Impact On Your Income Tax Provision
Authored By: James T. Hedderman
Over the past couple of years, the income tax provision world has seen a number of changes in SEC and PCAOB attention, auditor concerns, process documentation, and pressures for companies' tax functions to adapt. This article outlines some of the changes that you may have already encountered and/or should anticipate which could impact your environment in the near future.
Public Company Accounting Oversight Board ("PCAOB"), Securities Exchange Commission ("SEC"), and Committee of Sponsoring Organizations ("COSO")
The SEC has provided comments and the PCAOB have highlighted weaknesses within the various attest firms. These observations revealed concerns that audit firms relied too heavily upon management assertions, that the internal controls environment must be a primary area of focus for companies, and that company disclosures must become more robust for subjective areas and conclusions.
In addition, COSO released an updated framework in May 2013 which supersedes the original 1992 framework as of December 15, 2014. A recent Protiviti study reported:
Auditor Concerns and Changing Focus
With the pressure that is being applied to the attest firms by the PCAOB intensifying, audit firms have already rolled out new programs, modified to address PCAOB concerns.
The internal controls environment has seen the most scrutiny for publicly-traded companies. For some companies, Sarbanes-Oxley testing that historically was completed within a day is now beginning with lengthy inquiries about the quarterly and annual income tax provision process, followed by the actual testing. For example, one of our clients recently reported that two of its highest ranking tax professionals spent two entire days with external auditors discussing the internal controls environment.
A major change sweeping the tax community is the requirement to document your review and, at times, for auditors to witness the review process. Companies have addressed concerns and question the level of detail required to document the review process. How many versions of the review do you have to maintain? How do you document verbal communication with a colleague during an abbreviated closing process? From a junior staff perspective, are there risks inherent in documenting items missed and/or basic mistakes? These are all questions that the tax function needs to address not only with their external auditors, but within the tax function itself.
From a review perspective, we have seen clients maintaining a "reviewed" version binder with comments and notes on the various work papers. Tax directors are drafting memos which outline their income tax provision review process; within these memos, we have seen them highlight the material and key-controls addressed during the window of review, with a mark next to items completed (and dates) during the provision close cycle.
Auditors are also investigating more aggressively the internal controls around electronic evidence previously focused on applications such as Excel. They have expanded their scope to include system generated reports from financial reporting and tax systems, requiring users to validate and prove the reliability of these items. Within these applications are there controls in place to protect the integrity of calculations, to limit the ability to modify files, and to identify the protected environment separate from the human entry screens? Have you been rolling forward a historical process without giving serious consideration to these risks? Do you have controls in place that you have not given your team credit for? If your entire provision or a portion of the income tax provision process lies within Excel, have your auditors tested the documents for spreadsheet risks? Have you taken the initiative to inventory spreadsheets, outlining key items such as purpose of the tab, clear identification of manual entries and source documents, consistent legends throughout the file, and limiting access to critical calculations? As technology solutions are being implemented across the globe, auditors have become more critical of functions delaying/ deferring the transition and Excel is the primary target of these inquiries, so be sure to document your environment.
Many instances exist where firms, while implementing a top-down approach, placed undue emphasis on testing management review controls and other detective controls. This approach, however, may not adequately address the risks of material misstatement. As such, the risk assessment process is being further analyzed by external auditors to ensure a company appropriately comprehends the types of potential misstatements and the likely sources of those material misstatements.
Tax functions should further examine source documents utilized (such as accounting records, supporting information, and specific accounts in the financial statements) to initiate, authorize, process, and record transactions. Have these documents been appropriately reconciled to alternate sources that have sufficient controls attached to it? For example, is an external document being utilized that has not been reconciled to the general ledger?
While these examples of the changing environment illustrate the need to shift focus towards a more documented and controlled environment, many tax functions will see an increased focus from their internal audit functions. Within PCAOB inspection reports, situations exist where audit firms should not have relied upon work completed by internal audit functions for various reasons. As such, we should anticipate internal audit functions increasing inquiries, testing, and collaboration to further comprehend the risks that are inherent within the tax function. Has your internal audit already made this transition?
With the SEC requesting more disclosures and company-specific details in the quarterly and annual footnote disclosures, companies are elaborating on the language included for the investing community.
For example, companies historically may have included a sentence or two that confirmed the intention to permanently reinvest earnings in a foreign corporation outside of the United States, eliminating the need to establish a deferred tax liability for the future repatriation back to the U.S. Companies should now consider including language addressing the facts that impacted the conclusion that earnings of a foreign corporation are anticipated to be permanently reinvested, including business operations, liquidity positions, and management's ability to leverage debt if needed, and what factors may give rise to change in this assertion, among other factors.
Another item impacted is the documentation of the factors giving rise to the establishment or release of valuation allowances. Historically, a company may have included language stating that positive and negative evidence need to be evaluated for the realization of deferred tax assets, along with a few details about the expiration of assets (commonly net operating losses "NOLs"). Prospectively, companies should (at a minimum) consider, and address in the footnote, the impact that forecasted pre-tax income had on the analysis, and if there has been a recent history of NOLs and overall cumulative loss positions.
Companies should consider the amount of detail included in their footnotes and the precedents established as the income tax provision evolves with these changes.
With the pressure to adapt coming from above, companies are changing income tax provision platforms. Have you considered the benefits or already reaped them?
Technology has the ability to streamline our adaption to the new requirements and additional pressures put on tax functions to spend more time documenting their review, conclusions, and positions. No longer can a tax team spend all of their time during the close window ticking and tying work papers and checking excel formulas. That time must now be spent ensuring internal controls are working effectively, reviewing footnote disclosures so that they accurately reflect business operations and also include facts supporting company decisions for the given period, and gaining a higher level of comfort in the accuracy of the amounts reported in your financial statements.
By the way, if you have recently made the move (or are considering making the move) to use technology tools to enhance your reporting process, your internal controls environment has (or will) changed. Have you given your internal controls environment the appropriate attention for the updated risks and controls?
If the winds of change have blown you away or you are interested in learning more about a more robust provision process, leveraging technology, or strengthening your internal controls environment and documentation, we would love to contribute towards your success. Please reach out to us and let's navigate this process together.
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