
• General considerations
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Prepare rollforward of gross temporary differences
Compute tax effect based on expected rate upon reversal
Classify based on related asset/liability
Be mindful of deferred items reflected in OCI
Scheduling reversal patterns generally not necessary
• Situations that may require scheduling
 Phased changes in enacted tax law
 Future utilization of NOL carryforwards
 Considering the need for a valuation allowance
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Communication/Data Sharing
Common Traps
• Failure to maintain pre-tax financial data in a manner consistent with the
legal entity structure (resulting in re-work before tax calculations can be
performed)
• Failure to plan for adequate time to complete tax provision calculations,
often due to poor data flow
• Failure to properly consider the impact of “top-side” entries on different
taxing jurisdictions
• Lack of, or late involvement of, tax professionals in key corporate initiatives
(debt restructuring, acquisitions, etc.)
• Failure of tax professionals to communicate key tax matters (i.e., 382
ownership change triggers, upcoming expirations of NOLs and tax credits,
recent tax law changes impacting the company, etc.)
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Business Combinations Tax Accounting Considerations
• Taxable vs. tax-free
• Goodwill
 Acquisition method (under ASC 805-740; formerly FAS
141(R))
 Tax effect of differences between income tax and
financial reporting basis should be recognized as
deferred items as of the acquisition date
 Adjustments to Tax VA’s or Acquired Uncertain Tax
Positions after the one-year measurement period are
now generally recorded to tax expense (Pre 2009 all
adjustments were recorded to goodwill)
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Business Combinations
Common Traps
• Failure to properly compute and record deferred tax
items as part of purchase accounting (book and tax
basis differences of assets and liabilities)
• Failure to consider carryover tax basis of assets in
nontaxable business combinations which resulted in
step-up/down for financial reporting basis
• Failure to consider the different characterization of
goodwill and the resulting deferred tax implications
(component one vs. component two goodwill)
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Net Operating Losses –
Common Traps
• Failure to consider IRC Section 382 limitations
on ability to utilize NOLs (i.e., change of
ownership provisions)
• Failure to properly consider reversal periods
and potential expiration due to statutes of
limitations
• Failure to calculate different NOL’s under the
different tax systems (regular and AMT, states)
• Failure to consider different NOL carryforward
rules in different jurisdictions
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Stock Compensation
Tax Accounting Considerations
• Only awards ordinarily resulting in a tax
deduction create a temporary difference
 Grant of NQSO results in DTA based on book
compensation recorded
 Grant of ISO or ESPP does not result in a DTA
because tax deduction is not certain
• Disqualifying disposition of ISO or ESPP results
in a permanent tax benefit in the income
statement based on lesser of the deduction or
cumulative book compensation expense
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Stock Compensation Common Traps
• Failure to properly track Additional Paid In
Capital (APIC) pool
• Failure to remove deferred tax asset upon
expiration of unexercised stock options (ie.
upon termination of employment)
• Failure to distinguish between ISO’s and NQSO’s
when tracking expense for financial reporting
purposes
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Multistate Taxation Common Traps
• Failure to consider different state tax treatment
of certain items (i.e., depreciation addbacks, bad
debts, charitable contributions, capital gains &
losses, etc.)
• Failure to address state nexus issues as the
company grows or operations change
• Use of blended vs. actual tax rates to calculate
deferred tax balances
• Failure to timely consider changes in tax rates
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International Taxation Common Traps
• Communication barriers!
• Failure to engage competent local tax specialists
to prepare foreign tax provisions
• Failure of parent to understand key aspects of
local country tax system in order to provide
adequate oversight
• Failure to comply with tax holiday requirements
• Inadequate transfer pricing documentation
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Valuation Allowances –
Common Traps
• Failure to adequately consider all available evidence
(positive and negative) to determine when a company
should provide for a valuation allowance against its
deferred tax assets
• Attempting to identify a mathematical formula to
determine when to release a valuation allowance
• Improperly considering reversals of DTLs on indefinite lived
asset as a source of future income (so called “naked
credits” issue)
• Failure to consider reversal patterns of temporary
differences in assessing need for a VA
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Valuation Allowance –
Tax Accounting Considerations
• Negative evidence
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Cumulative losses in recent years
History of carryforwards expiring unused
Future losses expected by presently profitable entity
Future effects of contingencies, uncertainties
Statutory limits on future realization of tax benefits
• Positive evidence
 Existing contracts or sales backlog
 Appreciated asset value over tax basis
 Strong earnings history
– Exclusive of current loss
– Along with evidence that loss is nonrecurring
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Valuation Allowance –
Tax Accounting Considerations
• Sources of Taxable Income (ASC 740-10-30-18)
 Reversals of taxable temporary differences
 Future taxable income exclusive of reversals and
carryforwards
 Taxable income in prior carryback years
 Qualifying tax planning strategies
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Uncertain Tax Positions –
IRS Trap for Everyone!
• FIN 48 required a reserve to be recorded for an
uncertain tax position unless it met the “more
likely than not”(MLTN) criteria that the tax
position will be upheld upon examination
• IRS Schedule UTP is now required for
corporations issuing audited financial
statements with at least one tax position that
must be reported for GAAP purposes
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UTP Guidelines for
Evaluating Tax Positions
• Assumed examination by taxing authority
 Must assume that examination will occur
 Must assume examiner has all relevant information
• Each position judged on its technical merits
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Positions evaluated independently of each other
Application of authoritative tax laws
Specific facts and circumstances of tax position
Considers administrative practices and precedents
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Presentation and Disclosure
• Accounting policies
• Deferred tax assets and liabilities
• Income tax expense
• Net operating loss and tax credit carryforwards
• Other disclosures
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Balance Sheet Presentation
• Income taxes currently payable (refundable)
• Deferred income tax assets and liabilities
 Associated with particular assets and liabilities
 Not associated with particular assets and liabilities
• Reduction of assets by valuation allowances
• Liability for unrecognized tax positions
• No right of offset between tax jurisdictions
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Income Statement Presentation
• Current income tax expense (benefit)
• Deferred income tax expense (benefit)
 Generally equal to change in deferred income tax assets
and liabilities
 Return to provision true-up items for temporary
differences should not impact overall tax expense
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Tax Footnotes
• What they will tell you:
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Is income taxed in jurisdictions other than the U.S.?
Are some available tax credits being recognized?
Are there tax attributes that may expire unused?
Have tax positions been claimed on returns that may not be
sustained on audit?
• What they will not tell you:
 What jurisdictions and at what rate of tax?
 Are all available credits claimed and/or recognized?
 What are the unrecognized tax benefits by jurisdiction?
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Reporting Trends
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Disclosures relating to unrecognized tax benefits have been notably vague, query
whether introduction of Schedule UTP will impact how companies approach
uncertain tax positions going forward
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Nonpublic companies must disclose the types of significant temporary differences
but don’t have to quantify the tax effects of each
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Per recent AICPA Accounting Trends & Techniques, examples of rate reconciling
items included:
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State taxes, net of federal benefits
Non-deductible stock-based compensation expense
R&D tax credits
Current year FIN 48 changes (increase or decrease)
Valuation allowance (increase or decrease)
US domestic manufacturing deduction
Foreign tax rate differential
Nondeductible expense
Goodwill impairment (where DTA not previously established, circa 2008-09)
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Conclusion and Wrap-Up
Questions?
Wayne Hoeing – 317-569-6266
[email protected]
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