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February 26, 2008

One of the more confounding items that public companies must now deal with in the sales and use tax area is Financial Accounting Standards Statement Number 5 (FAS 5), Accounting for Contingencies. This statement was issued over 30 years ago by the Financial Accounting Standards Board (FASB). But because of growing investor interest in reliable financial statements, accounting firms have increased their focus on determining whether public companies are properly accounting for contingencies. Unfortunately, many companies may not have properly accounted for their FAS 5 reserve.

A large portion of transaction taxes are often overlooked or not considered in their entirety because external auditors have not asked the right questions or had the right resources to analyze the reserve properly. However, your company and your tax practitioner must be prepared for the inevitable and increased scrutiny by your external audit firm.

Companies should ensure all sales and use tax contingencies required by FAS 5 are accrued for and fully documented. However, given the nature of sales and use taxes, estimating the contingency can be challenging. First, let's review the rules.


It is important to understand the definition of a contingency. In March 1975, the FASB issued FAS 5, outlining the appropriate accounting for contingencies. Paragraph 1 defines a contingency as "an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur." Examples of loss contingencies include pending litigation and actual or possible claims and assessments.

Risk detection should not be considered in reporting loss contingencies regarding taxes. For example, the likelihood of being caught if a company does not comply with the law (i.e., does not file a return, does not collect the tax) is not a valid reason for not recording the liability. In addition, if an assessment is pending, the tax practitioner must assume all the evidence will be reviewed by the examiner when determining the likelihood of the outcome.

Next, it is important to know what contingencies need to be disclosed. Paragraph 8 of FAS 5 states "an estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met: (a) information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred" and "(b) the amount of the loss can be reasonably estimated." Probable is defined in paragraph 3 as "the future event or events are likely to occur."

If one or both of these conditions are not met related to a contingency, disclosure of the contingency must be made when there is at least a reasonable possibility that a loss or an additional loss may have been incurred. The disclosure must indicate the nature of the contingency and estimate the possible loss or state that such an estimate can not be made (paragraph 10). "Reasonably possible" is defined in paragraph 3 as "the chance of the future event or events occurring is more than remote but less than likely."

Once it has been determined that a contingency exists and that it must be disclosed, the contingency must be estimated. FASB Interpretation No. 14 (FIN 14) provides an interpretation of FAS 5 on how to provide for a reasonable estimation of the amount of a loss. But although guidance is provided on pending litigations and the use of ranges to estimate the liability, FASB does not provide substantial guidance on methods that may be used to calculate the contingency.


When evaluating whether a contingency may exist that may need to be disclosed for FAS 5 purposes, all aspects of sales and use tax compliance should be considered. However, ensuring your company is complying with the various sales and use tax regulations in each taxing jurisdiction may be a challenge. The obvious contingencies to account for relate to pending audits or assessments. However, the following additional items should be considered:

1.    Does the company have nexus in certain jurisdictions where it is not filing returns and/or collecting sales tax?

2.    Is it possible that there are missing resale or exemption certificates that could support sales on which no taxes have been collected?

3.    Did the company fail to accrue use tax on taxable purchases that were used for the company's own use and not taxed by the vendor?

4.    Does the company have transfers of property and/or services performed between affiliates that could be subject to tax?

5.    Does the company transfer property between taxing jurisdictions that could be subject to additional use taxes?

6.    Have there been changes in laws, regulations, and/or policies or court cases that could result in exposure for the company?

7.    Could the company be subject to additional taxes due as a result of a merger or acquisition?

8.    Has the company undergone any reorganizations or restructuring that could result in tax exposure?

All the situations described above must be considered when evaluating whether the contingency is probable. A company is not able to consider audit detection risk. For example, taxing authorities have never identified the exposure as a result of an audit examination or imposed an assessment. Reserves made for general issues or unspecified business risks are not permitted.

Once you have determined that a contingency exists, you must determine whether the contingency may be reasonably estimated. Unfortunately, FAS 5 provides minimal guidance as to what is reasonable. Merriam-Webster's dictionary defines reasonable as "being within the bounds of reason." Since sales and use taxes are transaction based, quantifying any of the above-mentioned potential contingencies could require reviewing large amounts of data even to calculate an estimated amount of liability or a range of liability.

There are several factors to consider when quantifying a FAS 5 contingency:

1.    Customer obligations/indemnifications — When quantifying your exposure, consider customer obligations. For example, your company may have failed to collect sales tax on taxable sales, something that could result in the need for an accrual. However, contact your customer to see if they have already self assessed and paid the tax, paid the tax as a result of a tax assessment, should have issued a resale or exemption certificate, or would be willing to be invoiced for the tax. If so, and assuming it can be reasonably estimated, your exposure should be modified to take this into account.

2.    Contingency estimate by state or legal entity — If you plan to perform a sample or use an alternative method to estimate the contingency, be prepared to identify the amount of the exposure by state, by legal entity and by period. This will be necessary to properly account for the accrual in the financial statements and to update the accrual periodically.

3.    Penalties and interest — Most states impose penalties and/or interest associated with an assessment; therefore, these additional costs should be included when calculating an estimated contingency. However, several factors could occur that would not require including penalties and interest. For example, if the liability is associated with failure to collect the tax in a particular state, and if the company may participate in a voluntary disclosure program or an amnesty program that may provide for full or partial waiver of penalties and/or interest, perhaps no additional liability need be included.

4.    Review by the external auditors — Bottom line, make sure you have proper documentation on file to support your accrual. It may be several months before the auditors will review your documentation. The schedules should speak for themselves and not require any explanation. If you performed a sample, make sure you have documented the methods you used to design and select your sample, as well as any assumptions made. Understand how the external auditors plan to audit the accrual you have calculated. Most auditors have experience doing samples; however, if they plan to test your sample, make sure you understand how they plan to project their results in case they find any errors.

Alvarez & Marsal Taxand Says:

Once you identify the contingencies that are probable and you believe reasonably estimateable, you may find yourself spending more time than originally thought to estimate or calculate the contingency, to document the contingency and to defend it upon review by your external auditors. Nonetheless, the time will be well spent because the FAS 5 accrual process may help you identify where to prioritize your time with your department to implement process improvements and minimize the exposure in the future. The costs associated with penalty and interest alone may provide the business case to invest in software or add resources to minimize or eliminate the exposure in the future.

Once the FAS 5 accrual is booked, don't forget to (1) add associated penalties and/or interest associated with the tax accrual booked for the prior periods and (2) take into account changes in tax rates and interest rates as well as changes in state tax laws that could affect the total accrual maintained on the books. In short, be prepared to defend the accrual with external auditors who may not be familiar with sales and use taxes, maintain the accrual on the books monthly or quarterly, and remember to add to the accrual or reduce the accrual as changes in the business occur.


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Alvarez & Marsal Taxand, LLC distributes a complimentary electronic newsletter to subscribers on a weekly basis. A&M Tax Advisor Weekly provides comprehensive and timely insight on a wide range of taxation issues including international tax, state and local tax, incentives and current issues. Readers are reminded that they should not consider these documents to be a recommendation to undertake any tax position, nor consider the information contained therein 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 these releases may not continue to apply to a reader's situation due to 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.


Carolyn Campbell Shantz
Managing Director, Houston
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Craig Beaty, Managing Director, contributed to this article.

For More Information on this Topic, Contact:

Mark McCormick
Managing Director, Atlanta
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Layne Albert
Managing Director, Houston
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Brian Pedersen
Managing Director, Seattle
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Craig Beaty
Managing Director, Houston
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