Recent Regulatory Movement
On July 21, 2010, President Obama signed the financial regulatory reform bill (Dodd-Frank Act) into law. One immediate effect of the bill was the permanent exemption of Section 404(b) of the Sarbanes-Oxley Act of 2002 (SOX(b)) for issuers with market capitalization of less than $75 million. This was met with much elation on the part of non-accelerated filers, given that the U.S. Securities and Exchange Commission’s (SEC) final deferral of SOX(b), which relates to the required auditor’s attestation on internal controls over financial reporting, expired on June 15, 2010. While the legislation does not affect the SOX(a) requirement, it nonetheless represents a burden lifted.
There is also a renewed focus on accelerated filers with market caps between $75 million and $250 million. The Dodd-Frank Act requires the SEC to complete a study on how to reduce the Section 404(b) audit compliance burden for these mid-market companies. The study will examine whether a reduced burden, or a complete exemption, would encourage companies to list on U.S. stock exchanges.
As a precursor to this mandated study, the SEC’s Office of Economic Analysis had conducted and published the “Study of the Sarbanes-Oxley Act of 2002 Section 404 Internal Control Over Financial Reporting Requirements” to help management and auditors reduce the cost of compliance. (Congressional reaction to the high cost of compliance is partially what led to the exemption provisions in the recently passed reform bill.) Results of the study included the fact that in-house 404 compliance costs or “internal labor costs” caused the highest financial costs to companies complying with 404, followed closely by external auditor fees.
With those facts as a backdrop, we come to a couple of weeks ago, when the SEC followed through on the mandate imposed by Section 989G(b) of the Dodd-Frank Act regarding compliance with Section 404(b) of the Sarbanes-Oxley Act. The SEC officially solicited comment from the public on how to reduce the burden on companies whose public float is between $75 million and $250 million that are currently complying with Section 404(b). The balancing act is that the SEC firmly believes it has achieved a level of investor confidence through these rules, yet it must find a way to mitigate the perception that companies may either list overseas or delist altogether, partly because of the onerous requirements and costs associated with SOX compliance.
Has SOX Changed Anything
Despite SOX rules being in place for many years now, the harsh reality is that many reading this article have either had a material weakness in taxes at their company or have known someone with a one. As a matter of fact, nearly one in five companies have reported a tax-related material weakness since the inception of SOX. And while the restatements occurring in financial statement filings have decreased somewhat over the last several years, the current statistic is that in 2009, a top-10 leading cause of financial restatement continued to be internal control failures specific to the tax reporting process.
The current economic environment hasn’t made it any easier on the tax function, either, as tax departments have had to grapple with the impacts of financial valuation and bad debt concerns, goodwill impairments, and other write-downs borne out of the market conditions. Add to that the fact that a struggling economy has led to staffing reductions in many corporate functions, and the need to manage risk in the tax function is as great as ever.
Consider, also, the unprecedented rate of financial statement change occurring in the U.S. right now, with the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) both working diligently on a set of convergence projects that affect everything from the most fundamental of areas, such as revenue recognition, to more technical yet widespread areas, such as lease accounting. Suffice it to say that the pending changes in the underpinnings of financial reporting will have significant impact on the tax function as a downstream process, whether through compliance, provision, controversy or planning.
Cause and Effect
Why do companies still struggle with internal controls over the income tax function? From our experience, we have continued to observe a number of reasons why companies were given material weaknesses related to accounting for income taxes. The following appear to make up the majority:
- Data availability;
- Technology interface;
- Understanding of financial accounting processes;
- Tax technical knowledge vs. accounting knowledge;
- Time pressures at financial close;
- Multinational cross-border issues;
- Education, experience, enterprise knowledge; and
- Increasing body of rules (tax contingencies, stock compensation, purchase accounting, etc.).
Though this list is broad and somewhat all-encompassing, we believe a few of these stick out, repeatedly, as common reasons given for material weaknesses in tax departments.
The first major issue relates to the competence of the tax staff in income tax accounting. Companies have not only been training their tax staff on Accounting Standards Codification (ASC) 740 issues for several years now, but they have also focused on hiring tax professionals who already possess tax accounting knowledge. Let’s face it: a tax specialist with a personal affinity toward debits and credits is not all that easy to find. The tax department’s staff generally identify themselves as tax planners, compliance specialists or tax technical experts. They usually do not, however, claim to be experts in tax accounting issues and generally don’t enjoy the internal control environment. Tax people, in general, are much more comfortable with the Internal Revenue Code than they are thumbing through Generally Accepted Accounting Principles. Unfortunately, because of the unique skill set and high demand these tax accounting specialists command, it is difficult to retain and recruit these individuals in today’s market.
A second general problem found inherent in the tax function is that many tax departments have historically operated in isolation, apart from accounting and business functions of the enterprise. Prior to SOX, the tax staff focused on the function of their tax calculations and were not as concerned with documenting their processes and controls. Top management and the board of directors’ audit committee rarely showed much interest in tax matters and did not keep tabs on how their tax departments were conducting their activities. SOX has forced tax departments to be more transparent to upper management and the audit committee. It has also required the tax department to be more actively engaged in company business operations. Tax departments have had to migrate to addressing tax issues on a real-time basis as a component of the financial statement process, not just when the tax return has to be filed.
Third, the financial statement close process is another major cause of material weakness that we’ve observed in the accounting for income tax area. The financial close process of many companies has only shortened over the years (due, in part, to accelerated filing requirements by the SEC). Add to that the fact that many tax departments previously held the philosophy that the financial close process was a “best guess” estimate, and that the estimate could be corrected during the tax return process. Now the expectation upon financial statement audit is that a tax provision calculation is predominantly correct and will be free from significant adjustment when the tax returns are filed. Furthermore, a majority of tax departments use ad hoc, non-standardized spreadsheets to compute current and deferred tax provisions reflected in their financial statements, sometimes leading to problems when a file is corrupted or data lost, during the innumerable turns of financial information that occur in a compressed time frame.
Best Practices & Practical Ideas
So, what suggestions, then, can we offer based on experience? Certainly, with all of the turmoil we’ve observed, we have also seen our share of best practice success stories. Those companies we’ve noted as best at managing their risk have implemented practices such as:
- Building and maintaining a tax-basis balance sheet;
- Providing more technical training to staff, particularly in the areas of ASC 740 and SOX;
- Considering the skills of current tax professionals to evaluate whether more specialized staff should be added, perhaps even rotating the roles of tax staff every few years;
- Establishing better communication with financial statement auditors, in addition to better leveraging third-party service providers;
- Analyzing current processes in the tax department in determining if there are duplicative efforts occurring or whether there is a better way to integrate the provision and return processes;
- Pursuing tax department process improvements such as tax technology and process automation as a way to achieve better quality, efficiency, timeliness and precision;
- Ensuring that tax department personnel are tapped into other departments and business units, in order to assess tax issues of business transactions as they occur; and
- Monitoring all tax department processes and controls to ensure that they are properly documented and followed.
Alvarez & Marsal Taxand Says:
We find, quite simply, that many tax departments have not looked at their documented process in some time. Often, it isn’t until crisis hits that we find the need to act. Yet with the stresses imposed by the economy on staffing levels and financial data nuances, risk remains high. Recall, also, the numerous changes currently occurring to accounting standards in this country, and ask yourself if you’re equipped to address their future tax impacts. Perhaps, as you head into another year-end financial statement audit, consider whether you have confidence in your people, process and technology as currently configured to address the stresses inherent in any tax reporting system. Maybe you’ll find that an addition of one or two “best practices” or a simple fresh look at your current processes and procedures will be the mitigating factor you need to successfully navigate another financial reporting season.
Senior Director, Chicago
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