Too Taxing

If accounting is full of gray areas, tax is a pea-soup fog. So it's no surprise that the most common material weaknesses revealed in the first round of Sarbanes-Oxley Section 404 filings are tax related.

For nearly one-third of the 488 filers that have thus far received adverse opinions on internal controls, tax accounting was listed as a contributing factor. According to Mark Cheffers, CEO of AuditAnalytics.com, the independent research firm that conducted the study, those numbers "could have been much bigger." There is a good possibility that many other companies just barely escaped the auditors' tax wrath, he says.

There are several reasons for this (see "Material Fallout" at the end of this article). First, tax professionals are in short supply. Second, Sarbox demands much more precision in tax-accounting procedures than has ever been required before. And because tax departments generally operated at a distance from the rest of the finance department, including internal audit, many companies had never before documented internal control procedures for tax.

"Tax accounting is its own little island," says Leslie Hauser, tax director for Wisconsin at Jefferson Wells, an internal-audit firm. Traditionally, she explains, internal audit and tax have operated independently. And if the two occupied the same room, she adds, they would disagree. Even external auditors, she says, would bring their own specialized tax auditors to evaluate a tax department.

Internal and external staff must communicate better if companies are going to avoid future adverse opinions. But more than compliance with the law is at stake. According to a study by independent research firm Glass, Lewis & Co. LLC, firms that report material weakness in tax accounting lose an average of 5.8 percent of their stock value 60 days after the announcement. In addition, says Cheffers, all but six of the companies in the AuditAnalytics study that received adverse opinions related to taxes had issued a tax-related restatement or a material year-end readjustment for 2004. In other words, he cautions, if you issue such a restatement or readjustment, be prepared for an adverse 404 opinion. "It will most likely become the standard," he adds.

The Evil of Estimating
Many of the adverse opinions so far can be attributed to the application of FAS 109, which governs the accounting for income taxes. Previously, says Timothy McCormally, executive director of the Tax Executives Institute (TEI), companies "had a lot more discretion." In fact, it was standard procedure to estimate tax obligations in the first three quarters, then "true up" the numbers at year-end. It was also routine, says Cheffers, to grab data from a variety of different sources (such as international subsidiaries) in order to prepare a "down-and-dirty tax estimation."

"It turns out some of that data was incorrect," adds Cheffers. Now companies are forced to take a more detailed approach and generate solid numbers each quarter based, for example, on how each deferred-tax position would unwind, and to which deals they should be attributed. Gross estimates are no longer acceptable, and procedures for gathering the data need to be codified. "All of a sudden we are moving from matters of judgment to matters of rules," says McCormally.

Applying specific rules takes time. Dynegy Inc., which received an adverse 404 opinion on its 2004 report due to a material weakness in tax accounting, knows the problem all too well. When the company began a deep analysis of its tax provisions in accordance with Sarbox requirements, CFO and executive vice president Nick J. Caruso and his staff realized that tax positions taken in earlier years were not adequately tracked. They discovered that the company had set aside too much in deferred taxes. "That's good information," he says, "but we then had to find out what caused [the discrepancy], and, thanks to Sarbanes, in which quarter."

As a result of the exercise, errors were identified and restated for pre-1999, 2001, 2002, and 2003, while adjustments were made to 2004 year-end figures. The good news: the company received a clean financial-audit opinion. The bad news: remediation of its tax-accounting systems and procedures had not been completed as of December 31, 2004, hence the adverse 404 opinion.

"I'm confident that we now have excellent controls in place," says Caruso. Dynegy has installed a new tax-software package — CorpTax ETS from Deloitte & Touche Technologies — to help it comply with Sarbox regulations and controls, and Caruso has added staff to the tax department to keep up with the "people-driven" nature of the new environment, which requires the company to keep a "complete set of tax books that allows us to keep up with depreciation from various acquisitions," says Caruso.

Shortage of Experts
Like Caruso, many CFOs are trying to beef up their tax departments in response to the increased scrutiny. Of the companies criticized for tax-accounting weakness, more than half blamed personnel deficiencies — lack of training, insufficient resources, and so forth. "I'm surprised [personnel issues] weren't listed in all of them," says Cheffers.

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