Restatements and Material Weakness – Income Tax Matters are Under the Spotlight

When public companies release their financial statements, investor expectations are that the financial statements are accurate and can be relied upon for making investment decisions.

Companies’ financial statements are the responsibility of management. But what are the negative implications to management and the company’s value if errors are discovered resulting in a restatement of financial results or an identification of a material weakness in the company’s financial controls? 

Financial reporting restatement and material weakness news has been flooding the business pages in recent years, forcing company management to reexamine internal controls and risk areas. Newly public companies, often with a higher risk of restatement, as well as long established companies concerned about material weaknesses, should focus on a prevalent risk area often overlooked: ASC 740 Accounting for Income Taxes. It is surprising to many that tax restatements are among the most frequent reasons for restatements, along with debt/equity issues and revenue recognition.

In a recent study by Audit Analytics, among 1,827 companies with initial public offerings (IPOs) since 2004, there have been 563 restatements. This high percentage in young company financial reporting occurs as newly public companies struggle in dealing with rapid growth without sophisticated internal resources for finance, accounting and tax. Tax related items were among the leading causes of these 563 restatements and contribute to roughly 8% to 12% of all restatements by U.S. Securities and Exchange Commission (SEC)  registrants in recent years.

Mature public companies tend to have lower rates of restatement due to income taxes; however, the risk of material weakness related to income taxes is still of major concern. Public companies are required to disclose material weaknesses: deficiencies in internal controls over financial reporting for which it is reasonably possible that material misstatement will not be detected/prevented. In recent years, accounting for income tax was the leading disclosed material weakness area. In 2010, insufficient review (quality, lack thereof, etc.) was cited as the number one contributor to tax-related material weaknesses. This isn’t surprising given the complex nature of income tax laws and accounting for income taxes, which are often reviewed by management who are less familiar with these specialty areas of accounting.

No matter the size or age of the company, income tax accounting and related risks should be considered by management on an on-going basis. There are several steps management can take to remediate weaknesses surrounding the accounting for income tax processes. For example:

  • Ensure the tax function is appropriately staffed or outsourced to proper specialists
  • Provide income tax accounting educational opportunities not only to those responsible for tax but to accounting and finance management
  • Improve communication between accounting/finance functions and those involved in the corporate tax function on a regular basis, including:
    • Formalize processes for tax-related reviews of new transactions, accounting policies, business functions and legal contracts
    • Define tax specialist input and review points surrounding on-going functions normally performed within accounting, such as fixed asset depreciation systems and lease accounting
    • Include tax specialists in regular accounting/finance communications regarding results and forecasts
    • Provide consistent guidelines to use across departments when making accounting estimates, including accounting for income tax estimate policies
  • Include tax specialists in the overall evaluation of all tax positions taken
  • Define and document the company’s policy on tax procedures and reviews, including a consensus on risk tolerance levels

Management, utilizing the expertise of the tax function professionals, should perform thorough reviews of the accounting for income tax process, including reviews to identify weaknesses and risks.  Once identified, internal control designs can be implemented or revised to best mitigate risk. Focusing on the review process and including the appropriately informed individuals should be a key focus of the control design. Upon implementation, the control process should be reviewed on a regular basis and upgraded with the growing tax needs of the company. 

In many cases, the importance of the tax function of a company has not received the attention it is due when compared to other areas of a business. But with the continuing flow of restatements and identified material weaknesses in tax reported by public companies, the importance of income tax accounting has gleaned the attention of not only corporate boards and management, but also the SEC and now IRS.

Despite the complexities of ASC 740, early involvement by a highly qualified ASC 740 tax professional can help the company avoid an expensive and embarrassing restatement or a material weakness related to tax matters.