Accounting for income taxes in the post-SOA world.

The Sarbanes-Oxley Act of 2002 (SOA) significantly changed the role of tax advisers who provide services to audit clients. In addition to adhering to Financial Accounting Standards Board Statement (FAS) No. 109, Accounting for Income Taxes, advisers are now expected to know and understand the constraints placed on services to audit clients, and their clients' documentation and attestation of internal controls over tax-related financial statement accounts.

Common issues encountered by tax advisers and auditors range from whether a company has the in-house, technical resources to competently handle tax provisions, internal controls and changes in the underlying tax laws, to whether the company should engage another accounting firm to prepare and/or review its FAS 109 computations.

Clients' decisions will affect whether (1) they obtain a clean audit opinion, (2) their internal auditor can attest to internal controls being in place and being adhered to and (3) they can avoid disclosing a significant deficiency or, worse, a material weakness, in their tax internal controls.

This item reviews recent SOA developments in tax services and how the relationship between tax advisers and their clients has affected the tax functions on which clients rely (such as determining tax contingencies).

The Debate

Which tax services can be offered to public clients? Recent guidance permits providing certain tax services to audit clients. Also, these services are subject to normal audit committee pre-approval requirements, including tax compliance, planning and advice. However, some services are prohibited, such as bookkeeping, valuation, fairness opinions, internal audit and management functions, for example. The guidance clarifies which tax services impair independence. Such services include, but are not limited to, representing an audit client before the Tax Court, a district court or the Federal Court of Claims, and providing other unique tax expertise. However, the guidance permits some special services, such as transfer-pricing and cost-segregation studies. Violations of the independence rules can have serious consequences, such as loss of a client and a re-audit of its financial statements by new, independent auditors.

Some audit firms are concerned about the lack of a clear "bright-line" rule on tax planning and advice. The absence of clarity has caused many firms to limit substantially how they offer tax services to public companies. To further complicate the picture, these concerns are seeping into private companies and nonprofit organizations; these entities' board members and advisers are now beginning to require the same level of scrutiny as public companies.

The SOA empowered the Public Company Accounting Oversight Board (PCAOB) to implement SOA provisions, by promoting the ethics and independence of registered public accounting firms that audit and review U.S. public company financial statements. The PCAOB issued proposed guidance that identifies tax services that pose, and do not pose, an unacceptable threat to auditor independence. On Dec. 14, 2004, it voted unanimously to propose rules prohibiting a registered public accounting firm from:

1. Providing certain tax services to public company audit clients;

2. Providing any tax services to officers in a financial reporting oversight position (e.g., chief executive officer (CEO) and chief financial officer (CFO)), after 2004 income tax filing obligations are met; and

3. Receiving contingent fees from public company audit clients.

The rules also require specific written and oral communications between an audit firm and its client's audit committee on the proposed allowable tax services the firm will provide; for details; see www.pcaobus.org, under "Rulemaking."

In response, three AICPA committees (the Center for Public Company Audit Firms, the Professional Ethics Executive Committee and the Tax Executive Committee) jointly issued comments, on Feb. 14, 2005 (available at www.aicpa.org/cpcaf/download/AIC PA_Response_PCAOB_Docket_ 017_Comment_Letter.pdf). In addition to addressing the specific issues, the comment letter demonstrates the committees' overall support of audit firms continuing to offer some tax services to public company clients, without impairing independence. For example, for financial executives of public companies, the letter states, "... [We] believe that tax compliance and routine planning should be permitted."

With respect to aggressive tax positions taken by a client that engaged a third-party adviser for planning purposes, the AICPA committees believe that the client's auditor should be able to consult with its in-house tax specialists, without impairing independence, even if the consultation results in a less risky alternative; this type of advice is intended to enhance tax compliance and is in the "public interest."

The committees recognize that mechanisms currently exist to prevent inappropriate actions by CPAs that would violate independence. For example, according to the letter, "[n]umerous layers of statutory, regulatory and ethical safeguards already apply to the provision of tax services by CPAs ... the Internal Revenue Code imposes penalties and other sanctions ... [p]ractice before the IRS is regulated by Circular 230 ... and the [AICPA's] Statements on Standards for Tax Services...." Further, "[v]iolating these rules of tax practice can subject CPAs to ethics investigations and possible sanctions by the AICPA and state CPA societies and potential license revocation by state boards of accountancy." The committees continue to support provision of tax return preparation and consulting services to publicly held audit clients. Tax advisers will have to watch how the debate develops.

How the SOA Affects Auditing Taxes

As income taxes typically equal 30% or more of pre-tax income and represent significant portions of recorded assets and liabilities, taxes, in general, are a significant process subject to the SOA's requirements for adequate, auditable internal controls for accounting for them. Under the SOA, public companies report on the adequacy of their internal controls, and auditors attest to the accuracy of the company's report. Attestation of internal controls for tax is not limited to Federal, state, local and foreign income taxes, but also includes all related tax matters (e.g., franchise taxes, sales and use taxes, excise taxes, value-added taxes, payroll taxes and property taxes, and tax reporting for employee benefit plans). The PCAOB standards clearly indicate that an audit firm cannot become a part of a company's system of internal controls. Thus, if a company is incapable of properly accounting for taxes without its auditors' assistance, it has an internal-controls deficiency.

Nonpublic Companies

In April 2003, the AICPA amended AU Section 9326, Evidential Matter: Auditing Interpretations of Section 326, which significantly changed the review and documentation standards for accounting for income taxes for nonpublic companies. Independent auditors are required to have sufficient evidence in their audit workpapers to support the adequacy of the judgments and estimates inherent in a client's accounting for income taxes, to avoid a scope limitation on their opinion. AU 9326 clarifies that the audit firm cannot rely on the advice or opinions of a client's other tax advisers; rather, it must reach supportable conclusions. Companies are now engaging tax advisers from firms other than their audit firm to assist in FAS 109 compliance. AU 9326 clarifies that the audit firm's tax advisers must review FAS 109 computations in the same depth as if client personnel had made the computations. Thus, the SOA's far-reaching arm now extends to nonpublic tax services.

Summary

An auditor's use of the "tax specialist" for tax matters is more important than ever before. Clear guidance on tax services is needed to satisfy audit firms, CEOs, CFOs and audit committees. Even though there is clear support for tax professionals to continue to provide tax services to audit clients, the debate continues.

FROM KATHERINE D. MORRIS, CPA, ATLANTA, GA