Three Ways to Reduce Income Tax Reporting Risk
Article one of a four-part series discussing ways to reduce risk and increase controls related to income tax accounting.
In a complex reporting environment in which public company filings are highly scrutinized, properly accounting for and disclosing income taxes under ASC 740 is increasingly important for mitigating your risk of restatement, material weakness or adverse internal control over financial reporting (ICFR) disclosures, and SEC comments. These issues can be costly, result in loss of stakeholder confidence, and adversely affect stock prices.
Here is what you need to know:
A recent report by the Center for Audit Quality showed that tax accounting issues averaged 12% of all restatements from 2013 to 2022. [1]
During that time, the Financial Accounting Standards Board (FASB) issued two accounting standards updates (ASUs) intended to simplify some tax accounting matters, and major legislative changes that added complexity to accounting for income taxes were enacted as part of the Tax Cuts and Jobs Act. Other legislative activity at both the federal and global levels has increased the complexity of income tax accounting matters. Further, the FASB recently issued another ASU targeting income tax disclosures that is expected to significantly increase the complexity and detail work for providing necessary income tax disclosures.
Accounting for income taxes under ASC 740 requires the preparer to have in-depth technical knowledge of both tax and financial reporting. However, it is uncommon for management teams to have expertise in all technical areas, especially when accounting for nonroutine transactions a company may encounter.
Adverse ICFR management reports for fiscal year 2022 revealed that the most common internal control issue that led to a conclusion that ICFR was ineffective was the need for more highly trained accounting personnel cited in approximately two-thirds of the adverse disclosures.
A common source of material weakness and adverse ICFR disclosures can be accounting for income tax errors stemming from a lack of internal expertise in a particular area of tax and of adequate basic internal resources. To mitigate the risk associated with financial reporting weakness, an entity’s tax providers should work closely with their external auditors to meet their audit documentation needs. Entities also should work closely with their external tax providers to identify gaps in knowledge and workload capacity.
An analysis of comment letter conversations between registrants and the SEC from 2013 to 2023 showed that tax expense/benefit/deferral was one of the top 10 topics overall and one of the top five topics specific to accounting issues.
Clear and transparent disclosures allow the SEC and stakeholders to gain a better understanding of the reporting entity’s income tax environment, reducing the possibility of SEC comment letters.
Awareness is step one. Once companies understand the risks, they can address ways to mitigate them. In-depth knowledge of tax and financial reporting, proper audit documentation, and clear and transparent disclosures can help reduce income reporting risk.
[1] Center for Audit Quality, “Financial Restatement Trends in the United States: 2013-2022” (June 2024).