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Taxation and Representation

The first international accounting standard to be adopted by the United States may well be the one dealing with tax. But rulemakers first will have to decide how to explain uncertainty to investors.
Tim Reason, CFO.com | US
July 3, 2008

For the first time since 1775, American taxes soon may be determined by people far away in London, England. But don't break out your squirrel guns and start dumping tea just yet — we're only talking about accounting.

In an effort to speed the convergence of American and international accounting, rulemakers at the Financial Accounting Standards Board are considering making no further tweaks to U.S. rules for tax accounting. Instead, they may simply toss out those rules in favor of the international financial reporting standard, which rulemakers in London are also modifying in an ongoing effort to reduce differences between the two systems.

"If ultimately convergence is going to be on IFRS," said FASB member George Batavick during a recent Webcast, "why not just go ahead and adopt their standard lock, stock, and barrel?"

Were FASB to adopt the IAS 12 standard, it would be the first time an international financial reporting standard with the "IAS" designation found its way directly into the U.S. GAAP hierarchy — a significant step on the path to moving the United States to full adoption of IFRS. But there is a major stumbling block in the way: how to represent on the financial statements the possibility that the government will challenge a company's taxes.

"One problem is [IASB] does not have a FIN 48 standard and they are not interested in having the same sort of model we have," said Batavick.

FIN 48 is a piece of guidance that tells companies in the United States how to account for uncertainty in tax positions. It went into effect for most companies at the beginning of last year, despite howls of protest and requests for delays from corporations. FIN 48 requires companies to include specific information regarding potential tax liabilities — information that was previously tucked in with other potential liabilities.

Much of the protest was sparked by fear that the new rule would provide the IRS and other taxing authorities with an audit roadmap. Indeed, some critics said FIN 48 breaks from accounting norms because it requires companies to assume the item in question will be audited and does not allow them to factor in the probability of not being audited or having the item in question go unnoticed by government auditors.

However, under the U.S. rule, companies must record a liability only if they determine that their tax position is "more likely than not" to be disallowed. "Our system is more of an 'all-or-nothing' approach," explains tax expert Robert Willens of Robert Willens LLC.

IFRS, by contrast, does not have a recognition threshold. Instead, it seems likely that the IASB will require companies to factor the potential uncertainty of a tax position, no matter how small, into the amount of taxes reported on the financial statement. How that liability is likely to be measured also differs from U.S. standards. Although IASB has not issued a specific proposal related to uncertainty in tax, "the board has reconfirmed that it wants to continue with the approach of doing probability weighted expected outcome," said IASB senior project manager Anne McGeachin during a recent KPMG Webcast that looked at the impact that adoption of IFRS would have on U.S. tax practices.

Take for example, the case presented in the KPMG Webcast, in which a company determines that a $1,000 tax benefit is the result of an uncertain tax position. The company then determines that there is a 35 percent possibility it will receive the full $1,000 tax benefit, a 20 percent chance it would get an $800 benefit, a 30 percent chance that it will receive only a $100 benefit, and a 15 percent chance it will get no benefit at all.

Under the cumulative probability approach used in FIN 48, a company may book only that amount with a cumulative probability exceeding 50 percent. Since there is a 55 percent chance of receiving an $800 or higher benefit, the company would recognize a tax benefit of $800.

Under the probability weighted approach currently favored by IASB, the amounts are individually computed and added together to achieve a probability weighted average. In other words, the 35 percent chance of a $1,000 benefit is worth $350, the 20 percent chance of an $800 benefit is worth $160, and so on, with the sum of all those amounts equaling $540 — the liability that the company would report. Although IASB has not formally stated that a probability weighted approach would be how it would handle taxes, this method is representative of the board's general approach to liabilities.

One criticism of that approach, raised during the webcast by moderator Ashby Corum of KPMG, is that there are many cases in which a tax position has a very high probability of surviving an encounter with the IRS. "In tax we've often run into high-volume transactions where we're not 100 percent certain, but we are perhaps 80 or 90 percent certain that we'd be able to sustain the position," said Corum. "In that case, there may be a high volume of these positions that need a small reserve."

"We don't necessarily expect entities to do a whole heap of extra work in doing that," said McGeachin. "All we are trying to do is make sure that that no information they have is ignored. If you do know it is only 90 percent likely you are going to get a tax benefit, you don't ignore that 10 percent chance that you won't get it."


Exactly how FASB and IASB would reconcile the different accounting for uncertainty in tax positions isn't clear. FASB's Batavick said the board intends to propose some sort of resolution "in the next few months."

"I'm not sure the systems are as incompatible as it seems," says Willens, noting the United States would have to be willing to accept an "expected value" approach to assessing tax liabilities. "I think it's doable," he says, "but probably not within the time frame they've set."




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