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Brainstorming to Identify and Manage Tax Risks Identifying and managing risks associated with tax engagements is critical for firms providing tax services. This article explains how firms can use brainstorming sessions effectively to identify and manage such risks, to protect both themselves and their clients. Mark S. Beasley, Ph.D., CPA J. Gregory Jenkins, Ph.D., CPA Roby B. Sawyers, Ph.D., CPA For more information about this article, contact Prof. Beasley at mark_beasley@ncsu.edu.
Risk management is critical for CPA firms and their clients today, due to an increased focus on corporate governance, greater Federal and state regulation and intensive scrutiny by the media and the general public. Press reports of widespread involvement by individuals and corporations in tax shelters have cast attention on tax advisers, who are increasingly under fire for developing and/or recommending such transactions to their clients. While most CPA firms are aware of the importance of managing the risks of financial statement audits, they can no longer ignore tax engagement risks. Otherwise, they will face malpractice suits, lose clients, damage their firm’s reputation and incur Federal and state penalties. In addition to the normal array of preparer penalties assessed by the IRS and state revenue departments, firms are now also being disciplined by government entities. This article describes how firms can identify potential risks associated with tax engagements by brainstorming. Firms can (1) manage risks within the firm to avoid malpractice claims, loss of clients and reputation risks and (2) help clients identify and manage risks related to tax functions. Risks within the Firm Managing risks within a firm generally centers on (1) client acceptance and continuance, (2) compliance and (3) development and recommendation of tax strategies. Client Acceptance and Continuance A prospective client’s appetite for risk may not always be acceptable to a firm. For example, does the client’s aggressiveness in tax planning translate to practices that stretch its compliance with statutes and regulations? Does the client consistently interpret tax compliance requirements beyond normal, acceptable views? If so, the firm may have to fire the client or not accept the engagement. Additionally, a CPA firm has to assess whether it can adequately service clients. For example, does it have sufficient expertise and resources to advise on multiple taxing jurisdictions on myriad tax issues? Does it have expertise in sales and use tax, as well as income tax? Can it deal effectively with foreign tax, as well as U.S. taxation? Compliance Engagements While taxpayers retain ultimate responsibility for complying with tax law, they frequently blame their CPA firm for post-audit tax bills, interest and penalties. They often accuse the firm of providing inadequate or faulty advice, not notifying them about a compliance obligation or not warning them of potential risks associated with a tax return position—regardless of whether the firm has been explicitly engaged to file the particular return or advise about a particular transaction. While the use of engagement letters can help minimize misunderstandings between firms and their clients, the risk associated with compliance engagements should still be assessed because they may be largely influenced by the client’s competency and tax expertise. Development and Recommendation of Tax Strategies Tax professionals have the responsibility to help clients minimize their tax liabilities and advocate on their clients’ behalf. Also, they have to avoid taxpayer and preparer penalties for recommending overly aggressive return reporting strategies. For example, penalties have been assessed for taking return positions that do not have a realistic possibility of success, have no substantial authority or do not meet other standards as outlined in the Code, the AICPA’s Statements on Standards for Tax Services and Circular 230.1 Over the last few years, however, the penalty potential for developing and recommending abusive tax strategies has increased substantially. For example, the American Jobs Creation Act of 2004 (AJCA) enhanced penalties aimed at both taxpayers and promoters of abusive tax shelters. These penalties include $200,000 fines for corporate taxpayers that do not disclose participation in so-called “listed” transactions; promoters are fined 50% of the gross income derived from abusive transactions.2 Besides penalties and fines, tax professionals and their firms face possible sanctions from the IRS and other regulatory agencies, bad publicity and the loss of professional reputation and clients. Identifying and Managing Tax Risks The average corporate tax department spends less than 10% of its time managing exposure to tax risk.3 Yet, a recent survey4 of over 350 corporate tax directors identified tax risk management as a top priority. Tax risk management involves identifying and managing risks within the tax function, as well as aligning the company’s appetite for such risk with its overall enterprise risk profile. Over two-thirds said that tax risk management was critical in preserving the organization’s overall reputation. Seventy-five percent said they are evaluated based on how they managed risks, which is higher than the percentages of those evaluated based on timely meeting compliance obligations, reducing costs or decreasing the company’s effective tax rate. At the same time, however, many of these directors expressed concerns about not devoting sufficient time or resources to risk management. This dilemma opens the door for CPA firms to provide a value-added service to companies, by helping them to identify and manage tax risks. Use of Brainstorming Professional auditing standards require auditors to conduct a brainstorming session as part of every audit, to assess the risk of material misstatements due to fraud.5 In an audit setting, brainstorming has two primary purposes: it (1) allows key members of the audit team to exchange ideas about fraud risks, such as how and when management fraud may occur; and (2) emphasizes the importance of applying appropriate professional skepticism throughout the audit engagement. One of the major benefits of brainstorming sessions is the discussion among the engagement team about why management might engage in aggressive financial statement reporting and how it might perpetrate and conceal fraud. Research shows that auditors who engage in such dialogue are more accurate in assessing their fraud risk than those who rely merely on checklists.6 There is no analogous requirement for tax engagements; however, brainstorming can be an effective tool for identifying risks associated with client acceptance, fulfilling compliance obligations and developing and recommending planning strategies. Brainstorming Fundamentals A brainstorming session will be most effective if the following fundamentals are followed. Identify Participants Properly managed brainstorming sessions bring together professionals within the firm from different backgrounds and with varying levels of experience to think creatively about a tax engagement or particular issue. When tax services are being performed for an audit client, audit professionals should be invited to participate as well, given their unique insight into the client’s operations and organizational structure. Others invited to the brainstorming session might include consultants, attorneys, the client’s tax director or internal audit professionals, and members of the client’s board of directors. These individuals can share information that provides insights about how aggressive management is toward tax compliance and planning. An issue to keep in mind when forming the brainstorming group is group domination. This occurs when one or a small number of individuals dominate the session because of their experience or vocal nature. Everyone must be encouraged to participate and respect others’ views. Set Ground Rules Each brainstorming session has a leader, such as the tax engagement manager or partner. That person sets the ground rules and ensures that everyone understands the session’s purpose, such as to identify the risks inherent in a client’s tax management activities. Ground rules might include: 1. Think “outside the box.” No idea or comment is unimportant. 2. Use others’ comments or ideas as building blocks for the session. 3. Do not criticize others’ comments or ideas. 4. Allow each person to speak and actively participate in the session; nobody should dominate the group. Failure to adhere to these rules can diminish the session’s value. For example, if a senior tax professional feels as though her ideas are not valued by other participants, she may cease to contribute to the session, leaving the brainstorming to others. Probably the quickest and surest way to squelch creativity is to allow criticism. Participants should be comfortable sharing their views during a session and feel as though there are no “dumb” ideas. Session leaders should unequivocally state that no criticism is allowed. Every idea is valuable, regardless of how irrelevant, minor or even silly it might seem. The goal is to generate as many ideas as possible about the risks involved in a particular tax engagement or strategy. In the end, session leaders should encourage a diversity of views and nonconformist thinking. Encourage Preparation Brainstorming sessions are most beneficial when participants come prepared. For example, if the session deals with identifying risks associated with a particular tax strategy or reporting position, the session leader should notify all participants about the meeting’s purpose well in advance, to ensure participants have sufficient time for self-brainstorming and to review client files and related tax laws. If the session deals with whether to accept a new client or engagement, participants can review the client’s business and legal structure, identify taxing jurisdictions and compliance requirements, and assess management’s integrity. Advance preparation increases both the quantity and quality of ideas discussed during the session, while at the same time reducing time spent brainstorming. Praise Group, Not Individuals Brainstorming session leaders should praise the group—rather than individuals—for ideas generated during the session. Once an individual shares an idea about tax-related risks, everyone should be encouraged to take ownership of that idea. Encouraging group ownership will lead to increased interest in the task and greater commitment. Manage Group Size There is no perfect size for a brainstorming group. The group’s size will depend on the nature and complexity of the tax engagement, the number of tax professionals assigned to it and the size of the CPA firm. However, there are some general guidelines when planning a brainstorming session. Smaller groups (with seven or fewer participants) generally complete tasks more quickly. In contrast, groups of 12 or more participants solve problems better and generate more ideas because there are more individuals thinking about risks; however, the larger size may deter certain individuals from participating. Large groups also have more difficulty clarifying and evaluating ideas. For some very large and complex engagements, it may be advisable to break up participants into smaller groups, to brainstorm about risks in specific areas affecting state and local taxation, international taxation and so forth. Representatives from each group can later convene to discuss identified risks and to brainstorm about consolidated tax-related risks. Other Considerations Brainstorming does have a few noteworthy quirks that should be effectively managed. A group may fall prey to “group think,” one of the more insidious problems associated with brainstorming. This phenomenon occurs when participants become preoccupied with completing a task and reaching a consensus and, as a result, do not realistically identify and evaluate all the potential risks associated with a position. Another potential problem associated with brainstorming in groups is “groupshift.” Groups tend to make judgments that are systematically different from those of individual group members. Some research7 indicates that groups usually make riskier judgments (or shift toward more risks) than do individual group members. Other research shows, however, that under certain circumstances group judgments lead to conservative shifts (or a shift toward accepting fewer risks).8 Both risky and conservative shifts can be problematic when trying to assess the risks of client acceptance, meeting compliance obligations and developing and recommending tax strategies and reporting positions. While the purpose of brainstorming in a tax engagement setting is to identify and evaluate the tax-related risks, care must be taken to recognize the potential for groupthink and groupshift, and not to over or underreact to the risks identified. Brainstorming Techniques There are a variety of brainstorming techniques, including open brainstorming, round-robin brainstorming and electronic brainstorming. Each of these methods can be used to identify tax-related risks associated with a firm’s tax practice. Open brainstorming: Many professionals have participated in “open brainstorming” sessions, which have very few rules and procedures. Operating in a mostly unstructured way, individuals share ideas as they come to mind in a kind of free-for-all. Although this approach is often used, merely forming a group will not generate many high-quality ideas about managing tax risks. In fact, if the brainstorming fundamentals discussed above are ignored, open brainstorming’s unstructured environment can degenerate the process to the input of only one or two individuals. However, if an open brainstorming session is conducted, it is best to ask someone who is not participating in the group to record ideas. That person is free to take notes without also having to generate ideas. This may be easily assigned to a new staff person on the engagement who has little knowledge about client-specific factors. It will also be educational. Round-robin brainstorming: Round-robin brainstorming is a structured technique that begins with a silent period during which participants engage in self-brainstorming. If participants were informed of the issues to be discussed before the session, this phase of the meeting should proceed quickly. Also, participants will be more productive and respond more favorably if they are given a benchmark. So, it is advisable to ask them to record and prioritize a moderate number of ideas about tax risks (e.g., three to five ideas) to share with the group. After the self-brainstorming phase, each individual takes turns sharing his or her ideas, presenting the most important idea first and so on until all ideas have been shared with the group. It is quite effective to have group members list each of their ideas on separate sheets of paper for posting on a wall or bulletin board. This nonverbal sharing of ideas is particularly helpful for people who may be reluctant to share an unusual idea verbally. It can also be efficient, because all the ideas are shared simultaneously. The sharing of ideas, whether silent or not, is followed by a period of discussion in which ideas are clarified, refined and consolidated. If the discussion proceeds in an open and constructive manner, the group is likely to take “ownership” of the shared ideas, which should translate into concrete actions after the meeting. Round-robin brainstorming eliminates the problem of one person dominating the group. Because team members take turns, input opportunities are equalized and each participant has a chance to speak. Of course, the structure imposed by this method also has a downside—a possible loss in creativity and spontaneity. Generally, round-robin brainstorming results in fewer ideas, and participants may feel less connected to the group’s mission if there is insufficient time for a free and spontaneous exchange. To remedy this, individuals should be allowed to interrupt the flow by sharing their ideas about a particular issue. Electronic brainstorming: Technology has ushered in an increasingly popular technique simply referred to as “electronic brainstorming.” As in the previously discussed techniques, participants are told of the topic prior to the meeting to allow sufficient time for self-brainstorming. The session begins when a participant enters an idea via traditional e-mail, instant messaging or special brainstorming software9 that is then electronically presented to other members of the group. Frequently, the idea stage is conducted anonymously. Unlike the previously discussed techniques, team members can share ideas as they come to mind. There is no need to wait for a turn to speak, because technology eliminates this problem. After idea generation is completed, brainstorming software assists the participants with the discussion and consolidation of the group’s ideas. Electronic brainstorming generally shortens meeting times, increases idea generation, and reduces the possibility of personalizing ideas when conducted anonymously. Group size ceases to be a limiting factor as well. While large groups are very good at generating ideas, they are slow at discussing, clarifying and evaluating them. Current technology allows reasonably large groups to have virtual meetings without many of the typical coordination and communication problems. In addition, an individual’s geographic location is not a problem as long as there is access to the appropriate software. Electronic brainstorming is a great tool for large, multinational client engagements, when tax professionals and other participants are globally dispersed. The disadvantages of electronic brainstorming are the obvious loss of social interaction. While face-to-face teams are often less efficient, nonverbal cues often help build trust and collegiality within the group. Because electronic brainstorming allows for idea generation and sharing in an anonymous setting, individuals may never receive the praise they feel is due. Consequently, some group members will feel that there is no incentive to participate. Conclusion Managing a firm’s tax practice is becoming more challenging every day. Increasingly complex tax laws, greater scrutiny by regulators and more awareness of abusive tax saving strategies all contribute to an expansion of risks associated with a CPA firm’s tax practice. While managers and partners are routinely aware of many of these risks, today’s fast-paced environment increases the potential for overlooking some of them. Brainstorming sessions can reduce this likelihood and increase a CPA firm’s ability to identify and engage in proactive risk management practices. |
