United States: Audit committees spotlight: what audit committees can do to stay on top of tax risk
17 February 2015
Posted by: Authors: Randy Robason and Janet Malzone
Authors: Randy Robason and Janet Malzone (Grant Thornton LLP)
Audit committees have significant responsibility over a company's tax and reputational issues. At stake are the potential for a financial restatement or tarnish on the company's reputation. Adding to these pressures are the increased focus on financial statement auditing by the Public Company Accounting Oversight Board and the SEC, and the fact that tax is so complicated that it's prone to issues.
To appropriately prepare a tax provision — the way the amount of current and deferred taxes placed on your company's balance sheet and income statement is determined — tax professionals have to understand all of the tax rules regarding the entity. And they have to understand all of the financial accounting standards. So, they have to be proficient in audit and tax. The preponderance of rules can lead to mistakes, and mistakes can lead to tax-related financial restatements or the identification of a material weakness or a significant deficiency in internal controls. That's why it's especially important for audit committees to ask management the right questions to identify potential mistakes and missteps, and to communicate any issues to the board.
Audit committees should determine and document that their members are proficient enough in tax to have dialogues with staff and the auditor. Tax provision is a highly complicated area that requires both audit and tax acumen.
Most accounting issues decreased between 2003 and 2012, but problems with tax-related financial reporting stayed near 10% until rising to 15% in 2012, according to the Center for Audit Quality's "Financial Restatement Trends in the United States: 2003–2012". The prevalence of tax-related financial restatements was likely caused by the "inherent and increasing complexity of both the tax code and tax-related GAAP, as well as increased scrutiny of tax reporting," according to the report.
Top 5 causes of tax-related financial restatements
The following are the five most common causes of tax restatements:
- Inadequate income tax disclosures
- Insufficient income tax liabilities related to foreign earnings
- Inadequate reporting of uncertain tax positions
- Incorrect intra-period allocation of tax expenses
- Incorrect conclusions regarding deferred tax assets that are capable of being realized
These causes represent complex, technical areas. Not all companies have staff skilled at the level needed to deal with these issues. In addition, technical rules might affect parts of the business differently. Cash management might be thinking one thing, and tax might be saying another. For example, foreign earnings that are kept offshore are not subject to U.S. tax if certain criteria are met. Yet, a company might say in one part of its financial statements that it needs cash (making the company subject to U.S. tax because it has to bring the cash into the United States), and yet for tax purposes, it might say it doesn't need the cash, creating a contradiction.
In dealing with global tax risk management, the audit committee must balance corporate growth expectations, shareholder expectations and public demands. Quite often those areas — and the supporting activities —conflict.
What audit committees should ask
Audit committees need to clearly understand the tax positions the company has taken that don't directly align with the expectations of revenue and taxing authorities and the intent of tax statutes. In the United States, ASC 740 establishes a more-likely-than-not threshold for evaluating uncertain tax positions on financial statements. International Accounting Standards 12 establishes guidance for accounting treatment for tax outside of the United States. Management assesses the risk of the company's positions, and the audit committee needs to understand what tax risks management has identified from a technical perspective. What is the level of risk, and what are the assumptions that management used in assessing the degree of risk?
Audit committees typically have quarterly discussions with the CFO and the CEO. They need to ask questions about the infrastructure, such as the following:
- Do we have the right people doing the right things, with the right tools and with the right amount of time? Factors in arriving at the correct outcomes include whether people are appropriately trained and have the right skill sets, timely access to the correct data and the necessary capacity.
- What are our processes and checks and balances to make sure we're correct?
- What assumptions were considered in reaching the correct answer, and what were the relative risks pertaining to these assumptions?
In tax, the phrase "more likely than not" means that even though an area is gray, there's a 50.01% or higher likelihood that the interpretation is technically correct if challenged by the taxing authority. For every material item, the audit committee needs to have an in-depth understanding of whether the answer is more-likely-than-not correct. If the answer meets that threshold, how much more likely than not is it? Are we at the 99% certainty level or only the 50.01% level?
In addition, audit committees should insist on meeting periodically with other individuals responsible for areas such as tax, internal audit and IT to make sure they are getting the complete picture without filtering. As audit committees evaluate whether to pre-approve any tax services to be performed by the audit firm, they should talk to the audit firm about independence, objectivity and professional skepticism related to the proposed services.
An audit committee might discuss a typical tax risk such as transfer pricing with management. This would include the positions the company has been taking, tax planning strategies in place and anticipated future events. What has the company done to lower its effective tax rate, and what's the relative risk? This is difficult because tax activities can span the entire array of foreign and domestic tax laws that apply to the company. To fulfill its risk management oversight, the audit committee should have a continual process for reviewing material tax risks by meeting regularly with management, internal audit and external audit, and by asking critical questions.
Inversions — an example of reputational damage
In recent tax inversions, the tax directors of the acquiring companies may have thought an inversion was a great idea because of the favorable impact on the companies' worldwide tax rate. Yet, the media and legislative and regulatory bodies in the United States and other countries viewed them negatively. Therefore, the companies that used them experienced some reputational damage and diminished shareholder value.
The audit committee's role is to surface such governance risks for the full board to consider. Then the board can decide, balancing corporate growth expectations, shareholder expectations and public demands.
It's not important to unequivocally know the reputational fallout. It is essential to recognize the issue and have a plan to deal with it. What will be the issues after inversions, the ones we haven't read about yet? These will be close to the 50.01% more-likely-than-not threshold, and audit committees should be asking questions about them now.
As a leading practice, audit committees should ask questions to understand the following:
- The company's overall tax strategy and risk management philosophy. Is the company in compliance mode, doing blocking and tackling, or is it in front of the tax provision, looking for ways to structure and reduce tax in a sustainable manner? What level of risk is considered acceptable?
- The tax risks during the due diligence process of any acquisition. Have management and the audit committee seen the results of formal tax due diligence? What significant uncertainties were identified in accounting for the business combination? What can be done to mitigate those? What does management think the tax consequences of the acquisition will be?
- The way in which global companies have structured their global footprint, including foreign subsidiaries. Does management plan to repatriate earnings or reinvest those earnings in foreign locations? If there is a buildup of cash in foreign subsidiaries, what are the specific plans for the use of this cash in order to avoid accruing the U.S. tax?
- The major risks in the tax provision. Numerous issues can affect the provision. Examples include:
- Foreign tax issues if the company isn't purely domestic
- Transfer pricing and related-party transactions
- Net operating losses and tax credit carry-forwards
- Valuation allowances
- Tax technology and the level of deployment — for example, does the company still rely on spreadsheets?
- Monitoring of tax law and regulatory developments
- Internal controls
- The resources and abilities of the tax team. Does the company do all tax work in-house, outsource all of it or use a combination? Does the company have the right team with the right level of resources to identify, manage and mitigate risks in a timely manner? Are the right resources in place to handle the full range of foreign tax issues?
Tax is complicated, yet audit committees have to be able to discuss the material risks and delve into whether the company has the right people doing the right things and making the right judgments. Then they have to inform the full board about the potential risks from decisions and judgments that have been made so that the board can make fully informed decisions.
This article first appeared on mondaq.com.