Tax issues foremost problem on 404 list.

It may seem hard to believe, but tax is becoming the scariest accounting-related issue in Sarbanes-Oxley Section 404 compliance--and that is changing the landscape for the larger accounting and audit firms.

A recent survey by Audit Analytics and the Ives Group found that tax issues (accruals and deferrals, etc.) cropped up at 34.5 percent of companies with generally accepted accounting principles (GAAP)/accounting failures in Year Two of Section 404, ahead of revenue recognition (see table). In year one, tax issues were also the No. 1 problem, at 32 percent of the companies.

Why is tax such a headache? Doug Sirotta, a partner and regional tax business line leader for BDO Seidman LLC, ticks off a number of reasons:

* 404 places new demands on tax departments, which historically have been something of an afterthought for finance.

* FAS 109, which covers accounting for income taxes, has created all kinds of problems in applying tax to financial statements. Training in FAS 109 has typically been inadequate, especially in foreign locations.

* Companies generally prepare tax returns on a legal-entity basis, but financial reporting usually rolls up data from those legal entities into a consolidated set of numbers, creating potential discrepancies.

Compounding these troubles, Sirotta says, is the fact that historically, tax practices followed on the coattails of the audit business, especially at the Big Four firms. However, under Sarbanes-Oxley, audit committees are limiting the amount of tax work they allow their audit firm to handle--pressuring the tax side to develop its own business. These limitations also have created conflicts of interest among the Big Four, especially at large global companies, opening up new opportunities for smaller firms.

"Tax, in general, uses a lot of judgments; in some cases, those will lead to potential material weaknesses," Sirotta says. "The tax rules are very complex, and by and large, auditors have never set up internal controls for tax. The auditors didn't want to focus on it. It's a high-risk area, and they relied on other outside providers."

Sirotta says that BDO Seidman views the tax crisis as an opportunity, and has been talking to and working with tax clients it never approached before--companies in the Fortune 50. It has realigned its practice to make FAS 109 compliance a core competency of its tax group, Sirotta says, adding that "it's a wedge for us" in getting new business.

Sirotta, who worked for Ernst & Young before joining Seidman five years ago, says that "tax has often been the forlorn stepchild; companies didn't put a lot of resources behind it." Now that the problems have erupted, many are considering outsourcing certain functions or seeking other outside consulting help.

Year 2 Section 404 GAAP/Accounting Failures

Tax Accruals, Deferrals, etc.  34.5%
Revenue Recognition            28.4%
Inventory/Vendor COS           23.7%
Leases or Contingencies         9.3%
Consolidation (FIN 46)          6.7%

Source: Audit Analytics/Ives Group research