Tax Executive Institute, Inc. - The preeminent association of tax professionals worldwide

Since the enactment of the Sarbanes-Oxley Act of 2002 (SOX), Income Tax has had the unenviable distinction of being one of the main reasons companies have been required to disclose material weaknesses in the audited financial statement. The total number of reported material weakness disclosures has been steadily decreasing each year since the compliance with SOX §§ 302 and 404 began. This trend, however, does not prove true when income tax is isolated. For example, Ernst & Young’s Global Tax Risk Survey found that, from 2006 to 2008, there has not been a decrease in tax material weakness. Indeed, the survey revealed that there is actually an overall increase of disclosures required for income tax-related control weaknesses. Despite considerable efforts to re-mediate and address the material weaknesses for income tax, the total continues to increase. Although there are additional steps that tax departments must take to improve their controls, there may just be an inherent weakness that is out of the control of the tax professional’s hands. A condition that has added to the tax professional’s control woes in many companies is a disconnection of the tax function from the rest of the functions in the controller’s department. Although there is a common deliverable for all involved in financial reporting, when decisions about the data, structure, process, and communication are made, if the tax components are not considered, a control weakness will likely be attributed to the tax area. If the tax leaders are involved in decisions, the potential effect of business decisions can be assessed and should assist in reducing some of the external weaknesses that the tax department is unable to control. If the external weaknesses are addressed, the tax department can focus on securing and fostering a controlled environment and, possibly, change the trend to reduce the number of material weakness disclosures required for tax.

Because of the nature of taxes, a single tax professional is often asked to perform diverse functions during the year. Those tasks can range from generating tax forecasts, accounting for income tax, complying with taxing authorities, and addressing audit controversy items. The multifaceted nature of the work performed by the tax department can lead to an overburdening of the limited resources. The lack of candidates with deep tax knowledge has forced many companies to hire a non-skilled labor force with the intention of training them for the tax department. The tax professional also must consider the ever-changing regulatory environment to assure that the right rules and rates were used when the tax was computed.

While a primary goal of the tax department is to properly account and provide for the expected income tax, there are expectations and targets that management is always considering. The director of tax is often asked to juggle conflicting corporate priorities. This does not mean that tax professionals are expected to mislead or misrepresent the results to the public or any other agency, but rather that they are often asked to investigate planning and strategies that could meet a specific result. These types of activities should be well documented and researched to confirm that they do not represent a process divergence and, therefore, a weakness in control.

When considering the overall financial strength of a company, the shareholders, investors and analysts now consider the SOX compliance status which includes the number and severity of material weaknesses that a company discloses. This change in how companies have been gauged and measured for tax has caused a shift in the spotlight in the tax department. There is an increased emphasis on the tax provision process which has led the once primary focus of the tax return compliance process to be less prominent. While the need to generate the proper filings in a timely manner did not change, the tax professional must now reorder their schedule to accommodate both the provision and the return requirements. Often, this factor, coupled with SOX, causes the tax department to become more conservative in its overall positions.

The tax department must show control for any amount it represents as income tax to avoid having to disclose significant deficiencies or material weaknesses. Internal Control for financial reporting is defined as "a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles" (PCAOB 2004, ¶ 7). Maintaining effective controls to ensure the income tax provision is generated, reviewed, and supported within a framework that is structured and auditable can be a challenge. The tax calculations and processes can unwittingly fall prey to a weakness simply because they began with data that was out of their control. If the pre-tax financial data is misclassified or is maintained in a format that requires rework before it can be used by tax, then they run the risk of inadvertently applying the wrong tax rules or rates. This is particularly prevalent when journal entries are made without respecting the legal entity structure or the use of top-side or consolidated entries is common place. When tax has to comb through and reallocate items to re-create legal entity or make adjustments outside the system between accounts, the potential for errors looms. The problem can be compounded year over year if those entries are pushed down to the correct legal entity in the subsequent year since, for tax, the proper reversal may also need to be addressed.

Some tax material weaknesses can arise during the typical life cycle in the tax department. When the prior year return to provision true-up items are posted, if the true-up amount is deemed to be the result of a weakness in the provision process, there may be a disclosure requirement. Releases or settlements of tax reserves for uncertain tax position could also trigger a material weakness, if the process that was used to establish the reserve was thought to be weak and generated an over accrual. Audit adjustments from taxing authorities that were not provided for through tax reserves can cause a disclosure requirement since there was an under accrual.

The underlying components of the tax calculations that ultimately become the journal entry postings for income tax will not be fully comprehended by many accountants in the finance group. The details in the footnote are meant to shed light on the tax components for the investor and yet many in the company are not able to understand them. In many companies, the Chief Financial Officer or Controller will work very closely with the Director of Tax to understand the components and factors that have an effect on the tax results. For a significant number of accountants, however, the tax calculations and the effective rate reconciliation remain a mystery. The concepts of statutory rates and effective rates are complex and when the tax results are consolidated and rolled up, there is not much insight to how they work.

The components and calculations that make up the tax reserves are considered highly proprietary data and were previously only understood by a select few in the tax department. Since the promulgation of FIN 48 (now codified under ASC 740-10) and the requirement of specific disclosures, some companies have changed how they delegate work and how they maintain tax reserve data. On the whole, the data and computations used to determine the amount reserved for tax controversy are still kept close to the vest in the tax department.

The entries for income taxes are typically the last entries to be booked in the general ledger before earnings can be released to the public. When a non-tax accountant does not understand the underlying calculations or scope of information that generates the tax entries, they may inadvertently make decisions that adversely affect their tax colleagues. Significant issues can be avoided by understanding that the income tax journal entries are a direct by-product, in one way or another, of every entry in all the financial systems. While many of the entries in the general ledger are treated identically for book and tax, every amount is ultimately disclosed in an Income Tax Return filing. Even small changes to the data structure or process should be known by the tax department since these changes can ultimately have an impact on the tax results. Historically, in many companies the tax department’s unique requirements were only partially addressed when decisions were made on how business systems were to be designed, structured, and implemented. Recently, the trend seems to be reversing and, for newly implemented systems, the tax department appears to have more involvement and influence. There is, however, a lingering issue with many legacy systems that simply do not effectively provide the tax department with information in a format that they can use to generate all the required deliverables.

Advancements in technology have facilitated compliance with transparency requirements by establishing processes to capture and maintain data for the controllers. Defined roles and responsibilities help ensure proper communication processes within the organizational structure, but income tax has been somewhat overlooked. All the facets of financial reporting, including income tax, should be considered when determining the process and structure. It is particularly important to consider all consumers when it comes to the design and implementation of a technology solution. When the SOX compliance requirements were enacted, many companies were allocated additional resources to analyze and address technology control weaknesses. In many cases, SOX was the impetus to allow the finance department to assess and modify the technology infrastructure. In the last few years, there have been advances in technology that have allowed faster and more accurate financial reporting. If tax is not considered as an integral part of the process, however, issues may arise and the process may become more time-consuming.

Tax information has a widespread effect on the financials. Tax data are found on each of the primary reporting sections in the financials. The Income Statement, Balance Sheet, and Cash Flow Statement show the summarized tax amounts. Certain components of those amounts are supported with detailed information in the tax footnotes which may also include supporting narrative descriptions. The tax effect of other specific financial components may also be separately stated in additional footnote disclosures. Because the tax calculation is dependent on other financial information, if any of the originating data is deemed to have a material weakness, the related tax may also inherit the weakness.

The income tax components cannot be finalized until the rest of the books have completed their work. Before the final financial statements can be issued, the tax entries must be completed. The amount of time that the tax department is allotted to both compute the required journal entries for tax and to prepare the footnote disclosure is much shorter than the rest of the finance department. The detail that is presented in the tax footnote depends on the final numbers so very little work can be done by the tax department in advance. Although there are tax technology solutions that assist in generating the amounts, the presentation of the tax amounts can change year over year. The Tax Director needs to ensure that the tax solution is flexible, assists with presenting and supporting necessary amounts, and helps avoid control issues.

The tax department is required to work with multiple types of data from many sources. The data must be analyzed to ensure that they comply with tax rules and, where differences occur, that there is a provision for them. Much of the data that is used by the tax professional is commonly referred to as ‘Book’ data. The sources are typically from general ledgers, consolidating packages, sub-systems, or spreadsheets. This information is used as the starting point by generating the Pre-Tax Book Income as well as the Book Basis Balance Sheet. Depending on the time period, this data might be based on actual or forecasted amounts or some combination of the two. The tax department will be able to effectively analyze data when amounts are booked correctly in the legal entity structure and according to the specific accounts. Often, the data in the consolidated ledger are maintained at too high of a level for tax analysis. In order to get a proper understanding of the components of an amount, the tax professional will need to drill down into the underlying general ledger. If the general ledger is maintained using the local statutory accounting rules, the amounts may have to be converted to the company’s reporting accounting standard before the tax analyst can begin their process. When top side entries are made in consolidating ledgers, it may make little to no difference in overall financial consolidation, but it will usually cause issues for the tax department since each entry will require manual reallocation and layering onto the source data.

In addition to the book data, there are also tax specific data that is typically separately maintained in spreadsheets or other systems. Because the tax professional needs to be able to quickly convert or combine data into a usable format to be able to make determinations about the tax treatment, spreadsheets are often used. Although spreadsheets may be thought to cause process weaknesses, there are instances where the tax department has very few other technology options. For many tax calculations, the data may be based on a historical basis and only maintained for tax purposes. If spreadsheets are maintained for multiple years, it may make sense to consider moving that data to a more structured database or other system to add more control to the process. Often the tax department must maintain different basis or different methods for certain assets. The alternative tax amortization, depreciation, and depletion methods can be used in some fixed asset financial sub-systems, but many do not have enough flexibility to accommodate changes such as when new legislation is enacted. Because of differing methods for accelerated and bonus depreciation, amortization of intangible assets and depletion base may require maintenance of ad hoc calculations for both the federal and state amounts. There are also certain tax attributes such as Net Operating Losses, Capital Losses, Foreign Tax Credits, etc., that may carry over for many years and may have an associated expiration date that also must be tracked.

Certain business activities can add additional responsibilities for the tax professional. Purchase price accounting for acquisitions and business mergers can create long-term tracking issues for tax. Tax-related items that arise in purchase accounting may be treated differently from how they are treated for book purposes, so it is critical that details are well-maintained to properly account for them. For example, in some tax-free acquisitions, the assets for tax will continue to be depreciated at the historic cost and a step-up basis to fair value will continue to be used for books.

The disparate data sources that a tax department must rely upon to ultimately provide the correct amount of income tax will most likely always exist. Pulling data from multiple sources can cause a control weakness in the overall tax calculation. If data can be standardized or maintained in structured system and decisions regarding data changes can be properly communicated to the tax department, weaknesses in income tax can be alleviated.

When income tax is not included in the process of determining how financial systems are implemented, there will likely be a negative effect on the company’s ability to rapidly close their books. Decisions that may seem innocuous, particularly those that net in consolidation, may cause substantial (duplicative) work for the tax department. By allowing the tax professional a voice, there can be a better appreciation for the level of data that is needed by the tax department. Finance professionals should also be invited to discussions about tax system design and structure. This may give the controller’s department a better understanding of tax calculations and tax system requirements. Additionally, tax professionals may be able to provide valuable input on the functionality of existing financial systems that could help better unite the systems.

It is also important that the tax department provide input on the ongoing maintenance of financial systems. The financial system may have been established to accommodate the original legal entity structure, but there also needs to be a strict policy to ensure additional legal entities can also be accommodated going forward. If entities are not isolated in a new unit, but are instead captured by repurposing an old unit or combining it with an existing unit, then the legal entity will be compromised. Although there may not be an effect on a consolidated basis, it is critical for tax that the system be able to generate legal entity level results, so that the proper tax rates and rules can be applied for both country and any local jurisdiction.

If the tax department is included in the discussion about systems, they may suggest modifications, even modest ones, that would allow the system to better integrate with the tax systems. The more the systems can move data electronically and avoid (or minimize) manual intervention, the better the process can be controlled.

In recent years, the financial close of the books for many companies has been accelerated from weeks to the goal of three days. Technology has played a large role in making such a rapid close possible for some companies. In order to implement a three-day close process, components of the existing close process must be operating in an efficient and streamlined manner. Traditionally, it is the tax entries that slow down the accelerated close process. When the controller’s group is finished with the pre-tax numbers, they are handed off to the tax department. Although the tax professionals strive to anticipate the data they will receive, they have to wait until the amounts are final, and then confirm that any late entries are being treated properly for tax. If finance works under the assumption that, for almost every action that they do during their close, there is a related tax action, then it may better comprehend the scope of work that tax must do to generate tax entries. It is not as simple as applying an effective tax rate or "pushing a button" to get the correct tax amounts; there will always be intervention required to ensure the correct amount is being accrued for tax.

It stands to reason that if there is good communication between tax and finance, they will make better decisions and have more control over what occurs. The more the tax department can be involved in discussions about company business activities, the better prepared the tax professionals will be to make the necessary tax assessments. This is particularly true when dealing with events related to corporate initiatives, acquisitions, top-side entries, post close adjustments, etc., since they can require tax elections or research to ensure the proper treatment for the tax event. Additionally, bringing the tax department into the discussion before the events are completed may help to uncover avoidable pitfalls. This approach will reduce the need for reactive responses.

Tax departments, on a whole, have not had adequate resources to meet all the responsibilities assigned by the controller’s department; it is not uncommon for some tax professionals being asked to take on double roles and responsibilities. Tax directors are responsible for supplying more detailed reporting more quickly. The tax department is responsible for multiple deliverables such as the tax provisions, tax compliance, information reporting, account reconciliation, cash-flow estimates, tax forecasting, etc. The scope of the tax provision has expanded in recent years to require more detail for components of the rate as well as the tax reserves. And yet, despite the expansion of workload, the resources to effectively meet those responsibilities are rarely added at the same rate.

In the current economy, where budgets are scrutinized and head count is closely monitored, requesting additional resources may not be practical. Even those companies that have the ability to add resources are struggling to find suitably trained tax professionals, since the pool of qualified candidates is constrained. Some companies have had open positions in the tax department for several years. In order to fill the gap, they have used staff seconded from accounting firms or hired less skilled staff in the hopes of training them.

Being a tax professional often requires that you must understand multiple accounting standards in order to provide the correct tax for various jurisdictions. For a U.S.-based company, there may be tax reporting requirements under local country statutory rules, Generally Accepted Accounting Principles (GAAP), and Internal Revenue Service regulations and rules. In the future, U.S. tax professionals will need to understand the implications of convergence with International Financial Reporting Standards (IFRS). Even with the possibility of a worldwide common standard of accounting on the horizon, taxing authorities of the local countries may still require the filings to be prepared based on the historic standard.

The tax professional has become less able to solicit opinions about concepts or ideas that are related to the tax treatment of an item. Income tax positions are best determined in a subjective environment that considers the facts and circumstances in order to draw a conclusion about the tax treatment. Before the enactment of SOX, the tax department’s analysis could be reviewed by external tax auditors, but under SOX’s independence riles, offering an opinion on these types of items is problematic.

Assessing, revamping, and automating tax processes can free up time for processes to be certified and audited to prove the existence of a controlled environment. Nonexistent or inefficient processes typically are time consuming and leave the tax reporting group in a reactive posture. The investment of time and energy spent establishing effective processes must be considered, but ultimately the value that is added should far exceed the cost. Tax reporting results are one of the last sets of numbers to be finalized before the books can be closed and earnings can be released. The tax reporting group must wait for the final book information before it can complete its calculations. There is normally a short amount of time between the time the books are handed off to tax and the time that tax is expected to make its tax entries.

Having a well-defined, effective tax automation process is critical to ensure that the data can be completed and reported as quickly and accurately as possible. The data needed by the tax reporting group can be classified as either structured or unstructured, and each type should be processed differently to ensure it is managed properly. Structured data originates from a source that maintains that data in a consistent manner accounting period-over-period. A general ledger package, databases, or sub-system feeds are all examples of structured data sources. Additionally, a spreadsheet can be considered structured data if there are proper controls in place. Automating structured data can substantially decrease the process time and remove potential user input errors. By having the data mapped, it can be moved electronically from one system to another either with an automated feed or with export/import functionality. Structured data can be pulled or uploaded multiple times during the close cycle to perform test runs of the process and obtain an estimate of the end result.

Unstructured data originates from sources that do not necessarily maintain the data in a consistent manner. This type of data is typically kept in ad hoc spreadsheets, comes from multiple sources, or is maintained a non-electronic (nonstandard) format. Attempting to directly automate unstructured data will most likely be a frustrating undertaking. Indeed, since there will likely be more exceptions than rules, no time or energy will be saved trying to institutionalize this data. A process can be established to convert unstructured data to structured data by implementing an intermediary solution that enables unstructured data to be populated into a structured environment. For example, if an electronic questionnaire or data-collection tool is populated with unstructured data, then that data can take on the characteristics of structured data and follow an automated process. Efficiencies created by automating data can be complemented by processes that have accountability events such as tiered sign-offs, status reports, and audit trails. Engaging users in the process by automatically informing them via email when an amount is submitted, changed, or approved will make the entire process more effective. For SOX, it is critical to document and substantiate events that have occurred in order to prove internal control. Systems that generate auditable logs are ideal, but any process with sign-offs will help users establish control and accountability of the data.

Ultimately, tax reporting will always require working with both structured and unstructured data. Creating a structured process that determines when and which events and data should be automated, versus which should be manual, will improve the accuracy and speed of tax data processing. When designing processes, the tax department should be sure to only automate those items that lend themselves to automation. The most effective tax departments have a combination of processes and human talent that creates a highly constructive work environment.

Conclusion

There are many challenges that the tax department faces to properly represent the overall tax picture in the financial statements. Minimizing or eliminating the material weakness associated with tax will require the tax department to make additional improvements to processes, as well as a combined effort with all functions responsible

for compiling financial data, to ensure the most controlled data can be maintained. The more the tax function is integrated in the overall finance function, the better it can perform their part of the reporting process. Tax directors should insist on being included in all communication to ensure they are fully aware of the events that are occurring in the company. If the tax department is informed and receives the appropriate data, it can build processes that demonstrate internal control and use their limited resources most effectively.

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Claire Crossman  has more than 21 years of tax experience with a primary focus in tax accounting and reporting. Currently, she is a senior manager of Product Management at the Tax & Accounting business of Thomson Reuters, supporting the ONESOURCE Taxstream Provision product suite. Before joining TaxStream in 2005, Ms. Crossman was responsible for the tax reporting at NBC Universal and ASARCO. She began her career at Ernst & Young in the Corporate Tax Division’s Media & Entertainment group. She can be reached at claire.crossman@thomsonreuters.com.