Yet More Convergence: Tax, Audit Functions

Thanks to a growing number of laws and regulations, the tax, accounting and auditing sectors are increasingly overlapping, forcing professionals to pay more attention to the ramification of issues beyond their particular field of expertise.

“It’s been coming from several sources,” says Mark Luscombe, principal federal tax analyst for consulting firm CCH. “Perhaps there was too much isolation in the past: tax people working too much in isolation, audit not knowing as much about the tax function. But the [overlap] sometimes creates a problem in terms of expertise.”

Richard Howard, of CBIZ Accounting, agrees. As financial reporting has evolved, he says, the typical auditor has begun to encounter challenges well beyond confirming numbers on the balance sheet—“everything from accounting and financial reporting to some tax expertise to some knowledge of securities laws, as well as some valuation expertise.”

Auditors and other professionals have always had to reach out to experts who can “bring that expertise to bear on the situation,” Howard says, but that need is growing as rules get more complex, and the judgment and estimates required in financial reporting continue to increase. “People start to get concerned,” he says. “They like bright lines and rules; then someone can’t say they didn’t follow them.”

O’Neil-Hennig

Cherie O’Neil-Hennig, a professor of accounting at Florida State University, says the increased overlap “is going to require a differently trained workforce. You have to have financial accountants and auditors who are more familiar with tax [issues].” Although O’Neil-Hennig tries to address overlap matters with her students, she says it’s “going to take a while” for the educational system to catch up with how the real world has evolved.

A Tax Example: Schedule M-3

Luscombe says the overlap on the tax side has stemmed primarily from “the IRS attack on tax shelters” and the agency’s determination that differences between items booked on financial reports and those listed on tax forms “can be a tip-off for tax shelter problems.”

To reconcile those differences, companies must file a Schedule M-3 with the Internal Revenue Service. Schedule M-3 was first required for large corporations in 2004, and is being rolled out for S corporations and partnerships this year. Unfortunately, Luscombe says, the current schedule runs on for more than three pages and “is much longer than the old reconciliation [form], which wasn’t very detailed.”

“The IRS is trying to use this schedule M-3 as an audit technique to spot transactions,” Luscombe says. “In the past, book-tax differences weren’t necessarily something you needed to worry about. There are valid reasons to have book-tax differences. But [Schedule M-3] has caused people to be a little more worried that they will get more IRS scrutiny than in the past [with] book-tax differences.”

O’Neil-Hennig says the requirement that companies detail how financial net income differs from taxable income has resulted in a “huge change in recordkeeping.” Now, she says, “you have to identify those transactions, you have to track them, and you have to make judgments as to why those assets were recorded as assets or not.”

And that process needs to be an ongoing one, she says. “Every period that you issue financial statements you have to go back and reassess your judgments to see if any of [the reasoning] has changed.”

An Audit Example: FIN 48

On the accounting side, the overlap can be seen in the Financial Accounting Standards Board’s new Financial Interpretation No. 48, requiring that all U.S. companies apply a new method for evaluating the expected tax benefits from uncertain tax positions.

O’Neil-Hennig notes that under FIN 48, any tax liability recorded as a contingent liability (that is, one that will happen only if the IRS nixes a company’s proposed tax position) will need to adhere to Financial Accounting Standard No. 109, Accounting for Income Taxes. That requires companies to use an asset-and-liability approach for financial accounting and reporting for income taxes.

The premise of FIN 48 was that “firms were using their contingent liability tax approval as a cushion to manipulate earnings per share,” O’Neil-Hennig says. “Now, you can’t put any income tax accrual into the contingent liability account. You’re going to have to run it through FAS 109 or you have to record a specific liability. Both have to be disclosed in footnotes in the financial statements.”

As a result, Luscombe says, accountants will need to examine the tax reporting of those uncertain positions, and how they are handled on the financial statements. “Before, you could play kind of an audit lottery and take into account how likely the IRS was to find out about the transaction and audit it,” he says; those days of neglecting to say that the tax position is more likely to fail just because the IRS isn’t likely to find out about it are gone.

EXCERPT

Below is a portion of IRS guidance explaining how Schedule M-3 should be compiled by corporate tax filers.

Effective for tax years ending on or after December 31, 2004, the IRS replaced Schedule M-1 with the new Schedule M-3 for corporations with assets of $10 million or more. Corporations with assets of less than $10 million continue to use Schedule M-1.4

Schedule M-3 provides a complete reconciliation from financial accounting net income to taxable income in a standardized and detailed format. The transition from Schedule M-1 to Schedule M-3 will involve taxpayer costs the first year in terms of accounting systems and staff time. Schedule M-3 should not significantly increase taxpayer burden after the transition to the new accounting systems is complete. In fact, Schedule M-3 should lead to a net taxpayer burden reduction over the long term because the Service will be able

to focus its resources on the greatest compliance risks and accurately limit the scope of examinations …

The IRS considers SEC filed financial statements to be the most reliable of the three categories presented on Part I. Therefore, if SEC financial statements are filed, they must be used as the starting point for Schedule M-3. Moreover, because these statements are publicly filed and available without

necessitating taxpayer contact, the Service can use these statements in performing pre-audit review and analysis. This will enable Service personnel to perform time saving audit steps prior to contacting the taxpayer, and, in some cases, may result in the decision that an audit is not necessary.

A certified audited income statement is considered a “second choice” financial statement and may be used only if the corporation did not file a Form 10-K with the SEC for the particular tax year. These statements are considered reliable, but not as reliable as statements filed with the SEC. If, and only if, none of the foregoing is produced by a corporation, the starting point for Schedule M-3 is income per the corporation’s books and records or financial statements which are neither filed with the SEC nor subject to a certified audit. This is considered the last choice and the least reliable of the three choices.

Regardless of the type of income statement prepared, if a taxpayer is selected for audit, an IRS examiner will use Schedule M-3 to as a pre-audit analysis tool. This will typically involve reviewing the financial statements, including footnote disclosures, and taking note of any material book-tax differences and large, unusual, or questionable items. The examiner will then typically develop a list of expected book-tax differences that would be expected to be reported on Schedule M-3.

Source

Internal Revenue Service (Spring 2006)

Howard, of CBIZ, says he thinks there has been a tendency to “overanalyze” the effect of FIN 48 and read into it “new definitions for terms that have been defined for a long time.” But FIN 48 does “change the way people look at these positions, and creates a new model for when to record a new liability and when not to,” he says. Howard also notes that most companies should have internal tax experts who will have the skills to provide the necessary analysis.

The SOX 404 Factor

On the audit side, Luscombe says, Section 404 disclosures show that a major weakness in internal controls is tracking tax matters to be reported on financial statements. Indeed, a Compliance Week analysis of more than 400 companies found that one-third of them reported internal control weaknesses in 2005 related to taxes. “The Sarbanes-Oxley reporting on the audit side is leading to a lot more attention to how these transactions are being reported,” Luscombe says.

Howard notes that difficulties in straddling both Financial Accounting Standards Board and IRS requirements, to ensure that an accounting entry for one doesn’t undermine an accounting entry for the other, may well lead to overall concerns about internal controls that can mar SOX 404 certifications.

“To the extent you have a problem coming up with this information, that could be an internal control issue,” he says. “One needs to be continually cognizant of the fact that the inability to come up with estimates or interpret the rules could be a control issue that could fall under Section 404 certifications. You’re constantly having to think about other ramifications. It’s not isolated to one silo.”

Section 404 reflects the “new belief that corporations must be much more transparent in their transactions that differ with how they reported transactions for financial accounting and how they report it to the IRS,” O’Neil-Hennig says. “If auditors come to audit your tax accrual and you can’t explain what’s in your tax accrual, the presumption is that you lack internal controls over this process. If auditors say you have to restate a prior period because your tax accrual is wrong, that’s another indicator of a lack of internal control.”

The overlap of tax, accounting and audit functions is necessarily leading to a recognition “that you may need some expertise beyond your own,” says Luscombe. “You may need to develop a broader circle of experts to bring in and consult with.”