If accounting is full of gray areas, tax is a pea-soup fog. So it’s no surprise that the most common material weaknesses revealed in the first round of Sarbanes-Oxley Section 404 filings are tax related.
For nearly one-third of the 488 filers that have thus far received adverse opinions on internal controls, tax accounting was listed as a contributing factor. According to Mark Cheffers, CEO of AuditAnalytics.com, the independent research firm that conducted the study, those numbers “could have been much bigger.” There is a good possibility that many other companies just barely escaped the auditors’ tax wrath, he says.
There are several reasons for this (see “Material Fallout” at the end of this article). First, tax professionals are in short supply. Second, Sarbox demands much more precision in tax-accounting procedures than has ever been required before. And because tax departments generally operated at a distance from the rest of the finance department, including internal audit, many companies had never before documented internal control procedures for tax.
“Tax accounting is its own little island,” says Leslie Hauser, tax director for Wisconsin at Jefferson Wells, an internal-audit firm. Traditionally, she explains, internal audit and tax have operated independently. And if the two occupied the same room, she adds, they would disagree. Even external auditors, she says, would bring their own specialized tax auditors to evaluate a tax department.
Internal and external staff must communicate better if companies are going to avoid future adverse opinions. But more than compliance with the law is at stake. According to a study by independent research firm Glass, Lewis & Co. LLC, firms that report material weakness in tax accounting lose an average of 5.8 percent of their stock value 60 days after the announcement. In addition, says Cheffers, all but six of the companies in the AuditAnalytics study that received adverse opinions related to taxes had issued a tax-related restatement or a material year-end readjustment for 2004. In other words, he cautions, if you issue such a restatement or readjustment, be prepared for an adverse 404 opinion. “It will most likely become the standard,” he adds.
The Evil of Estimating
Many of the adverse opinions so far can be attributed to the application of FAS 109, which governs the accounting for income taxes. Previously, says Timothy McCormally, executive director of the Tax Executives Institute (TEI), companies “had a lot more discretion.” In fact, it was standard procedure to estimate tax obligations in the first three quarters, then “true up” the numbers at year-end. It was also routine, says Cheffers, to grab data from a variety of different sources (such as international subsidiaries) in order to prepare a “down-and-dirty tax estimation.”
“It turns out some of that data was incorrect,” adds Cheffers. Now companies are forced to take a more detailed approach and generate solid numbers each quarter based, for example, on how each deferred-tax position would unwind, and to which deals they should be attributed. Gross estimates are no longer acceptable, and procedures for gathering the data need to be codified. “All of a sudden we are moving from matters of judgment to matters of rules,” says McCormally.