Sarbanes-Oxley Section 404 and Mandatory E-filing
Are Corporate Tax Departments Burning the Candle at Both Ends?

By Mark J. Cowan and Tom English

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Material Weaknesses

Auditors are required by AU section 325 to report, to the company’s board of directors, control weaknesses that are considered “reportable conditions,” defined as “significant deficiencies in the design or operation of internal control, which could adversely affect the organization’s ability to initiate, record, process, and report financial data.” AU 325 further indicates that auditors “may choose” to report to the board those reportable conditions that are considered “material weaknesses.” Material weaknesses are defined as controls that do “not reduce to a relatively low level the risk that misstatement caused by error or fraud in amounts that would be material in relation to the financial statements being audited may occur and not be detected.” While material weakness reporting is optional for nonpublic companies, SOX section 404 (which relates only to public companies) requires them to be disclosed in a report to the SEC. Thus, significant internal control weaknesses that result in a high level of risk that a material financial statement error will occur should be reported to the SEC.

The big story of the first cycle of SOX section 404 compliance has been the number of material weaknesses that have arisen from accounting for income taxes. In a February 9, 2006, speech, SEC Chairman Christopher Cox announced that almost one-third of companies that reported material weaknesses cited income tax reporting as one of their problem areas. Tax accounting issues are second only to revenue recognition issues as the leading causes of material weakness disclosures. These weaknesses were due to tax processes and controls, and resulted in a significant number of financial statement restatements. Several large companies, such as Kodak and MCI, have reported material weaknesses related to income taxes. Ironically, even H&R Block announced on February 23, 2006, that, as a result of its review of material control weaknesses, it was restating its fiscal 2004 and 2005 financial statements by $32 million for understated state income tax liabilities.

These results are from accelerated filers, which are required to comply with SOX section 404 for fiscal years ending on or after November 15, 2004. Accelerated filers are generally companies that have a market capitalization of $75 million or more. Nonaccelerated filers, generally companies with a market capitalization of less than $75 million, are required to comply for fiscal years ending on or after July 15, 2007. The SEC Advisory Committee has recently proposed exempting or relaxing the section 404 requirements for smaller companies. It is unclear at this time whether section 404 will ultimately be implemented on schedule in its current form. It is clear from the results of the accelerated filers that tax departments have changes to make and, barring any relaxation of the rules, it is likely that nonaccelerated filers will find themselves in similar circumstances.

Causes

KPMG reports that the biggest reason given for material weaknesses in the tax function was related to corporate tax staff competence in income tax accounting. When MCI, for example, announced its income tax material weakness on March 16, 2005, it went so far as to describe how it would remedy the problem going forward, including hiring a new vice president of taxation and increasing the number of staff knowledgeable in tax accounting issues.

Companies are finding that their in-house tax professionals are often well versed in technical tax topics but weak when it comes to accounting for income taxes under SFAS 109. Historically, many corporations, particularly smaller ones, would rely on the audit and tax teams from their independent audit firm to help with the SFAS 109 calculation. Independence issues and public accounting firm staffing shortages have eliminated this option, leaving many tax departments with a dearth of in-house SFAS 109 expertise. Companies have begun aggressively training their tax staff in SFAS 109 issues and hiring tax professionals with an SFAS 109 skill set. Unfortunately, such individuals are hard to find in today’s recruiting market.

Another significant material weakness found among accelerated filers was inadequate documentation of tax-effected cumulative book and tax temporary differences. In addition, processes and controls over analyzing and establishing valuation allowances and contingency reserves were also found to be inadequately documented.

These problems can be linked to the staff competence issues noted above and to the attitude that many corporate tax departments have historically taken toward SFAS 109 reporting. Many tax departments would use ad hoc, nonstandardized spreadsheets to compute tax provisions and deferred tax amounts for year-end financial statement reporting. At best, these spreadsheets provided an estimate of the appropriate deferred tax accounts. Only months later, when the return was actually prepared and filed, were the tax accounts “trued up” to the correct amount. To some extent, this approach was understandable, given that tax departments must work at the end of the reporting cycle and have a very small window—from the receipt of pretax book income to the earnings release—in which to finalize the tax accounts.

Tax departments were able to take this spreadsheet estimate/true-up approach because they often maintained “free” or “unallocated” reserve amounts in their contingent tax liabilities that they could increase or decrease to meet the estimated tax provision calculated for financial statement purposes. Such practices can no longer be used in a SOX section 404 context. Tax departments must identify the specific tax exposures that the contingency reserves are meant to cover. The tax department’s view of the company’s exposures must be documented and supported by a detailed legal analysis.

A general, overarching problem in applying SOX section 404 to the tax function is that many tax departments historically operated in isolation, apart from the financial accounting, finance, and business functions of the enterprise. Tax staff generally considered themselves to be technical tax planners or technical tax compliance specialists, not experts in financial accounting issues, and certainly not experts in internal controls. Members of the tax staff focused on the substance of their calculations and, unlike staff in other accounting departments (e.g., accounts payable), were not as concerned with documenting their processes and controls. Top management and the audit committee of the board of directors rarely showed much interest in tax matters and did not keep tabs on how their tax departments were fulfilling their mission. SOX section 404 has forced tax department operations to be more transparent to upper management and the audit committee, and forced the tax department to be more actively engaged in company business operations to address tax issues on a real-time basis.

Best Practices

Ernst & Young reports that successful accelerated filers were proactive in their approach to these issues by providing early training to their tax staff, especially with respect to following SFAS 109; supporting deferred tax balances with tax-basis balance sheets and other supporting calculations; and using tax-provision software and other support tools.

The current SOX environment forces tax departments to provide better tax reporting and to manage tax risks. In response, tax departments are seeking best-practice guidance to ensure that they are on track. Several best-practice surveys have been conducted providing information in this regard [e.g., Ernst & Young’s Sarbanes-Oxley Year 1 Review: Tax Observations and Lessons Learned (www.ey.com/global/content.nsf/
International/Tax__Tax_Accounting_and_Risk_Advisory_Service); KPMG’s 2005 Tax Department Survey (www.us.kpmg.
com/RutUS_prod/Documents/9/Tax_Survey_2005.pdf); and the Tax Executives Institute’s 2004-2005 Corporate Tax Department Survey (http://www.tei.org/Resource.phx/public/ctds.htx)]. In addition, some commentators have focused on a specific aspect of improvement, such as changes in reporting structure (e.g., Jasper L. Cummings, “Chief Tax Officer Reporting Structures,” Tax Adviser, October 2005), or have offered extensive advice on improving internal controls and the overall operational efficiency of the tax function (e.g., George R. Goodman, “Internal Controls for the Tax Department,” Tax Notes, May 4, 2004; and David E. Hardesty, “Sarbanes-Oxley Compliance in the Corporate Tax Department,” Financial Reporting Watch, Mar. 1, 2005).

A summary of some of these findings is as follows:

• Build and maintain a tax-basis balance sheet, or otherwise support deferred-tax balances.
• Establish a control group that includes a tax representative to sustain the section 404 effort, and work with third parties to remediate control deficiencies.
• Develop an annual section 404 calendar for the tax department.
• Evaluate the oversight, policies, and effectiveness of overseas tax accounting operations.
• Consider the need to perform an earnings and profits study for foreign subsidiaries.
• Reconcile all tax accounts at least quarterly and annually.
• Devote more time to interim reporting.
• Update and document specific tax exposure items, valuation allowances, and related internal control processes.
• Review appropriate skills, capabilities, and training of tax professionals to cope with the added financial and internal control reporting requirements.
• Provide more technical training, particularly in the areas of tax accounting and internal controls.
• Seek earlier and more-effective communications with and between auditors and third-party tax providers, to avoid surprises.
• Pursue tax process improvement as a way to achieve better effectiveness, efficiency, timeliness, and accuracy; to address growing internal and external demands; and to face growing risks.
• Increase staff to handle increased demands (one survey reported that one-third of companies have increased staff more than 25%, and that half anticipate an additional increase in the next 12 months).
• Undertake tax department process improvements, including tax-technology improvements such as process automation.
• Ensure that tax department personnel are tapped into other departments and business units, in order to assess tax issues of business transactions as they occur.
• Plan project focus to include SOX compliance, financial reporting, tax provision automation, and process simplification.
• Draw on resources of outside tax advisors to provide internal tax training.
• Prohibit the use of the external auditor for tax services.
• Increase internal audits of tax departments.
• Consider having the Corporate Tax Officer report to the legal or internal audit functions rather than to the CFO.
• Ensure that tax department processes and controls are properly documented.

Best practices will no doubt continue to evolve as accelerated filers improve their processes and as nonaccelerated filers begin to wrestle with the complexities in SOX section 404. In response to the changing tax department landscape, Tax Analysts, publisher of Tax Notes, now provides an online service, Financial Reporting Watch (see www.taxanalysts.com), to keep tax executives and their advisors up to speed on emerging issues and best practices.

Long-term Implications for the Tax Function

The implementation of SOX section 404 in corporate tax departments has obviously been costly and burdensome. Tax departments hope that once they have the best practices and controls in place to eliminate any material weakness issues, the costs of compliance will abate and ultimately inure to the long-term benefit of the company in general, and the tax function in particular.

One long-term benefit is that SOX section 404 forces tax departments to abandon their insular nature and address company tax issues on a real-time basis. Before section 404, some proactive tax departments worked side by side with the business planners as transactions took place. Many, however, did not. Tax departments operating in isolation from the financial reporting, finance, and business functions within their companies inhibited tax planning. SOX section 404 will force all tax departments to become more engaged, which should improve overall tax planning and ultimately enhance shareholder value.

Another potential benefit is that tightened controls force tax departments to document their risks and exposures with greater specificity, allowing resources to be directed toward resolving the most significant problems. Whether these potential benefits will come to fruition remains to be seen.

Mandatory E-filing

As tax departments struggle to meet the increased demands of SOX compliance, they must not forget the new IRS electronic filing requirements for 2006. The new IRS mandate requires all companies with at least $50 million in assets that file at least 250 tax returns annually to e-file their 2005 Forms 1120 or 1120S. Income, excise, information (e.g., Form 1099), and employment tax (e.g., Form W-2) forms count toward the 250-return threshold. Most businesses that meet the $50 million asset threshold, therefore, will probably also meet the 250-return threshold.

Even though the Treasury Department issued temporary and proposed regulations under IRC section 6011 mandating e-filing in early 2005, few corporate tax departments have been proactive in preparing for this new requirement. KPMG reported that, as of December 2005, only 2% of eligible companies were prepared to comply with the requirement, while 15% had a plan in place and 35% had not even started. The IRS’s position is to provide an extension only on a very limited basis, so tax departments should not hope for a waiver. KPMG reported that three-quarters of tax departments plan to license tax software to process and e-file their return.

Like SOX section 404, this is another challenge that large companies currently face and that smaller companies will have to confront eventually. Companies with assets of $10 million or more that file over 250 returns per year will be required to electronically file their Forms 1120 or 1120S for tax years ending on or after December 31, 2006.

Potential E-filing Problems

Companies that are e-filing for the first time should understand that return preparation may require several additional weeks because of issues with attaching documentation, concerns over data security, and problems with importing data from multiple software sources.

As any tax veteran can attest, the preparation and filing of a major corporate tax return is a process that can involve multiple software packages (for example, one for foreign issues and one for domestic issues), overrides of calculated numbers within those software packages, various Microsoft Word and Excel attachments, the occasional handwritten note, and a game of “beat the clock” on filing day to get the return in the mail. Inevitably, some issue, great or small, will arise that will hold up the return until the extended filing deadline. As a result, schedules and forms are often slipped into the return at the last minute.

These quirks of the tax return process are not available with e-filing. The entire return must go through the e-filing system. The return and attachments must run through IRS-approved software in extensible mark-up language (XML). In certain limited situations where conversion to XML is not possible (for example, the corporation must attach an appraiser’s report), the attachment must be scanned and submitted in PDF format. Tax staff cannot make manual corrections. There is no guarantee that overrides of software-computed amounts will translate into the e-filed return. Last-minute attachments cannot be “slipped in” to a return as it goes to the post office.

Last-minute filing is no longer a practical option. Tax departments cannot be cavalier and expect to “push the button” on the filing deadline and hope that all goes well. The risk of something interfering with a successful filing is substantial. Furthermore, companies using a software vendor to transmit the return to the IRS may have to enter a queue for filing on a first-come, first-served basis. Given the risks and the novelty of the situation, it is best to plan for a substantial margin of error.

Best practices. As of this writing, most companies have not yet prepared for the first year of e-filing. Thus, there are no established best practices to follow. The best advice, in light of the potential problems noted above, is to be proactive and allow extra time for the new e-filing process. Smaller corporations scheduled to implement e-filing in 2007 should monitor large companies’ experience with e-filing the 2005 return to anticipate any potential problems.

Long-term Implications of E-filing

Corporations with $10 million or more in assets are now required to file, with their tax returns, Schedule M-3, a much-expanded version of Schedule M-1 that details the corporation’s permanent and temporary book/tax differences. Mandatory e-filing, coupled with the new Schedule M-3, is designed to allow the IRS to more quickly select taxpayers and issues for audit. This will allow the IRS to be more efficient and focused in its audit process and should, in theory, allow the IRS to begin and finish corporate tax audits quicker. Thus, while corporate tax departments will have to spend a considerable amount of time putting reporting systems in place to complete the M-3 and file returns electronically, ultimately corporate taxpayers will benefit from these innovations. Their IRS examinations should become more focused, and less time should be wasted on insignificant transactions.

As Cliff Jernigan, former Senior Industry Advisor in the Large and Midsize Division of the IRS, notes in his book, Corporate Tax Audit Survival (Olive Hill Lane Press, 2005), corporations should prefer shorter audit cycles. It reduces the potential for interest expense on deficiencies and provides more certainty. Viewed from a certain perspective, the current headaches over the M-3 and e-filing can be seen as an investment in a smoother compliance and audit process going forward.

In addition, as Jernigan notes, using e-filing and the M-3 to more efficiently handle larger corporation audits will free up IRS resources to focus more on medium-sized and smaller companies. Smaller companies that are not accustomed to being audited may be unpleasantly surprised to find themselves getting more-frequent visits from the IRS. Of course, it remains to be seen whether, and to what extent, the IRS’s hopes of streamlined audits come to fruition.

Two Challenges That May Improve Practices

SOX section 404 compliance and e-filing represent significant challenges currently confronting large corporate tax departments. Unless the rules are relaxed or delayed, these same issues will soon be challenging tax departments and their advisors at smaller companies as well.

Tax departments must improve controls over SFAS 109 and the processes that surround it to avoid material weaknesses in the tax area. Likewise, tax departments can no longer make last-minute manual corrections to returns filed electronically. In short, tax department processes must be tighter, for both financial accounting and tax return compliance. With any luck, these tighter processes will ultimately benefit the corporation’s tax planning, compliance, and IRS examination processes. For now, however, large corporate tax departments are, to invoke an apt cliché, burning the candle at both ends. If they are to meet the coming challenges, smaller companies and their advisors should study the experience of their larger brethren, and start implementing changes now.