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Mar 31, 2007

Out of the shadows

New accounting change puts tax reserves on the books for the first time

Mention the words ‘tax accounting change’ and you’re guaranteed a lukewarm response. Taxes are one of the most complex and least understood areas of accounting and most IROs leave it to the professionals. ‘Our tax department will handle any change, I won’t deal with it until we focus on closing the quarter,’ notes Laidlaw International’s director of IR, Sarah Lewensohn. But this latest move may require checking in early with the tax people since experts are predicting it could impact earnings, which means drawing questions from the investment community.

‘This is as comprehensive a pronouncement as FASB has ever had – it’s bigger than stock options,’ says Robert Willens, a Lehman Brothers tax expert who is fielding more and more questions from analysts on this topic. ‘Accounting for Uncertainty in Income Taxes’, or FIN 48 requires companies put tax reserves on the balance sheet for the first time. The move forces issuers to only disclose tax positions that have a 51 percent chance of surviving an audit and is effective for fiscal years beginning after December 15, 2006.

The bottom line

In a recent research note on the change, Credit Suisse predicts FIN 48 will result in more volatile tax rates that could, in turn, impact earnings. It also suggests the rule may increase tax liability on the balance sheet and that added disclosure could result in more tax costs for companies. David Zion, a tax and accounting analyst at Credit Suisse, thinks this could be a hot button issue with fourth quarter earnings and again with first quarter results. ‘We think investors and analysts should be asking companies about FIN 48,’ he says.

As with most accounting rule changes, FASB’s aim with FIN 48 is to increase transparency. It was prompted to act by the SEC which was concerned about companies using the relative obscurity of tax positions to manipulate earnings. Prior to FIN 48, there was no consistency in terms of how companies could measure and report on tax positions. The Commission suspected some issuers were making overly aggressive reserve assumptions and then dipping into them to smooth out rough quarters. ‘Investors overwhelmingly wanted this change,’ says FASB spokesman Gerard Carney.

But companies didn’t show the same support, with FASB receiving over 400 letters requesting a delay in FIN 48’s implementation. The board didn’t concede. ‘As always, the board carefully considered each of the considerations in these letters, many of which were similar in form and nature, and it decided there was not significant reason for a delay,’ adds Carney. This was a big disappointment for the Tax Executive Institute (TEI), the tax professionals’ trade body that led the call for more time. ‘We wanted an extension because of the uncertainty about everything required to properly identify, document and monitor your uncertain tax position,’ explains Timothy McCormally, executive director of TEI. McCormally thinks there could now be inconsistencies in how companies report tax positions in the first quarter of compliance.

Knowing the score

FIN 48 requires a two-step approach to dealing with uncertain tax positions. Each step involves a significant amount of management judgment. And any difference between the position taken on the tax return and the amount reported in the financial statements will result in a FIN 48 liability for the unrecognized tax benefit (i.e., a tax reserve). In addition, companies may have to accrue interest and penalties on their FIN 48 liability, as if they have underpaid their taxes.

One of the major hurdles for assessing the materiality of FIN 48 is the current lack of disclosures on tax reserves. Credit Suisse’s Zion recently looked at the 2005 10Ks of 1000 companies that mention tax reserves or contingencies. ‘The trouble is they don’t say much around it other than how the tax reserve is accounted for,’ he notes.

Disclosures around FIN 48 have been also been similarly light. Zion searched the 10Ks and 10Qs filed during the last three months of 2006 and found 449 companies mentioning the rule change. Of that, most companies say they are still assessing its impact with 60 claiming the rule will be immaterial. Six companies go on to predict a material impact: Constellation Energy Group, Electronic Arts, Altria Group, PPL Energy Supply, Qwest Communications and Tenet Healthcare.

Only one S&P 500 company, BB&T, provided a proper estimate for the financial impact of FIN 48, however. BB&T writes: ‘Management is currently evaluating the impact of adoption and estimates that the potential adjustment could be approximately $150 million and would be recorded as a cumulative effect to retained earnings due to change in accounting principles on January 1, 2007.’

The right questions

So if most accountants haven’t yet figured this change out, what is IR supposed to do? ‘You want to find out what your deferred tax assets and credits are that may not be transparent ,’ suggests John Chironna, director of IR at ABB. ‘Companies have different balance sheet levels of disclosure and the tax credit or debit may be hidden in the assets or liabilities.’

Once you know where the numbers are disclosed, it’s important to determine their materiality and whether it will change under the new rule. ‘With tax-related questions, it really depends on the interpretation of the company’s tax advisors as to how you report and book certain things and its important to make sure you have the correct interpretation,’ advises Robert Borchert, IRO at Per-Se Technologies. This first quarter of compliance may result in some confusion in the market so it is key to be ready to answer questions from investors and analysts. As Zion concludes, ‘Investor relations needs to understand how this has worked in the past and how FIN 48 might change things.’

Adrienne Baker

Adrienne Baker is the former editor of IR magazine and is currently producer at Green Power Conferences