This article focuses on one particular category of OCBOA financial statements. It explains various implementation and practice issues related to the audit of financial statements prepared on the tax basis of accounting.

What Qualifies as an OCBOA?

SAS 62 specifies four categories of bases of accounting that qualify as OCBOAs. These categories are basically unchanged from SAS 14, which SAS 62 supersedes. The four categories are:

* Regulatory basis;

* Tax basis;

* Cash basis; and

* A definite set of criteria having substantial support that is applied to all material items.

The requirements applicable to auditing and reporting on OCBOA financial statements are discussed in detail in "Special Reports: Conforming Changes and New Services" by Kay W. Tatum and Paul Munter in the October 1989 issue of The CPA Journal.

SAS 62 describes the tax basis as the basis of accounting that the reporting entity uses or expects to use to file its income tax return for the period covered by the financial statements.

When Should Tax Basis Accounting Be Considered?

The income tax basis of accounting is based on the rules and regulations for accounting for transactions under the IRC. Tax basis financial statements are particularly useful when statement users are primarily interested in the tax aspects of their relationship with the entity. For example, the investors in a tax shelter limited partnership are primarily interested in the tax consequences of transactions. However, these users typically want more information and detail than would be provided simply by receiving a copy of the entity's tax return. Tax basis financial statements fill this need.

Generally, profit-oriented entities are required to maintain records of the tax basis of their assets and liabilities. This means that using the tax basis instead of GAAP in preparing financial statements can usually reduce overall financial reporting costs.

Several factors make tax basis financial statements more attractive than ever for small businesses. First is the increasing complexity of GAAP. A significant issue within the accounting profession for many years has been the problem called "standards overload." The vast number and relative complexity of accounting standards is a real burden to many small businesses and the independent CPAs who provide them with professional services. Some accounts view tax basis financial statements as a way of providing some relief from the standards overload problem. Both the AICPA and the FASB have acknowledged the existence of the problem of standards overload, but this recognition has not noticeably reduced the complexity of authoritative accounting literature.

The owner-manager of a small business views the independent CPA as a professional advisor who provides sound business advice and helps to keep the owner-manager out of trouble. An important aspect of this is ensuring that the business is in compliance with the many federal, state, and local laws that effect business operations. The CPA does not provide legal services, but many laws result in the periodic filing of information based on the accounting records. For example, there are payroll taxes, sales taxes, franchise taxes, income taxes, pension requirements and some license, permit and similar requirements about which the CPA who provides service to this type of client must be very knowledgeable.

The client expects the CPA to understand the client's business and to be able to provide good common sense advice on improving operations. Additionally, the CPA must keep up with the never-ending flow of authoritative literature.

When Congress passed TRA 86, the burden became even greater. The IRS continues to issue many complex regulations needed to implement the new provisions. Because of the time and cost of training, there can be considerable savings to CPA firms in being able to use the same basic knowledge base to prepare tax returns and financial statements.

AMT Brings Added Value to Tax Basis Financials

A significant incentive for using tax basis financial statements for corporate clients, particularly closely-held corporations, arises out of the alternative minimum tax (AMT). Under that tax system, the basis of accounting used in preparing financial statements can have an effect on the client's tax liabilities. The AMT provisions of TRA 86 were adopted to help ensure that a corporation earning significant economic income would not escape paying income taxes by use of various exclusions, deductions, and credits. The use of tax basis financials could lower the AMT bill for corporations under certain circumstances.

An Overview of the AMT for Corporations

The tax laws have many provisions for tax-advantaged investments. The laws were designed to fulfill certain social or economic policy objectives other than raising revenue. The tax breaks generally take the form of rapid write-offs of certain costs or the deferral of income for tax purposes. Through the skillful use of these special tax provisions, some high-income taxpayers have been able to avoid the payment of any tax or to pay a minimal amount of tax. As a result of displeasure with the inequity of the current situation, Congress enacted the AMT to ensure that no taxpayer with substantial economic income could avoid significant tax liability.

Exhibit 1 shows the elements of an AMT computation formula for corporations. As shown in this exhibit, the AMT is computed by starting with taxable income before net operating loss (NOL) deductions and adding or subtracting certain "adjustments." Then certain "preferences" are added. The most important distinction between a preference item and an adjustment item is that a preference is always a positive number, but an adjustment can be either positive or negative. The alternative minimum taxable income (AMTI) is reduced by the AMTI NOL and the exemption amount and the resulting AMT base is then multiplied by 20%. This amount, less the AMt foreign tax credits, equals the Tentative Alternative Minimum Tax (TAMT). The TAMT, less the regular tax, equals the AMT. The taxpayer ends up paying the regular tax plus the AMT. Thus, the AMT is not really an "alternative" but, rather, an "add-on" tax. Exhibit 2 presents an example of an AMT computation.

How Does the AMT Affect OCBOA Considerations?

For tax years beginning on or after January 1, 1987, corporations have to compute tax liabilities under both the AMT system and the regular tax system and, effectively, end up paying the larger of the two amounts.

Among the adjustments to determine AMTI for a corporation is one related to the difference between the income reported in its financial statements and its taxable income.

In tax periods beginning before 1990, a corporation will need to add a book income adjustment (the "Business Untaxed Reported Profits" or "BURP" adjustment) to regular taxable income to determine AMTI. The BURP adjustment is calculated as 50% of the amount by which adjusted book income exceeds AMTI exclusive of the BURP adjustment. Book income is the pre-federal tax income or loss shown on an entity's financial statements that include a balance sheet. TRA 86 assigned priorities to corporate financial statements and required use of the highest ranked statements from which to extract the book income amount to be used.

Where Does Book Income Come From?

The priorities include four separate ranks. First is financial statements that are filed with the SEC. Generally, the SEC requires financial statements in conformity with GAAP, and corporations that must file with the SEC cannot achieve any economies by using tax basis financial statements.

Second is audited financial statements used for credit purposes, reports to shareholders or for any substantial non-tax purpose. This means if the corporation has audited tax basis financial statements that are used by lenders or other significant users, savings can be achieved. The authors are not encouraging the use of tax basis financial statements for lending or other investment decisions. However, if a lender understands tax basis financial statements and is willing to accept them for credit purposes, savings can be achieved, at least for years beginning prior to 1990. These savings can result from both lower financial reporting costs and lower taxes.

Third is financial statements that must be filed with federal, state or local governments or agencies. For this purpose it makes no difference whether the financial statements are audited, reviewed, or compiled. As long as the governmental unit does not specify that GAAP financial statements are required, tax basis financial statements may be used, and the savings may still be achieved.

Finally, there is a fourth catchall rank of any financial statements prepared for a substantial non-tax purpose. If the corporation prepares financial statements in this category, a possibility would be to use tax earnings and profits reduced by distributions to owners and federal income tax to derive book income.

In summary, unless a corporation must file with the SEC or an important lender or other user requires GAAP basis financial statements, the corporation may use tax basis financial statements as its highest level of financial statements. In that case, in computing AMt, the BURP adjustment would be negligible and taxes payable would be less. Financial reporting costs would also be reduced because of the elimination of the need to keep two sets of books.

The legislative history of the book-income adjustment indicates it was a temporary compromise. Initial proposals in Congress would have required the addition of the entire difference between book and tax income. The result, for many taxpayers, would have made AMTI and book income identical. These corporations would therefore have had to pay tax based on book income. However, this proposal was voted down in December 1987.

Watch Out for ACE

As part of the compromise, however, starting in 1990, the book income adjustment is due to be replaced by an adjustment based primarily on the Subchapter C concept of earnings and profits (E&P). This adjustment is called the "Adjusted Current Earnings" or ACE adjustment. There is no specific statutory definition of E&P in the IRC. However, Sec. 312(c) and related regulations contain several rules for determining the effect of particular transactions on the computation of E&P. The measure of E&P, which is supposed to represent a corporation's economic income, is a determining factor in the taxability of distributions to shareholders.

Retained earnings and tax E&P will generally differ because Sec. 312 and other nonstatutory rules developed for computing E&P contain some elements that are not ordinarily part of retained earnings. In any event, most corporations do not routinely compute their current E&P, and the implementation of the new rules is bound to be problematic. The Revenue Reconciliation Act of 1989 (H.R. 3150, introduced August 4, 1989) which at this writing is working its way through Congress, contains proposals to simplify the ACE computation effective for years beginning after December 31, 1989. It should be noted that under existing law, ACE is scheduled to replace book-income as the benchmark against which to compare AMTI in the AMT calculation.

However, in considering whether tax basis financial statements are appropriate for a corporate client, a CPA should realize that for 1989 their use may favorably impact a client's tax liability. Also, the use of tax basis financial statements should continue to save on financial reporting costs.

What Implementation Issues Does AMT Create?

The existence of two parallel tax systems--an AMT system and a regular tax system--raises a puzzling point. The tax basis of accounting is defined by SAS 62 as, "a basis of accounting that the reporting entity uses or expects to use to file its income tax return for the period covered by the financial statements." Does this mean that the client should prepare financial statements on the basis of the regular tax system when no additional taxes are payable due to the AMT and use the AMt system in years when such taxes are payable? Or, beginning in 1990, should the tax basis statements be prepared using ACE as the measure of income? Since there is no authoritative literature for tax basis accounting, there is room for interpretation. However, the usefulness of tax basis financial statements would probably be improved by consistently using the regular tax system (including non-taxable revenue and non-deductible expenses as discussed later) to prepare financial statements. In years when additional taxes are payable because of the AMT provisions, that information and the amount of the tax expense and liability attributable to AMT should be disclosed.

Other Implementation Issues

What if the CPA also Prepares the Tax Return?

This implementation issue relates to the normal dueal role of a CPA as tax return preparer and the independent auditor, reviewer or compiler of financial statements. When a CPA reports on tax basis financial statements without modifying the report, that means the CPA believes that the tax accounting actually used in preparation of the financial statements represents acceptable tax practice. That is the case because the tax laws and regulations constitute the criteria the CPA is using in formulating the opinion in the special report on those tax basis financial statements. Some accountants view this as the most troublesome aspect of reporting on tax basis financial statements.

What standard should the CPA use in evaluating whether financial statements reflect acceptable tax practice? Does the role of independent reporter on financial statements conflict with the advocacy role of a tax preparer?

Should the standard for judging acceptable tax practice become more stringent simply because tax accounting is also the basis used to prepare financial statements? Generally CPAs answer this question "no" and apply the following reasonable rule of thumb. A CPA may conclude that financial statements reflect acceptable tax practice if a CPA preparer, with knowledge of all information brought to light during an audit, review, or compilation, would be willing to sign the tax return as preparer.

Potential IRS Adjustment

Even though the CPA believes that the financial statements reflect acceptable tax practice, there are still uncertainties. An IRS examination may occur at some point in the future and an adjustment of taxable income and tax liability may result.

Generally, the treatment of an adjustment that results from IRS examination is different on the tax basis than it would be on a GAAP basis. If the IRS disallows amounts charged to expense in prior years or requires recognition of previously unrecognized revenue, these tax adjustments should be treated as prior period adjustments in tax basis financial statements. If the years in question are presented, they should be restated. If they are prior to the earliest period presented, the effect on the earliest period should be recognized by adjusting the assets or liabilities affected and beginning owner's equity.

Because of the potential adjustment that could result from an IRS examination, a note disclosure such as the following is usually advisable.

"The corporation prepares its financial statements in conformity with methods of accounting it considers appropriate for federal income tax reporting. As with all tax presentations, these tax accounting methods are subject to review and possible adjustment by the Internal Revenue Service."

This routine note disclosure can be incorporated in the note on significant accounting policies that describes the basis of accounting used to prepare the financial statements. When an IRS examination is actually in progress or is expected, additional disclosure may be appropriate.

Non-taxable Revenues and Non-Deductible Expenses

Another question that arises in the preparation of tax basis financial statements is the treatment of non-taxable revenues and non-deductible expenses. Certain revenues, such as interest on state or local government bonds, are not taxable, and certain expenses, such as premiums on company officers' life insurance policies, are not deductible. Common practice is to include these items in tax basis financial statements, even though they do not enter into the determination of taxable income. Generally, all significant sources of revenue and expense should be included in the tax basis income statement.

Materiality

Another issue concerns the proper measure of materiality. Some accountants believe that the measure of significance, or materiality, should be different for tax basis financial statements than it is for GAAP basis financial statements. This notion stems from the fact that the IRC and regulations do not explicity recognize the concept of materiality, and tax return preparation, as a result, has usually involved more exacting measurements than considered necessary for preparing financial statements. Thus, an adjustment regarded as not material for financial reporting purposes would be posted in preparing the tax return. Materiality, however, is used for both accounting and auditing purposes. That is, materiality is used for evaluating financial statement presentation and disclosure, and for making decisions about the necessary scope of auditing procedures to detect a material statement. In evaluating financial statement presentation and disclosure for tax basis statements, it is probably appropriate to use the same threshold of materiality that would be used for tax return preparation.

Generally, this would mean that materiality, when considering the need for adjustment to tax basis financial statements, would be lower than for evaluating the need for adjustment to comparable GAAP basis financial statements. This does not mean that an audit of tax basis financial statements must be more extensive than an audit of GAAP basis financial statements.

SAS 47, Audit Risk and Materiality in Conducting an Audit, recognizes that the auditor may decide to insist on an audit adjustment or a disclosure even though the scope of the audit was not planned to detect misstatements of that size. Therefore, the amount used as the preliminary judgment about materiality in planning the audit may be different from the amount considered material when evaluating the financial statements.

Thus, the amount considered material when planning the audit of tax basis financial statements is likely to be conceptually the same as the amount considered material in planning the audit of those financial statements presented on a GAAP basis. However, in deciding about financial statement presentation and disclosure, a lower amount that is consistent with tax preparation decision-making is more likely.

Statement Titles

There should be prominent disclosure that the financial statements are prepared on the income tax basis of accounting. This can be accomplished by using the term "tax basis" in the titles of the financial statements, such as Balance Sheet--Tax Basis, and by including a legend that refers to the notes to the financial statements on each page of the financial statements.

Accounting Policies Note

The notes to the financial statements preferably should begin with a note that summarizes the significant accounting policies. In addition to indicating that the financial statements are prepared on the basis of accounting that the company expects to use to file its income tax return for the period, the note should disclose several other matters.

It should indicate whether the basic method of accounting is cash or accrual. If the entity is other than a normal taxable corporation, the tax filing status of the entity should be disclosed. The note should explain that the tax basis means that revenues and related assets and expenses and related liabilities are recognized when they are reported or deducted for federal income tax purposes. Any non-taxable income or non-deductible expenses that are included in the determination of income should be disclosed.

If any optional tax methods of accounting are followed, their nature should be disclosed. Also, there should be disclosure of the nature of any important judgments or policies necessary for an understanding of the methods of recognizing revenue or allocating costs to current and future periods.

As with the OCBOA financial statements, this note should explain the nature of the differences between the income tax basis and GAAP, but need not quantify those differences.

Accounting Changes

Any accounting changes made for the period should be identified and the nature and effect on income should be disclosed. Under the tax basis, accounting changes can be treated very differently from GAAP. The effect of an accounting change, for tax purposes, may be recognized prospectively over a prescribed period. In the year of the change, the total effect should be recorded in the tax basis balance sheet and the amount should be amortized over the appropriate period.

Other Note Disclosures

For other note disclosures, the criteria is essentially the same as for GAAP basis financial statements. What information is necessary for using, understanding and interpreting the financial statements? Information on related parties, contingencies, subsequent events, leases, pension obligations, and similar matters should be disclosed. Certain items, such as depreciation, are recorded in both tax basis and GAAP basis financial statements, and the disclosures should be essentially the same.

Statement of Cash Flows

Under GAAP, when a balance sheet and income statement are presented, a statement of cash flows is also required. However, for tax basis financial statements a statement of cash flows is not required. If the CPA believes that such a statement would provide useful information to users, a statement of cash flows may be presented. Nevertheless, adequate disclosure for tax basis financial statements does not require presentation of a statements of cash flows.

What Are the Audit Reporting Issues?

An audit report on tax basis financial statements follows the standard four-paragraph format for a special report on OCBOA financial statements prescribed by SAS 62. The reporting requirements and the report modifications are largely the same for all OCBOA financial statements and are not discussed here.

Going-Concern Problems

One reporting issue related to tax basis financial statements was at one time a controversial subject. Some accountants argued that doubt about a company's status as a going-concern indicated uncertainty about whether the going-concern basis or the liquidation basis was appropriate for preparing financial statements. These accountants maintained that since tax laws and regulations did not permit a choice between the going-concern and liquidation basis, there was no conceptual support for a going-concern report modification on tax basis financial statements.

The controversy was ended by the issuance of SAS 59 on consideration of going-concern status in an audit. SAS 59 indicates the going-concern concept applies to both GAAP basis and OCBOA financial statements. Thus, the auditor should evaluate whether there is substantial doubt about the company's ability to continue as a going concern and, if there is, an additional paragraph to the report should be added when reporting on an audit of tax basis financial statements.

Tax Law Changes

Another reporting issue is whether a change in the tax law constitutes a change in accounting principle that under the consistency standard requires the addition of an explanatory paragraph that refers to the change. The tax basis of accounting is based on the rules and regulations for accounting for transactions under the IRC.

Thus, some accountants have argued that a change in the tax law is the equivalent of a change in accounting principle under GAAP. SAS 62 answers this question explicitly. A footnote explains that, "a change in the tax law is not considered a change in accounting principle for which the auditor would need to add an explanatory paragraph, although disclosure may be necessary."

Conclusion

The release of SAS 62, the AMT provisions of the tax law, and the ever increasing complexity of accounting standards combined increase the potential desirability of tax basis financial statements for certain clients. A corporation with statement users who are primarily interested in the tax aspects of their relationship with the entity can probably achieve tax savings while reducing overall financial reporting costs by issuing tax basis financial statements. There are several implementation issues associated with auditing tax basis financial statements that are discussed in this article, but there are practical answers to these issues. A CPA should give careful consideration to which clients might benefit from being on the tax basis for financial reporting purposes, especially for years beginning before 1990.

Douglas R. Carmichael, PhD, CPA, is Wollman Distinguished Professor of accounting at Baruch College and Technical Editor, Accounting & Auditing, of the CPA Journal, as well as a consultant. He is a member of the AICPA, the NYSSCPA, and the Illinois Society of CPAs. Dr. Carmichael is an author of accounting texts and a contributor to many accounting journals. He is a former Vice-President of the AICPA and author of, and frequent lecturer at, professional education courses.

Akshay K. Talwar, JD, LLM, CPA, is an Associate Professor of accounting and taxation and a member of the graduate faculty of Baruch College, as well as a consultant. He is Technical Editor, Taxes of The CPA Journal, Chairman of the Tax Education Committee and a member of the AICPA, ABA, and NYSBA. Mr. Talwar has written articles for many accounting and other journals.