Publications & Resources

February/March 2007
Focus: Balance Sheet Management

Accounting Just Became More “Taxing”

By Kenneth R. Astle

Beginning with the first quarter in 2007, all companies will be required to change the way they measure and report their income taxes. Because financial institutions have uniquely complex tax positions, they are particularly impacted by the new rules. Many companies may find they must make a one-time adjustment to their tax accounts. Even more will struggle with new extensive disclosure requirements regarding their tax return positions. No longer will companies be able to maintain a general “cushion” for uncertain and unknown tax adjustments.

These changes are the result of a new accounting pronouncement referred to as FIN 48 (FASB Interpretation No. 48) which is an interpretation of FASB 109, Accounting for Income Taxes. For companies with a Dec. 31 year end, it became effective on Jan. 1, 2007 and must be incorporated in the first quarter financial statements as of March 31, 2007. All other companies must adopt the pronouncement by their first year beginning after Dec. 15, 2006.

New Measurement of Uncertain Tax Positions

FIN 48 deals specifically with accounting for uncertain tax positions. These positions often arise because of lack of clarity in the law or its application. Some examples would include the deductibility of costs in a merger or acquisition transaction, the appropriate time for tax purposes to stop accruing interest on non-accrual loans, the character of gain or loss as capital or ordinary and when nexus is established for paying taxes in another state.

Prior to FIN 48, tax liabilities were accrued for uncertain tax positions if they were probable and reasonably estimable (the FASB 5 standard). FIN 48 now requires the accrual of a tax liability for uncertain tax positions unless the tax position taken is “more likely than not” to succeed, a new term that means a probability of success of more than 50%. This is problematic because tax returns can be filed containing positions with as little as a 20-30% probability for success. Furthermore, FIN 48 clarifies that in determining the probability for success of a particular tax position, the merits of the position alone are to be considered and not the likelihood of discovery. That is, in assessing the probability, you must assume the tax authorities will examine the issue and have complete knowledge about it. Certain tax benefits previously recognized may not be sustainable under the new standard.

No Way to “Cushion” the Blow

In the past many companies have maintained a little extra reserve for taxes, often referred to as a “cushion”, to cover unexpected tax liabilities that might arise as a result of examination by tax authorities, or otherwise. The term “cushion” has officially become a dirty word as general tax reserves are no longer allowed under FIN 48. Those who have cushions will be required to specifically identify potential liabilities requiring the reserve or else adjust these amounts out of their liability accounts.

Financial Statement Effect of Tax Adjustment

As a result of the new pronouncement, many companies will be required to make adjustments to their tax accounts. Some will have to increase their liabilities because of the “more likely than not” standard, others may have to eliminate their tax “cushion”. Whichever the reason, FIN 48 provides a one-time opportunity in the initial year of adoption to adjust the tax liability accounts without taking the effect through earnings. The adjustment must be made as of the first day of the year, with the effect taken to beginning retained earnings.

Painful Disclosures

Perhaps the most painful aspect of the new pronouncement for most companies is the additional disclosures required. The requirements are too exhaustive to detail in their entirety, but here are a few highlights (or lowlights if you prefer).

A tabular reconciliation of the changes in the reserve for uncertain tax positions, from the beginning of the period to the end.
The total of such positions that, if recognized, would impact the effective tax rate.
The amount of related interest and penalties recorded in the financial statement.
The years for which the statute of limitations is still open, by jurisdiction.
For tax positions expected to change within the next 12 months - the nature of the issue, the event that could cause the change and the estimated amount of the change.

If you think the tax authorities are excited about the new disclosure requirements, you are right. Imagine being in dispute with the IRS over an issue you expect to resolve in the next twelve months and having to disclose in the financial statements the expected settlement amount before negotiations are complete - so much for your bargaining position.

Companies across the nation, working with their advisers, are hurriedly calculating the effect of this pronouncement on their organizations and trying to craft disclosure language that meets the requirements without telling more than necessary. It will be interesting to see what tax adjustments and creative disclosures surface.

Kenneth R. Astle is partner with Perry-Smith LLP in Sacramento, Calif. He can be reached at 916-441-1000 or kena@perry-smith.com.