Accounting for uncertainty

By Kevin Pasma
Illustration: Gary Clement

The adoption of FIN 48 takes effort, as such, assessment of the implementation time and effort should be undertaken ASAP

In July 2006, the US accounting standard-setter Financial Accounting Standards Board issued FASB Interpretation No. 48 (FIN 48) — Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109, Accounting for Income Taxes.Canadian foreign private issuers and other reporting issuers that file financial statements with the US Securities Exchange Commission (SEC) will need to adopt FIN 48, the most significant change to accounting for income taxes in accordance with US GAAP since the adoption of the liability approach.

Although FIN 48 is not mandatory under Canadian GAAP, one question that arises is whether FIN 48 can or should be adopted for purposes of Canadian GAAP, to eliminate a Canadian/US GAAP difference. This determination should be made in consultation with external auditors. The principles outlined in FIN 48, including the recognition threshold and measurement principles, may be consistent with Canadian GAAP. However, adoption of FIN 48 for Canadian GAAP purposes may represent a change in accounting policy and thus may require application on a retrospective basis. FIN 48 disclosures are not mandatory under Canadian GAAP.

Canadian accounting standard-setters have indicated that they may soon amend CICA Handbook Section 3465, Income Taxes, to converge with revisions to International Financial Reporting Standard IAS 12, Income Taxes, expected to be issued by the International Accounting Standards Board. Revisions to IAS 12 (expected to be issued in the second half of 2007) are expected to contain much different measurement principles than those set by FIN 48. Thus, Canadian enterprises reporting only in Canadian GAAP may be unlikely to adopt FIN 48 for purposes of Canadian GAAP, at least in the short term.

FIN 48 is effective for fiscal years beginning after December 15, 2006. SAB 74 (SEC Staff Accounting Bulletin No. 74 [Topic 11-M]) will require disclosure of the expected impact of FIN 48, in periods prior to its adoption. Affected enterprises not already in the process of adopting FIN 48 should take at least the steps suggested.

The effort required to adopt this new accounting pronouncement — even for the purpose of providing a reconciliation between Canadian GAAP and US GAAP — should not be underestimated.

In a letter dated December 12, 2006 to the FASB, David Bernard, international president of the Tax Executives Institute Inc., recommended that the effective date of FIN 48 be extended to fiscal years beginning after December 15, 2007. Bernard describes the burden imposed by FIN 48 as being “tantamount to, and as challenging as, re-filing an income tax return in every jurisdiction for every open tax year,” and states that the effort involved with FIN 48 “is enormous, especially for large, multi-en-tity issuers filing in multiple jurisdictions.” FASB voted not to extend the effective date of FIN 48.

As alluded to by Bernard, there are a number of reasons the implementation effort is proving significant. For example, the broad scope and the retroactive application of FIN 48 to all open tax years, fundamental differences between the FIN 48 benefit recognition approach and the FASB Statement No. 5, Accounting for Contingencies (FAS 5) impairment approach, differences in the measurement of benefits, onerous new disclosure requirements and process, controls and technology requirements.

Differences between the amounts recognized in the financial statements prior to the adoption of FIN 48 and the amounts recognized after adoption should be accounted for as a cumulative-effect adjustment recorded to the beginning balance of retained earnings. This cumulative-effect adjustment does not include items that would not be recognized in earnings, such as the effect of adopting FIN 48 on tax positions related to business combinations.

Because FIN 48 applies retroactively to all open tax years, the effort required to adopt FIN 48 may be particularly onerous. FIN 48 applies to all tax positions related to income taxes subject to FASB Statement No. 109, Accounting for Income Taxes, including withholding taxes, permanent and temporary difference items, a decision not to file a tax return in a jurisdiction (e.g., permanent establishment), an allocation or shift of income between jurisdictions (e.g., transfer pricing), the characterization of income (e.g., income versus capital), and a change in the expected realizability of deferred tax assets (e.g., tax planning strategies).

FIN 48 may also apply to business combination uncertainties such as the allocation of the purchase price to individual assets and liabilities for tax purposes in asset acquisitions, the tax basis of assets, liabilities and carry-forwards in share acquisitions, and tax return positions for periods prior to the acquisition.

FIN 48 prescribes a benefit recognition approach to accounting for income taxes, a completely different approach than the current impairment approach. Under the impairment approach, an as-filed tax position is recognized in the financial statements when the position meets the enterprise’s existing initial recognition threshold, and an asset impairment or liability is recognized when, at a probable level, a tax asset is considered impaired. Under the FIN 48 benefit recognition approach, only a tax position that meets the more-likely-than-not recognition threshold is recognized in the financial statements.

While this difference in approaches may seem subtle, the introduction of FIN 48 means that entitlement to any benefit of tax positions recognized in the financial statements must now be supported by FIN 48 working papers.

FIN 48 requires an inventory of all tax positions, an assessment of the unit of account for each tax position and an assessment of all tax positions as against the more-likely-than-not recognition threshold. Further documentation will be required to address the measurement step and also the disclosures required by FIN 48.

This difference in approaches also explains why the adoption of FIN 48 may require much more effort than just a simple review of existing tax positions reserved pursuant to FAS 5. Of course, existing tax positions reserved pursuant to FAS 5 must be analyzed for recognition under FIN 48, but so must all other tax positions recognized in the financial statements.

Prior to the issuance of FIN 48, all enterprises subjected tax benefits to some form of initial recognition test before recognizing such benefits in their financial statements. However, if the recognition threshold used by an enterprise was anything but the more-likely-than-not recognition threshold prescribed by FIN 48, this difference in initial recognition thresholds will give rise to differences between the number of tax positions recognized under the previous recognition threshold versus under FIN 48.

Enterprises will need to review existing tax accounting working paper support for conclusions reached on all tax positions under any initial recognition threshold previously followed.

In many cases, there will be a gap between existing tax ac-counting working paper support and the working papers required under FIN 48, a gap that will need to be closed for all tax positions.

FIN 48 does not provide a bright line or significance test to determine what constitutes an appropriate unit of account for a particular tax position. Determination of the appropriate unit of account is a matter of judgement, which must take into consideration the manner in which an enterprise prepares and supports the amounts claimed in the tax return and also the approach the enterprise anticipates the taxing authority will take in an examination. The selection of the unit of account can have a significant impact on financial statement reporting of a given tax position because the recognition threshold test is applied at the unit of account level.

In measuring the tax benefit related to tax positions (a) that meet the initial recognition threshold, (b) that are not highly certain as that term is defined in FIN 48, and (c) for which one individual expected outcome is not greater than 50% likely to occur, FIN 48 introduces a cumulative-probability concept that requires the consideration and scheduling of the various potential measurement outcomes. This cumulative-probability concept can produce different measurement results than the current measurement approach, which uses the single best estimate of the amount that is likely of being realized. The different measurement results possibly produced under these two approaches has been illustrated in much of the literature already published on FIN 48.

Not all tax positions meeting the recognition threshold will require a detailed scheduling of potential outcomes. Highly certain tax positions are an example of such tax positions. These are tax positions for which the law is clear and unambiguous and for which management is highly confident that the full amount of the deduction will be allowed.

Experience suggests that the majority of tax positions will likely be highly certain tax positions. The effort required to document a highly certain tax position should be considerably less than that required to document and analyze other tax positions meeting the recognition threshold. Most of the effort required to implement FIN 48 may likely be devoted to the analysis and documentation of tax positions that are not highly certain tax positions, i.e., uncertain tax positions.

While many tax positions may not have more than a few possible outcomes, the cumulative probability approach will considerably complicate the analysis for other tax positions. For instance, transfer pricing positions taken by an enterprise could have many possible outcomes when having to analyze transactions from both sides of the border and when considering issues such as the aggregation or disaggregation of transactions, the possible application of different transfer pricing methodologies, the availability of Competent Authority or other dispute resolution procedures, etc. Transfer pricing transactions may also be open for reassessment longer than domestic transactions in jurisdictions including Canada.

One of the more controversial aspects of FIN 48 is the codification of greatly expanded disclosures related to unrecognized tax benefits.

Controversial disclosures include a tabular roll-forward of unrecognized tax benefits at the beginning and end of each period and the total amounts of unrecognized tax benefits for which it is reasonably possible the amount will significantly increase or decrease within 12 months of the reporting date.

When the requirements set out by FIN 48 are considered in aggregate, one wonders whether this new standard effectively provides a road map for taxing authorities to follow. It remains to be seen whether taxing authorities will put FIN 48 working papers at the top of the list on their audit information requests.

The effort required to adopt FIN 48 should not be underestimated, and an initial assessment of the implementation effort required — if not already performed — should be undertaken as soon as possible.

If external resources are required, management of the enterprise must make all determinations and judgments of accounting and reporting matters contained in the enterprise’s financial statements (e.g., identification of tax positions, units of account, recognition thresholds and measurement). In making such judgments, management may rely on external tax advice and should document the basis for its evaluations, judgments and conclusions related to external tax advice. The computation of the provision and related disclosures remain the sole responsibility of management.

To reduce the risk associated with FIN 48 adoption efforts, consult throughout your FIN 48 implementation with external auditors and agree on major issues such as scope of the project, materiality thresholds, process and controls and expectations around documentation.

Because FIN 48 is an accounting pronouncement affecting financial statements and internal controls over financial reporting and disclosures, ensure that the appropriate people within your organization — including appropriate members of tax, finance, the SOX team and the audit committee — are also involved early in the project.

FIN 48 represents a significant change to accounting for income taxes under US GAAP that may require considerable effort for your organization to adopt. If your organization has not yet begun to address FIN 48, start as soon as possible with an initial assessment of the effort and time required to adopt FIN 48.

Kevin Pasma, CA, is senior manager in tax with Ernst & Young in Toronto

Technical editor: Trent Henry, CA, leader of international tax services, Ernst & Young in Toronto