Controlled framework for income taxes.

• Author: Crossman, Claire

Since the enactment of the Sarbanes-Oxley Act of 2002 (SOX), Income Tax has had the unenviable distinction of being one of the main reasons companies have been required to disclose material weaknesses in the audited financial statement. The total number of reported material weakness disclosures has been steadily decreasing each year since the compliance with SOX [section][section] 302 and 404 began. This trend, however, does not prove true when income tax is isolated. For example, Ernst & Young's Global Tax Risk Survey found that, from 2006 to 2008, there has not been a decrease in tax material weakness. Indeed, the survey revealed that there is actually an overall increase of disclosures required for income tax-related control weaknesses. Despite considerable efforts to remediate and address the material weaknesses for income tax, the total continues to increase. Although there are additional steps that tax departments must take to improve their controls, there may just be an inherent weakness that is out of the control of the tax professional's hands. A condition that has added to the tax professional's control woes in many companies is a disconnection of the tax function from the rest of the functions in the controller's department. Although there is a common deliverable for all involved in financial reporting, when decisions about the data, structure, process, and communication are made, if the tax components are not considered, a control weakness will likely be attributed to the tax area. If the tax leaders are involved in decisions, the potential effect of business decisions can be assessed and should assist in reducing some of the external weaknesses that the tax department is unable to control. If the external weaknesses are addressed, the tax department can focus on securing and fostering a controlled environment and, possibly, change the trend to reduce the number of material weakness disclosures required for tax.

Tax Department Internal Weakness Issues

Because of the nature of taxes, a single tax professional is often asked to perform diverse functions during the year. Those tasks can range from generating tax forecasts, accounting for income tax, complying with taxing authorities, and addressing audit controversy items. The multifaceted nature of the work performed by the tax department can lead to an overburdening of the limited resources. The lack of candidates with deep tax knowledge has forced many companies to hire a non-skilled labor force with the intention of training them for the tax department. The tax professional also must consider the ever-changing regulatory environment to assure that the right rules and rates were used when the tax was computed.

While a primary goal of the tax department is to properly account and provide for the expected income tax, there are expectations and targets that management is always considering. The director of tax is often asked to juggle conflicting corporate priorities. This does not mean that tax professionals are expected to mislead or misrepresent the results to the public or any other agency, but rather that they are often asked to investigate planning and strategies that could meet a specific result. These types of activities should be well documented and researched to confirm that they do not represent a process divergence and, therefore, a weakness in control.

SOX Tax Control Climate

When considering the overall financial strength of a company, the shareholders, investors and analysts now consider the SOX compliance status which includes the number and severity of material weaknesses that a company discloses. This change in how companies have been gauged and measured for tax has caused a shift in the spotlight in the tax department. There is an increased emphasis on the tax provision process which has led the once primary focus of the tax return compliance process to be less prominent. While the need to generate the proper filings in a timely manner did not change, the tax professional must now reorder their schedule to accommodate both the provision and the return requirements. Often, this factor, coupled with SOX, causes the tax department to become more conservative in its overall positions.

The tax department must show control for any amount it represents as income tax to avoid having to disclose significant deficiencies or material weaknesses. Internal Control for financial reporting is defined as "a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles" (PCAOB 2004, [paragraph] 7). Maintaining effective controls to ensure the income tax provision is generated, reviewed, and supported within a framework that is structured and auditable can be a challenge. The tax calculations and processes can unwittingly fall prey to a weakness simply because they began with data that was out of their control. If the pre-tax financial data is misclassified or is maintained in a format that requires rework before it can be used by tax, then they run the risk of inadvertently applying the wrong tax rules or rates. This is particularly prevalent when journal entries are made without respecting the legal entity structure or the use of top-side or consolidated entries is common place. When tax has to comb through and reallocate items to re-create legal entity or make adjustments outside the system between accounts, the potential for errors looms. The problem can be compounded year over year if...