Tax Contingency Reporting

Tax advisers are often asked whether Financial Accounting Standards Board (FASB) Statement (FAS) No. 109, Accounting for Income Taxes, changes the accounting for tax contingencies. The answer is undoubtedly “no.” However, the statement has drawn new attention to tax contingency reporting; the unwary could apply the wrong standard to their evaluation of tax contingencies and their relationship to deferred taxes.

Background

When there is a loss contingency, the likelihood that a future event(s) will confirm the loss or an impairment of an asset or the incurrence of a liability can range from probable to remote. FAS No. 5, Accounting for Contingencies, states, in part, that a “loss contingency” will be charged to income if (1) it is probable that a loss has been incurred at the date of the financial statements and (2) the amount of the loss can be reasonably estimated. If neither of these requirements is met, disclosure is required if it is reasonably possible that a loss has been incurred. There is no support for an accrual if the chance of the future event(s) occurring is slight or remote. FAS 5 does not quantify the terms “probable,” “reasonably possible” or “remote.” In practice, CPAs generally interpreted “probable” or “likely” as greater than a 60% to 70% chance of occurrence, “reasonably possible” as between 10% to 20% and 60% to 70%, and “remote” as less than 10% to 20%.

While these standards are very difficult to apply in practice, supporting and documenting any conclusions may be even more complicated. However, documentation is still required, no matter how difficult. In many cases, it may not be possible to estimate the likelihood of a tax contingency being assessed. In addition, openly disclosing in financial statements, tax positions that might be challenged by the IRS or other taxing authorities, is also undesirable.

The Securities and Exchange Commission (SEC) commented on disclosure at the AICPA National Conference on Current SEC Developments, held in Washington, DC, on Dec. 6–8, 2004. It observed, “while registrants may have concerns regarding the disclosure of confidential income tax positions, those concerns are not valid reasons for noncompliance with GAAP.”

Handling Contingencies

Once a company determines that a tax contingency exists, it must:

1. Evaluate and support the balance sheet account to which the contingency should be reported (if it was recorded).

2. Decide how much detail should be disclosed about the contingency in the footnotes to the financial statements.

The company should not bundle tax contingencies with deferred tax liabilities or with a valuation allowance. For the most part, they should include such contingencies in current taxes payable or with long-term liabilities. The more difficult determination is the disclosure of tax contingencies in footnotes. Such determinations should straddle a fine line between complying with GAAP and not providing taxing authorities with a roadmap of tax return positions taken.

Uncertain Tax Positions

At the AICPA’s 2003 National Conference on Current SEC Developments, the SEC stated that uncertain tax benefits should be recorded in financial statements only if realization is probable. That changes the burden of proof as compared to a loss contingency. After that conference, it became clear that practices regarding uncertain tax benefits varied, and that many companies treated tax benefits like loss contingencies—recording the benefit unless disallowance was probable. In response, the FASB added to its agenda a project to interpret FAS 5 for uncertain tax positions. An exposure draft is expected this year.

FAS 5’s Implications

Public registrants will be under more scrutiny than ever before from the SEC, Public Company Accounting Oversight Board and audit firms to support their tax contingency evaluations properly and to report and disclose them. Careful analysis and evaluation of the facts and circumstances and of the appropriate reporting rules will be crucial elements of a policy to ensure appropriate reporting.

From Scott Guertin, CPA, Boston, MA