roots MHMMessenger Accounting for Uncertainty in Income Taxes MAYER HOFFMAN MCCANN P.C. AN INDEPENDENT CPA FIRM

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1 March 2012 MAYER HOFFMAN MCCANN P.C. AN INDEPENDENT CPA FIRM 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. roots TM our run deep 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 (Continued on Page 2)

2 (Continued from Page 1) 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 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 (Continued on Page 3)

3 (Continued from Page 2) 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. Smaller companies typically do not have in-house tax expertise and resources. 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. 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 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 ) Background Information Overview of FIN 48 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 (Continued on Page 4)

4 (Continued from Page 3) 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 (Continued on Page 5)

5 (Continued from Page 4) 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 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 aburczyk@cbiz.com or 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.