©2005 AICPA

TaxClinic

Practical Advice

on Current Issues

Editor:

Terence Kelly, CPA Partner

BDO Seidman, LLP

Phoenix, AZ

©2005 AICPA

Accounting Methods & Periods

The AJCA’s FAS No. 109 Implications

The American Jobs Creation Act of 2004 (AJCA), signed into law by President Bush on

Oct. 22, 2004, attempted to balance tax breaks for domestic manufacturers and tax relief

for multinational corporations and intended to provide U.S. manufacturing companies

with an economic edge for competing in the global economy. The AJCA’s financial

reporting considerations began to materialize when accounting for income taxes in first-

quarter 2005 financial statements. As a result, the Financial Accounting Standards Board

(FASB) finalized two staff positions (FSPs) to provide guidance to companies and their

auditors on how to handle post-AJCA income taxes under Financial Accounting Statement

(FAS) No. 109, Accounting for Income Taxes.

FSP FAS 109-1

The AJCA’s qualified production activities deduction (Sec. 199) is the lesser of 3%

(increasing to 9% in 2010) of either a taxpayer’s “qualified production activities” income

or taxable income, determined without regard to this deduction. Importantly, however, no

deduction is available if a taxpayer has a net operating loss (NOL) for the current tax year,

or NOL carryovers that eliminate taxable income for the current year.

Companies had to consider the AJCA’s changes to accounting for income taxes and apply

FSP FAS 109-1, Application of FASB Statement No. 109, Accounting for Income Taxes, to

the Tax Deduction on Qualified Production Activities Provided by the American Jobs

Creation Act of 2004, to the first quarter of 2005. According to FSP FAS 109-1, after the

AJCA, companies should account for the tax deduction on qualified production activities

as a special deduction—a permanent difference—rather than as a rate reduction.

Companies may have to consider the deduction’s effect on their effective tax rate in

determining the estimated annual rate used for interim financial reporting.

Any benefit from the deduction has to be reported during the year in which the deduction

is claimed. Separate disclosure in the effective tax rate reconciliation may be warranted.

Due to the need for interpretation, some companies may have to record an accrual for a

potential disallowance of the deduction. Further, state guidance on deductibility for state

business taxes is still unavailable in many jurisdictions.

FSP FAS 109-2

The AJCA provides a special one-time, 85% tax deduction of certain foreign earnings

repatriated to a U.S. taxpayer under Sec. 965, provided certain criteria are met, including:

©2005 AICPA

Investing dividends in the U.S. under a domestic reinvestment plan (Sec.

965(b)(4)(B)).

Obtaining an approval of the reinvestment plan by the chief executive officer (or

official of equal standing) or the board of directors, within the required period

(Sec. 965(b)(4)(A)).

Using the funds for certain qualifying activities (Sec. 965(b)(4)(B)).

Specifying the activities’ nature in the plan.

FAS 109 requires recognition of a deferred tax liability for the excess of the book basis

over the tax basis of investments in foreign subsidiaries or joint ventures. However, an

exception for the excess attributable to undistributed earnings is provided in Accounting

Principles Board Opinion No. 23, Accounting for Income Taxes—Special Areas, if the

parent affirmatively asserts that the earnings are indefinitely reinvested outside its home

tax jurisdiction.

FAS 109 Paragraph 27 typically requires adjustments to deferred tax liabilities and assets

for the effects of a change in tax laws or rates in the period that includes the enactment

date. Because of FSP FAS 109-2, Accounting and Disclosure Guidance for the Foreign

Earnings Repatriation Provision within the American Jobs Creation Act of 2004,

companies, in applying FAS 109, now have more time to evaluate the AJCA’s effect on

their plans for reinvestment or repatriation of certain foreign earnings. Without this

extension, they would have been required to examine their plans for reinvestment or

repatriation and apply FAS 109 in the enactment period.

Although FSP FAS 109-2 extends time, it does not relieve companies of having to record

an appropriate deferred tax liability when they decide to repatriate earnings. In some

situations, they may have to use their judgment to determine when to repatriate earnings.

Companies should not delay accruing a tax liability until they declare or pay dividends.

However, under FSP FAS 109-2, certain disclosure requirements apply until a company

decides whether to repatriate earnings. Management will need to evaluate compliance with

the AJCA provisions to ensure that repatriated earnings qualify for the beneficial tax

treatment.

Public companies subject to reporting under the Sarbanes-Oxley Act of 2002 (SOA) will

want to evaluate their controls in place to reasonably assure timely and accurate reporting

of any changes in income taxes that may have resulted from changes in reinvestment or

repatriation plans.

In the new world of the SOA, advisers interpreting complex tax law changes must now

assume even greater responsibility for accounting for income taxes under FAS 109. This

statement has not been revised, except for the two FSPs, since it was issued in February

1992. Thus, tax advisers now find themselves not only interpreting complex tax guidance,

but also interpreting complex accounting literature. Although the SOA has drawn the line

between providing independent audit services and providing tax consulting services to

public companies, the two service groups—auditors and tax advisers—appear to need

each other’s expertise more than ever.

By: Katherine D. Morris, CPA

BDO Seidman, LLP - Atlanta, GA

©2005 AICPA

Procedure & Administration

Accounting for Income Taxes in the Post-SOA World

The Sarbanes-Oxley Act of 2002 (SOA) significantly changed the role of tax advisers

who provide services to audit clients. In addition to adhering to Financial Accounting

Standards Board Statement (FAS) No. 109, Accounting for Income Taxes, advisers are

now expected to know and understand the constraints placed on services to audit clients,

and their clients’ documentation and attestation of internal controls over tax-related

financial statement accounts.

Common issues encountered by tax advisers and auditors range from whether a company

has the in-house, technical resources to competently handle tax provisions, internal

controls and changes in the underlying tax laws, to whether the company should engage

another accounting firm to prepare and/or review its FAS 109 computations.

Clients’ decisions will affect whether (1) they obtain a clean audit opinion, (2) their

internal auditor can attest to internal controls being in place and being adhered to and (3)

they can avoid disclosing a significant deficiency or, worse, a material weakness, in their

tax internal controls.

This item reviews recent SOA developments in tax services and how the relationship

between tax advisers and their clients has affected the tax functions on which clients rely

(such as determining tax contingencies).

The Debate

Which tax services can be offered to public clients? Recent guidance permits providing

certain tax services to audit clients. Also, these services are subject to normal audit

committee pre-approval requirements, including tax compliance, planning and advice.

However, some services are prohibited, such as bookkeeping, valuation, fairness opinions,

internal audit and management functions, for example. The guidance clarifies which tax

services impair independence. Such services include, but are not limited to, representing

an audit client before the Tax Court, a district court or the Federal Court of Claims, and

providing other unique tax expertise. However, the guidance permits some special

services, such as transfer-pricing and cost-segregation studies. Violations of the

independence rules can have serious consequences, such as loss of a client and a re-audit

of its financial statements by new, independent auditors.

Some audit firms are concerned about the lack of a clear “bright-line” rule on tax planning

and advice. The absence of clarity has caused many firms to limit substantially how they

offer tax services to public companies. To further complicate the picture, these concerns

are seeping into private companies and nonprofit organizations; these entities’ board

members and advisers are now beginning to require the same level of scrutiny as public

companies.

©2005 AICPA

The SOA empowered the Public Company Accounting Oversight Board (PCAOB) to

implement SOA provisions, by promoting the ethics and independence of registered

public accounting firms that audit and review U.S. public company financial statements.

The PCAOB issued proposed guidance that identifies tax services that pose, and do not

pose, an unacceptable threat to auditor independence. On Dec. 14, 2004, it voted

unanimously to propose rules prohibiting a registered public accounting firm from:

1. Providing certain tax services to public company audit clients;

2. Providing any tax services to officers in a financial reporting oversight position (e.g.,

chief executive officer (CEO) and chief financial officer (CFO)), after 2004 income tax

filing obligations are met; and

3. Receiving contingent fees from public company audit clients.

The rules also require specific written and oral communications between an audit firm and

its client’s audit committee on the proposed allowable tax services the firm will provide;

for details; see www.pcaobus.org, under “Rulemaking.”

In response, three AICPA committees (the Center for Public Company Audit Firms, the

Professional Ethics Executive Committee and the Tax Executive Committee) jointly

issued comments, on Feb. 14, 2005 (available at http://www.aicpa.org/cpcaf/download/

AICPA_Response_PCAOB_Docket_017_Comment_Letter.pdf ). In addition to

addressing the specific issues, the comment letter demonstrates the committees’ overall

support of audit firms continuing to offer some tax services to public company clients,

without impairing independence. For example, for financial executives of public

companies, the letter states, “…[We] believe that tax compliance and routine planning

should be permitted.”

With respect to aggressive tax positions taken by a client that engaged a third-party

adviser for planning purposes, the AICPA committees believe that the client’s auditor

should be able to consult with its in-house tax specialists, without impairing

independence, even if the consultation results in a less risky alternative; this type of advice

is intended to enhance tax compliance and is in the “public interest.”

The committees recognize that mechanisms currently exist to prevent inappropriate

actions by CPAs that would violate independence. For example, according to the letter,

“[n]umerous layers of statutory, regulatory and ethical safeguards already apply to the

provision of tax services by CPAs…the Internal Revenue Code imposes penalties and

other sanctions…[p]ractice before the IRS is regulated by Circular 230…and the

[AICPA’s] Statements on Standards for Tax Services….” Further, “[v]iolating these rules

of tax practice can subject CPAs to ethics investigations and possible sanctions by the

AICPA and state CPA societies and potential license revocation by state boards of

accountancy.” The committees continue to support provision of tax return preparation and

consulting services to publicly held audit clients. Tax advisers will have to watch how the

debate develops.

©2005 AICPA

How the SOA Affects Auditing Taxes

As income taxes typically equal 30% or more of pre-tax income and represent significant

portions of recorded assets and liabilities, taxes, in general, are a significant process

subject to the SOA’s requirements for adequate, auditable internal controls for accounting

for them. Under the SOA, public companies report on the adequacy of their internal

controls, and auditors attest to the accuracy of the company’s report. Attestation of

internal controls for tax is not limited to Federal, state, local and foreign income taxes, but

also includes all related tax matters (e.g., franchise taxes, sales and use taxes, excise taxes,

value-added taxes, payroll taxes and property taxes, and tax reporting for employee benefit

plans). The PCAOB standards clearly indicate that an audit firm cannot become a part of a

company’s system of internal controls. Thus, if a company is incapable of properly

accounting for taxes without its auditors’ assistance, it has an internal-controls deficiency.

Nonpublic Companies

In April 2003, the AICPA amended AU Section 9326, Evidential Matter: Auditing

Interpretations of Section 326, which significantly changed the review and documentation

standards for accounting for income taxes for nonpublic companies. Independent auditors

are required to have sufficient evidence in their audit workpapers to support the adequacy

of the judgments and estimates inherent in a client’s accounting for income taxes, to avoid

a scope limitation on their opinion. AU 9326 clarifies that the audit firm cannot rely on the

advice or opinions of a client’s other tax advisers; rather, it must reach supportable

conclusions. Companies are now engaging tax advisers from firms other than their audit

firm to assist in FAS 109 compliance. AU 9326 clarifies that the audit firm’s tax advisers

must review FAS 109 computations in the same depth as if client personnel had made the

computations. Thus, the SOA’s far-reaching arm now extends to nonpublic tax services.

Summary

An auditor’s use of the “tax specialist” for tax matters is more important than ever before.

Clear guidance on tax services is needed to satisfy audit firms, CEOs, CFOs and audit

committees. Even though there is clear support for tax professionals to continue to provide

tax services to audit clients, the debate continues.

By: Katherine D. Morris, CPA

BDO Seidman, LLP - Atlanta, GA

©2005 AICPA