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Morris FAS 109 Tax Advisor Articles May 2005

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An article published in Tax Advisor Magazine - AICPA - about the impact of Sarbanes-Oxley on Accounting for Income Taxes under FAS 109

An article published in Tax Advisor Magazine - AICPA - about the impact of Sarbanes-Oxley on Accounting for Income Taxes under FAS 109

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  • 1. TaxClinicPractical Adviceon Current Issues Editor: Terence Kelly, CPA Partner BDO Seidman, LLP Phoenix, AZ ©2005 AICPA
  • 2. Accounting Methods & PeriodsThe AJCA’s FAS No. 109 ImplicationsThe American Jobs Creation Act of 2004 (AJCA), signed into law by President Bush onOct. 22, 2004, attempted to balance tax breaks for domestic manufacturers and tax relieffor multinational corporations and intended to provide U.S. manufacturing companieswith an economic edge for competing in the global economy. The AJCA’s financialreporting considerations began to materialize when accounting for income taxes in first-quarter 2005 financial statements. As a result, the Financial Accounting Standards Board(FASB) finalized two staff positions (FSPs) to provide guidance to companies and theirauditors on how to handle post-AJCA income taxes under Financial Accounting Statement(FAS) No. 109, Accounting for Income Taxes.FSP FAS 109-1The AJCA’s qualified production activities deduction (Sec. 199) is the lesser of 3%(increasing to 9% in 2010) of either a taxpayer’s “qualified production activities” incomeor taxable income, determined without regard to this deduction. Importantly, however, nodeduction is available if a taxpayer has a net operating loss (NOL) for the current tax year,or NOL carryovers that eliminate taxable income for the current year.Companies had to consider the AJCA’s changes to accounting for income taxes and applyFSP FAS 109-1, Application of FASB Statement No. 109, Accounting for Income Taxes, tothe Tax Deduction on Qualified Production Activities Provided by the American JobsCreation Act of 2004, to the first quarter of 2005. According to FSP FAS 109-1, after theAJCA, companies should account for the tax deduction on qualified production activitiesas a special deduction—a permanent difference—rather than as a rate reduction.Companies may have to consider the deduction’s effect on their effective tax rate indetermining the estimated annual rate used for interim financial reporting.Any benefit from the deduction has to be reported during the year in which the deductionis claimed. Separate disclosure in the effective tax rate reconciliation may be warranted.Due to the need for interpretation, some companies may have to record an accrual for apotential disallowance of the deduction. Further, state guidance on deductibility for statebusiness taxes is still unavailable in many jurisdictions.FSP FAS 109-2The AJCA provides a special one-time, 85% tax deduction of certain foreign earningsrepatriated to a U.S. taxpayer under Sec. 965, provided certain criteria are met, including: ©2005 AICPA
  • 3.  Investing dividends in the U.S. under a domestic reinvestment plan (Sec. 965(b)(4)(B)).  Obtaining an approval of the reinvestment plan by the chief executive officer (or official of equal standing) or the board of directors, within the required period (Sec. 965(b)(4)(A)).  Using the funds for certain qualifying activities (Sec. 965(b)(4)(B)).  Specifying the activities’ nature in the plan.FAS 109 requires recognition of a deferred tax liability for the excess of the book basisover the tax basis of investments in foreign subsidiaries or joint ventures. However, anexception for the excess attributable to undistributed earnings is provided in AccountingPrinciples Board Opinion No. 23, Accounting for Income Taxes—Special Areas, if theparent affirmatively asserts that the earnings are indefinitely reinvested outside its hometax jurisdiction.FAS 109 Paragraph 27 typically requires adjustments to deferred tax liabilities and assetsfor the effects of a change in tax laws or rates in the period that includes the enactmentdate. Because of FSP FAS 109-2, Accounting and Disclosure Guidance for the ForeignEarnings Repatriation Provision within the American Jobs Creation Act of 2004,companies, in applying FAS 109, now have more time to evaluate the AJCA’s effect ontheir plans for reinvestment or repatriation of certain foreign earnings. Without thisextension, they would have been required to examine their plans for reinvestment orrepatriation and apply FAS 109 in the enactment period.Although FSP FAS 109-2 extends time, it does not relieve companies of having to recordan appropriate deferred tax liability when they decide to repatriate earnings. In somesituations, they may have to use their judgment to determine when to repatriate earnings.Companies should not delay accruing a tax liability until they declare or pay dividends.However, under FSP FAS 109-2, certain disclosure requirements apply until a companydecides whether to repatriate earnings. Management will need to evaluate compliance withthe AJCA provisions to ensure that repatriated earnings qualify for the beneficial taxtreatment.Public companies subject to reporting under the Sarbanes-Oxley Act of 2002 (SOA) willwant to evaluate their controls in place to reasonably assure timely and accurate reportingof any changes in income taxes that may have resulted from changes in reinvestment orrepatriation plans.In the new world of the SOA, advisers interpreting complex tax law changes must nowassume even greater responsibility for accounting for income taxes under FAS 109. Thisstatement has not been revised, except for the two FSPs, since it was issued in February1992. Thus, tax advisers now find themselves not only interpreting complex tax guidance,but also interpreting complex accounting literature. Although the SOA has drawn the linebetween providing independent audit services and providing tax consulting services topublic companies, the two service groups—auditors and tax advisers—appear to needeach other’s expertise more than ever. By: Katherine D. Morris, CPA BDO Seidman, LLP - Atlanta, GA ©2005 AICPA
  • 4. Procedure & AdministrationAccounting for Income Taxes in the Post-SOA WorldThe Sarbanes-Oxley Act of 2002 (SOA) significantly changed the role of tax adviserswho provide services to audit clients. In addition to adhering to Financial AccountingStandards Board Statement (FAS) No. 109, Accounting for Income Taxes, advisers arenow expected to know and understand the constraints placed on services to audit clients,and their clients’ documentation and attestation of internal controls over tax-relatedfinancial statement accounts.Common issues encountered by tax advisers and auditors range from whether a companyhas the in-house, technical resources to competently handle tax provisions, internalcontrols and changes in the underlying tax laws, to whether the company should engageanother accounting firm to prepare and/or review its FAS 109 computations.Clients’ decisions will affect whether (1) they obtain a clean audit opinion, (2) theirinternal auditor can attest to internal controls being in place and being adhered to and (3)they can avoid disclosing a significant deficiency or, worse, a material weakness, in theirtax internal controls.This item reviews recent SOA developments in tax services and how the relationshipbetween tax advisers and their clients has affected the tax functions on which clients rely(such as determining tax contingencies).The DebateWhich tax services can be offered to public clients? Recent guidance permits providingcertain tax services to audit clients. Also, these services are subject to normal auditcommittee pre-approval requirements, including tax compliance, planning and advice.However, some services are prohibited, such as bookkeeping, valuation, fairness opinions,internal audit and management functions, for example. The guidance clarifies which taxservices impair independence. Such services include, but are not limited to, representingan audit client before the Tax Court, a district court or the Federal Court of Claims, andproviding other unique tax expertise. However, the guidance permits some specialservices, such as transfer-pricing and cost-segregation studies. Violations of theindependence rules can have serious consequences, such as loss of a client and a re-auditof its financial statements by new, independent auditors.Some audit firms are concerned about the lack of a clear “bright-line” rule on tax planningand advice. The absence of clarity has caused many firms to limit substantially how theyoffer tax services to public companies. To further complicate the picture, these concernsare seeping into private companies and nonprofit organizations; these entities’ boardmembers and advisers are now beginning to require the same level of scrutiny as publiccompanies. ©2005 AICPA
  • 5. The SOA empowered the Public Company Accounting Oversight Board (PCAOB) toimplement SOA provisions, by promoting the ethics and independence of registeredpublic accounting firms that audit and review U.S. public company financial statements.The PCAOB issued proposed guidance that identifies tax services that pose, and do notpose, an unacceptable threat to auditor independence. On Dec. 14, 2004, it votedunanimously to propose rules prohibiting a registered public accounting firm from:1. Providing certain tax services to public company audit clients;2. Providing any tax services to officers in a financial reporting oversight position (e.g.,chief executive officer (CEO) and chief financial officer (CFO)), after 2004 income taxfiling obligations are met; and3. Receiving contingent fees from public company audit clients.The rules also require specific written and oral communications between an audit firm andits client’s audit committee on the proposed allowable tax services the firm will provide;for details; see www.pcaobus.org, under “Rulemaking.”In response, three AICPA committees (the Center for Public Company Audit Firms, theProfessional Ethics Executive Committee and the Tax Executive Committee) jointlyissued comments, on Feb. 14, 2005 (available at http://www.aicpa.org/cpcaf/download/AICPA_Response_PCAOB_Docket_017_Comment_Letter.pdf ). In addition toaddressing the specific issues, the comment letter demonstrates the committees’ overallsupport of audit firms continuing to offer some tax services to public company clients,without impairing independence. For example, for financial executives of publiccompanies, the letter states, “…[We] believe that tax compliance and routine planningshould be permitted.”With respect to aggressive tax positions taken by a client that engaged a third-partyadviser for planning purposes, the AICPA committees believe that the client’s auditorshould be able to consult with its in-house tax specialists, without impairingindependence, even if the consultation results in a less risky alternative; this type of adviceis intended to enhance tax compliance and is in the “public interest.”The committees recognize that mechanisms currently exist to prevent inappropriateactions by CPAs that would violate independence. For example, according to the letter,“[n]umerous layers of statutory, regulatory and ethical safeguards already apply to theprovision of tax services by CPAs…the Internal Revenue Code imposes penalties andother sanctions…[p]ractice before the IRS is regulated by Circular 230…and the[AICPA’s] Statements on Standards for Tax Services….” Further, “[v]iolating these rulesof tax practice can subject CPAs to ethics investigations and possible sanctions by theAICPA and state CPA societies and potential license revocation by state boards ofaccountancy.” The committees continue to support provision of tax return preparation andconsulting services to publicly held audit clients. Tax advisers will have to watch how thedebate develops. ©2005 AICPA
  • 6. How the SOA Affects Auditing TaxesAs income taxes typically equal 30% or more of pre-tax income and represent significantportions of recorded assets and liabilities, taxes, in general, are a significant processsubject to the SOA’s requirements for adequate, auditable internal controls for accountingfor them. Under the SOA, public companies report on the adequacy of their internalcontrols, and auditors attest to the accuracy of the company’s report. Attestation ofinternal controls for tax is not limited to Federal, state, local and foreign income taxes, butalso includes all related tax matters (e.g., franchise taxes, sales and use taxes, excise taxes,value-added taxes, payroll taxes and property taxes, and tax reporting for employee benefitplans). The PCAOB standards clearly indicate that an audit firm cannot become a part of acompany’s system of internal controls. Thus, if a company is incapable of properlyaccounting for taxes without its auditors’ assistance, it has an internal-controls deficiency.Nonpublic CompaniesIn April 2003, the AICPA amended AU Section 9326, Evidential Matter: AuditingInterpretations of Section 326, which significantly changed the review and documentationstandards for accounting for income taxes for nonpublic companies. Independent auditorsare required to have sufficient evidence in their audit workpapers to support the adequacyof the judgments and estimates inherent in a client’s accounting for income taxes, to avoida scope limitation on their opinion. AU 9326 clarifies that the audit firm cannot rely on theadvice or opinions of a client’s other tax advisers; rather, it must reach supportableconclusions. Companies are now engaging tax advisers from firms other than their auditfirm to assist in FAS 109 compliance. AU 9326 clarifies that the audit firm’s tax advisersmust review FAS 109 computations in the same depth as if client personnel had made thecomputations. Thus, the SOA’s far-reaching arm now extends to nonpublic tax services.SummaryAn auditor’s use of the “tax specialist” for tax matters is more important than ever before.Clear guidance on tax services is needed to satisfy audit firms, CEOs, CFOs and auditcommittees. Even though there is clear support for tax professionals to continue to providetax services to audit clients, the debate continues. By: Katherine D. Morris, CPA BDO Seidman, LLP - Atlanta, GA ©2005 AICPA
  • 7. ©2005 AICPA