It has been nearly four years since the legislation was first introduced in the US and businesses and individuals around the globe are still feeling the impact of the Sarbanes-Oxley (SOX) Act of 2002. Most have been particularly impacted by section 404 of the Act, which requires an annual report by management regarding internal controls and procedures for financial reporting and an attestation as to the accuracy of that report by the company's auditors.
Arguably, no one has felt the sting of SOX 404 more acutely than the tax departments. Tax departments globally are feeling the pressure as tax, for the second year in a row, holds the dubious distinction of being one of the most common areas of internal control failure (material weakness) cited in the adverse opinions filed in 2005 (Year 2).
Before SOX, perhaps due to the many complexities and unusual rules, accounting for income taxes more often than not was handled somewhat differently than the other financial statement accounts as there seemed to be less formalized processes. Often, the tax entries were the responsibility of one individual who kept much of the knowledge in their head rather than in clearly documented schedules and reports. Calculations were manual, complex and to a large degree reliant upon information gleaned from informal conversations with other departments, business units and, potentially, countries. Taxes were a "mystery", often deemed more of an art than a science and a chief financial officer's comfort over these accounts was probably gained more through dialogue than through review.
SOX 404 has thrown the spotlight on accounting for income taxes and the results have highlighted issues at many companies both large and small. A lack of understanding of US Generally Accepted Accounting Principles (GAAP) tax accounting rules, formalized processes, internal controls and documentation continued to be problem areas in Year 2. Year 2 has shown that much work is still left to do in the area of income taxes.
Tax trends and issues
PricewaterhouseCoopers, along with many others, has been tracking public disclosures of confirmed and potential material weaknesses discussed in Form 10-Ks, earnings releases and Form 8-Ks since 2004.
Year 1
The following is a brief list of the areas of failure cited most often in Year 1 which in certain instances also led to restatement:
lack of documentation of processes, controls and evidence of controls;
lack of process and controls over foreign tax provisions;
lack of understanding of tax risk and where it impacts reporting – "tax contingencies";
lack of understanding of US GAAP as applied to income tax accounting; and
communication and controls breakdown between tax and units within the organization.
Initially when the deficiencies outlined above were noted there was an attempt to rationalize and attribute the deficiency to the informal manner in which the tax computation and review were documented. In many cases, tax managers suggested that they indeed had solid processes and internal controls, however, those processes and controls simply were not adequately documented. There was resistance to expand documentation especially in areas that might be considered sensitive.
However, many of those observations proved unfounded when company's remediation of gaps in internal controls uncovered various errors in the tax accounts. In some cases the discovery of the error led to a restatement of the financial statements. In fact, most of the companies that disclosed a material weakness in the tax area in the first year of SOX 404 also had a restatement.
Also in Year 1 were those tax departments who took SOX 404 as an opportunity to highlight their efforts and resource needs in the area of income tax accounting. These companies set forth to enhance the documentation around existing processes and controls, as well as, implement new processes and controls in an effort to ensure SOX compliance in Year 1. In some cases these efforts led to documentation to almost the desk level which was much more than required to document adequately the key internal controls over the financial reporting of the income tax accounts. In fact, one of the more significant challenges in the first year was trying to achieve the balance of documentation and testing necessary to provide the "reasonable assurance" required by SOX 404.
Year 2
The overall number of adverse opinions has decreased from Year 1 to Year 2. Unfortunately, tax has continued to be one of the leading areas of "material weakness" disclosures.
Most companies that have been through Year 2 have cleared the documentation hurdle. They have, in large part, identified those internal controls that are key and rationalized the documentation needed to evidence the existence and operation of the control. Having said this, as noted above, there were still material weaknesses in the tax function.
Year 2 results included certain of the same material weaknesses in the tax area as those reported in Year 1. The following issues were once again reported as issues in Year 2 reporting:
lack of controls around foreign tax provisions;
lack of understanding of US GAAP accounting for income taxes; and
lack of communication/application of changes in US GAAP and tax law to the accounting for income taxes.
There were instances where there were material weaknesses in Year 2 at companies where there had been no material weakness in the prior year. While we have not done an in-depth study of these situations, the following observations are offered as probably explanations.
In Year 1 there was significant focus on the internal controls and remediation of deficiencies before year end. In some cases it would appear that the remediation, while addressing the immediate issue, was insufficient to address fully the underlying issues in the tax process. In other words, a certain control may have operated effectively in Year 1 due to the remediation steps taken in Year 1; however, those steps were never truly ingrained as a permanent improvement in the process and as a result, did not operate effectively in Year 2.
Another explanation might be that there were certain issues that were uncovered in Year 2 that may not have been highlighted in Year 1 for whatever reason. For example, if a company did not have any acquisitions in Year 1, it would not necessarily be evident that a company's controls around recording deferred taxes as part of purchase accounting did not operate effectively.
Finally, businesses change. They change their systems, the people change positions and in some cases the business itself expands into new markets and/or products. Each of these changes impact the internal controls applied to the accounting for income taxes. Failure to recognize the impact of these changes may lead to deficiencies that did not exist in the prior year.
It is no secret that management, audit committees and boards of directors have become more active and more engaged in the financial reporting process and the internal controls around those processes. SOX 404 is not viewed as a periodic compliance exercise to the company stakeholders, rather it is an ongoing process and a mindset.
It is also apparent that although great strides have been made in addressing gaps in controls when comparing Year 1 to Year 2 the results indicate that, tax still has room for improvement.
So, what issues still need to be addressed and what does the future look like for tax departments?
Specific issues – what still needs to be addressed?
Material weaknesses can be isolated and specific gaps in internal controls can be remediated, but a micro approach may only result in a temporary solution. One cannot assume that controls that have operated effectively in the past will operate effectively in the future.
A major challenge for many tax departments will be the need to embrace the discipline of maintaining, executing and documenting "controls" as part of the day to day activities. The truly effective tax department of the future will identify those key activities that can provide value and insure that they leverage those activities to the fullest extent.
In the future, the success of the tax department may hinge on vigilance and a holistic approach to internal controls and tax risk. Rather than documenting a multitude of control activities and adopting a compliance mentality, (individuals focusing on sign-off on checklists) tax departments must focus on those controls that provide the reasonable assurance that there are no significant errors. Having said this, many organizations may find that a well designed checklist that challenges the preparer to consider and document their activities can be a valuable tool. From a SOX 404 perspective, the objective is to provide reasonable assurance that no significant errors go undetected in the identification, computation and financial statement reporting of the tax accounts.
The concepts of this holistic approach may be captured by a series of questions. The persons responsible for tax controls should be able to identify, document and test the responses to the following questions:
How do I know that changes in tax laws, regulations and/or judicial decisions have been identified and the implications to the tax accounts accurately evaluated on a timely basis?
How do I know that the tax implications of changes in accounting pronouncements (including those not directly applicable to the tax accounts) have been identified and the implications to the tax accounts accurately evaluated on a timely basis?
How do I know that the data/information that is being provided and utilized in the tax computation is complete, accurate and received on a timely basis?
How do I know that the tax laws/regulations and the tax accounting principles have been applied properly to the information received?
How do I know that the computations are accurate (including consideration of systems and spreadsheets used in the computation)?
How do I know that the tax amounts computed are recorded properly in the general ledger?
How do I know that the disclosures included in the financial statements are complete and accurate?
Each organization must review their processes and procedures to determine how they address these questions. For a decentralized organization, this may involve numerous individuals throughout the organization, many of whom may not be in the tax department. In these situations, there may be a series of control activities that build on each other to provide the reasonable assurance. In an organization that is highly centralized, one might see fewer overall control activities. In these organizations the issue may become one of identification of redundant controls given the potential implications of a deficiency in a single area.
One other significant hurdle as companies move forward will be the identification and training of resources. This includes resources that not only understand tax technical issues and the related tax accounting but also understand the concepts of internal control.
Different 404 attitudes
At the macro level, SOX 404 may equate to enhanced corporate responsibility, enhanced financial disclosure, and a means to prevent corporate and accounting fraud. At the micro level, from the perspective of a vice-president of tax and a tax department, SOX 404 may be seen as a blessing or a curse.
For those unprepared or unwilling to comply, SOX 404 will mean increased administration, pressure, scrutiny and anxiety. These are the individuals resistant to change who believe that nothing of value can come from SOX 404.
For those ready to meet the challenge, SOX 404 will mean process improvement, efficiency, best practices and a direct line management. SOX 404 can be the tool to improve communications, responsiveness and the position of the tax department in the hierarchy of the company.
Those that realize that SOX 404 is not merely a project but a behavioural shift in thinking and actions will be better positioned to take advantage of SOX 404 and elevate their departments to the next level. Those who think of SOX 404 as a "pass/fail" exercise will most likely continue to struggle and feel the increased pressure of poor performance.
Biography |
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Larry serves as the national lead for the initiative addressing the application of Sarbanes Oxley Act section 404 (SO 404) to the tax function. His responsibilities include developing tools and training materials related to SO 404. Prior to his present role, Larry was in the BPO line of service and served as CFO of that line of service from June 2001 to January 2003. He also participated as a member of contract negotiation team and process transition team for multinational outsourcing clients. Before joining the BPO line of service, Larry had 23 years of experience providing services to clients, including 5 years as an auditor and 18 years providing tax services. Larry's current clients include: IKON, Hercules, Campbell Soup, Exide, VF Corporation and Kulicke & Soffa. Joseph Pearce PricewaterhouseCoopers Two Commerce Square, Suite 1700 Philadelphia PA 19103 US Tel: +1 267 330 1704 Fax: +1 813 329 7813 Email: joseph.pearce@us.pwc.com Joe is a tax director in the Philadelphia office of PricewaterhouseCoopers and works in the Industry Services Group where he focuses on providing tax consulting and planning services to multinational corporations. Joe has over eight years of public accounting experience and has served clients in a variety of industries, including technology, manufacturing, pharmaceutical and financial services. Joe earned his Masters of Business Administration with a concentration in taxation from Drexel University and is member of the AICPA and PICPA. |
