June 06, 2006
Author: Ted Thomas
Organization: Grant Thornton LLP
One of the most resounding messages heard regarding the implementation of Sarbanes-Oxley Section 404 is that accounting for income taxes is not an easy task. In fact, for some of the country’s largest publicly traded corporations, accurately accounting for income taxes has proved to be quite difficult. Sarbanes-Oxley accelerated filers have cited material weakness in internal control over financial reporting (ICFR) of income taxes more often than any other accounting area.
A review of Management’s Report on Internal Control over Financial Reporting that found material weakness assessments in accounting for income taxes – of which there have been roughly 150 to date – provides insight into the various causes of those material weaknesses. This review also provides all companies, both public and private, with valuable lessons for improving corporate tax department policies and procedures.
Tax department resources and oversight
Personnel, staffing and oversight issues are among the most prevalent material weaknesses in internal controls related to accounting for income taxes. In some cases, these weaknesses resulted from inadequate resources in the corporate tax department—for example, insufficient personnel or a lack of specific expertise, such as experience with FAS 109 or international tax issues.
Additionally, inadequate oversight or a lack of understanding by management of complex tax calculations prepared by the tax department caused material weaknesses. This type of weakness was also reported in some cases where the tax function was outsourced, with inadequate oversight of the third-party tax consultant or lack of understanding of the calculations prepared by the third-party tax consultant. Furthermore, for corporations with complex structures or with overseas operations, lack of proper oversight in tax reporting by domestic and foreign subsidiaries resulted in material weaknesses.
Other frequently cited material weaknesses
The failure to properly calculate, disclose or update valuation allowances against deferred tax assets was also a frequently cited problem. Reports filed by accelerated filers reveal that inadequate management oversight contributed significantly to errors in valuation allowance calculations. In some cases, these allowances may have been properly calculated in the year the allowance was first recorded, but management failed to consider subsequent changes, such as changes in business profitability or expiration of loss carryforwards, that may have impacted the allowance in subsequent years.
Companies also disclosed several material weaknesses in reconciling information used in the provision calculation to the supporting detail, the provision calculation to the tax return filings and the amounts recorded in the general ledger to the supporting provision calculation.
A common theme
Even when personnel, staffing and oversight were not reported as material weaknesses in and of themselves, resource constraints in these areas likely contributed to the material weaknesses that were reported. And, it is probable that many corporations found similar issues that were graded only as significant deficiencies, and therefore, were not reported publicly.
While accelerated filers may have been caught off guard by resource issues, non-accelerated filers should take notice of the significance of the control weaknesses their brethren have disclosed. With the premium placed on specialized tax accounting resources by accelerated filers who are remediating material weaknesses and significant deficiencies related to tax resources, non-accelerated filers are well-advised to deal with those issues now. A proactive stance will go a long way toward preventing not only resource-related weaknesses and deficiencies, but the variety of control problems that accompany a lack of qualified resources.