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December 7, 2011

With your Thanksgiving turkey long digested and the holiday season in full swing, what better time to take a few moments away from your celebrations and shopping to read about the state of tax-related material weaknesses in 2011. With your year-end tax provision (for calendar-year companies) soon begging for attention, we thought providing some insights into what continue to be the usual suspects that can result in tax-related material weaknesses, as well as how companies have been able to successfully remediate them, might help you plan for changes or additional procedures to your year-end provision work.

When we last visited this topic, we were applying suntan lotion (see ). As you might have noticed, there is no question mark at the end of this week's title. It's no longer a question ----  tax-related material weaknesses are still alive and kicking in 2011. Witness the following excerpt from a Form 8-K filed in November 2011:

"The Company has determined that the understatement of its deferred tax asset, together with the associated restatements, resulted from a material weakness in its internal control over financial reporting related to the processes, procedures and controls surrounding the Company's accounting for income taxes, specifically related to the tax basis of the Company's inventory....

In order to remediate this material weakness and further strengthen the overall controls surrounding the Company's accounting for income taxes, the Company has taken or will take the following steps to improve the overall processes and controls in its tax function...place a senior accounting professional in a leadership position within the tax department and hire additional tax professionals in order to spread workloads and facilitate additional levels of review...review the tax department, to ensure that the areas of responsibilities are properly matched to the staff competencies and that the lines of communication, processes, procedures and controls are effective...enhance the documentation of all deferred tax items."

Now that we've got your attention, let's kick off our discussion with a review of the basics of SOX 404.

SOX 404
As we all know by now, the focus of Sarbanes-Oxley Act Section 404 is on internal controls over financial reporting (ICFR). Financial reporting includes recording transactions, reporting those transactions in financial statements and safeguarding assets.

One of the requirements of SOX 404 is that public companies must include a report on internal control from management in each of their annual reports. This report needs to include a statement of management's responsibility for establishing and maintaining adequate ICFR and an assessment by management of the effectiveness of ICFR, as well as the framework used by management to conduct the required evaluation of the effectiveness of the company's ICFR. (Most U.S. companies have used the Committee of Sponsoring Organizations of the Treadway Commission, or COSO, framework.) Documentation must be maintained (in the form of narratives, risk control matrices, etc.) for management's assessment of internal controls and testing of both the design and operating effectiveness of these controls.

The other more burdensome requirement of SOX 404 is the requirement that your company's external auditor must opine on the effectiveness of the system of ICFR. This process requires independent testing of controls and testing of areas involving estimates.

Statement on Auditing Standards (SAS) No. 115 and Public Company Accounting Oversight Board (PCAOB) Auditing Standard No. 5 (AS 5) provide guidance to auditors in communicating matters related to internal control identified in audits. These publications contain definitions of the various kinds of deficiencies in internal control and related guidance for evaluating such deficiencies.

  • Internal control deficiency exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or to detect and correct misstatements on a timely basis.
    • Design deficiency exists when a control necessary to meet the control objective is missing, or when an existing control is not properly designed so that, even if the control operates as designed, the control objective would not be met.
    • Operating deficiency exists when a properly designed control does not operate as designed, or when the person performing the control does not possess the necessary authority or competence to perform the control effectively.
  • Significant deficiency is a deficiency or a combination of deficiencies in internal control that are less severe than a material weakness, yet important enough to merit attention by those charged with governance.
  • Material weakness is a deficiency or combination of deficiencies in internal control such that there is a reasonable possibility that a material misstatement of the entity's financial statements will not be prevented or detected and corrected on a timely basis.

Key Controls
An entity's control activities are the policies and procedures that help ensure management directives are being carried out. They help ensure that necessary actions are taken to address risks to the achievement of management's objectives. Preventive controls are intended to prevent errors from occurring (e.g., approvals, authorizations, verifications). Detective controls are intended to provide reasonable assurance that material errors would be detected on a timely basis (e.g., reconciliations).

Frequently there is uncertainty over what actions constitute a "process" versus a "control." The distinction is that a process refers to the performance of an activity to achieve management's business objective (e.g., recording and classifying transactions), whereas a control is intended to ensure management directives are being carried out, as discussed above.

There is no commonly accepted definition of a "key control." Functionally, a key control is intended to provide reasonable assurance that material errors in the financial statements will be prevented or detected and corrected on a timely basis.

Income Tax Process
The income tax process can be characterized as follows:

  • Computing an estimate of taxes to be paid (or refunded) on taxable income (or loss) today (i.e., current tax provision or benefit) and taxes payable or creditable in the future (i.e., deferred tax provision or benefit, reserve for uncertain tax benefits );
  • Adjusting the initial estimate of current tax based on the filing of the income tax returns for that year with adjustment either to the future tax or total tax; and
  • Recording the final settlement of a year's current tax with adjustment either to the future tax or total tax based on the results of a taxing authority audit for that year.

Key controls in the income tax process should be designed such that they:

  •  Ensure that tax laws and U.S. GAAP tax accounting principles (and changes in such laws and/or principles) are timely and properly identified;
  • Ensure that current and deferred income tax provisions are properly calculated on a quarterly and annual basis;
  • Ensure that current and non-current income tax balance sheet accounts are properly stated (e.g., income taxes payable, deferred taxes);
  • Ensure that financial statement disclosures are accurate and complete; and
  • Ensure that senior financial management participates in all significant tax planning or tax accounting decisions and understands the financial reporting impact of any material tax filing positions as well as related issues and/or exposures.

Common Income Tax Reporting Risk Areas
Some of the more common income tax reporting issues that have challenged companies and that should be addressed in the design of your company's controls include the following:

  • Valuation allowances
  • Uncertain tax positions
  • Undistributed earnings of foreign subsidiaries
  • Change in "estimate" versus "error"
  • Purchase accounting
  • Interim reporting (e.g., "discrete" vs. "annual effective tax rate")

Usual Suspects
Having reviewed key control areas in the income tax process, we've identified below a list of issues that can result in "operating deficiencies" and have been labeled as the usual suspects that can lead to a tax-related significant deficiency or material weakness.

  • Personnel issues
    • Lack of resources
    • Lack of technical expertise and training
    • Lack of communication and coordination within the tax department and between the tax and finance departments
    • Review failures
    • Lack of segregation
  • Complex transactions
  • Business combinations, especially purchase price accounting
  • New rules and laws (GAAP and tax)
  • Tax shelters and reportable transactions
  • Transfer pricing, supply chain, global monetary planning, and trading and hedging
  • Change of control
  • Items requiring judgment (e.g., uncertain tax benefits, valuation allowances)
  • Accounting for taxes in foreign jurisdictions
  • State taxes
  • New rules and laws (GAAP and tax)
  • Automation
  • Reconciliations to financial statements
  • Ineffective process over tax accounting

Best Practices
So what are companies doing to avoid or remediate material weaknesses in internal controls over the tax function? The process we prefer to use is based on assessing the issues, creating controls with people, tools and process, and then testing and validating the results.

  • Issue assessment
    • Complete a global risk assessment encompassing all taxes in each territory.
      • If your company has endured challenges, you need to understand the source of what led to the problems.
      • If not, you should ensure you understand the full range of tax responsibilities.
  • People issues
  • Assess the tax department.
  • Continue to develop the technical tax and ASC 740 skills of tax department personnel.
  • Determine what tools the tax department personnel need.
  • Develop job descriptions.
  • Increase the use of external consultants.
  • Automate as necessary (see Tax Advisor Weekly, Issue 48, "Are You Happy with How Your Spreadsheet Application Handles Your Income Tax Provision?" December 3, 2010).
  • Prepare risk-control matrices.
  • Implement tax due diligence.
  • Use checklists.
  • Re-evaluate existing controls.
  • Implement best practices.
  • Integrate finance and tax functions.
  • Review documentation and role of consultants.
  • Periodically review and monitor identified inefficiencies.
  • Test with management and auditors (financial and controls).
  • Tools
  • Process
  • Test and validate

Alvarez & Marsal Taxand Says:
Review your people, process and tools regularly (at least as often as your business changes) to be sure you are capturing the right information, performing the appropriate analyses and using the most efficient means to accomplish the task. Many issues relating to the reporting of income taxes arise from a lack of communication within the tax department and between the tax department and other corporate functional areas. Use the best practices above to break down the communication barriers and create a strong tax department that can minimize the risk of material financial statement errors. Use the budgeting process to increase the bench strength of your income tax accounting function. Most disclosures we have reviewed discussing tax material weaknesses also refer to a lack of adequately trained personnel or ineffective use of outside consultants. Consider what you want to wish for during these holidays to help you navigate smoothly through the tax provision process.

We at A&M would like to take this opportunity to wish you and your family a very happy and healthy holiday season and a prosperous new year.

Author

Paul Helderman
Managing Director, New York
+1 212 763 9760 | Profile

Layne Albert, Managing Director contributed to this article.

For More Information:

Layne Albert
Managing Director, New York
+1 212 763 9655 | Profile

Robert Filip
Managing Director, Seattle
+1 206 664 8910 | Profile

Gregory Gunderson
Managing Director, Dallas
+1 214 438 8410 | Profile

Charles Henderson
Managing Director, Atlanta
+1 404 720 5226 | Profile

Sean Menendez
Managing Director, Miami
+1 305 704 6688 | Profile

Footnote

Sarbanes-Oxley Act of 2002, Sec. 404 (b). This requirement applies to SEC reporting companies with market capitalization of $75 million or more. See discussion in , where we referred to the results of the SEC's study to determine how the commission could reduce the burden of complying with Section 404(b) of the Sarbanes-Oxley Act for companies whose market capitalization is between $75 million and $250 million. The study's two principal recommendations did not include a complete exemption from the requirements of Section 404(b) for accelerated filers. 

Disclaimer
As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.

The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

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