The SEC is holding a roundtable on November 8, 2011 on measuring uncertainty in financial reporting that will focus on, among other things, fair value and uncertain tax positions. Uncertainty exists in financial statements where measurements to a large extent are based on estimates, judgments, and models rather than exact depictions. This roundtable will bring together investors, preparers, and auditors to provide input about those measurements (and associated disclosures) where the outcome depends on future events that by definition are presently unknown. The chairs of the Financial Accounting Standards Board and the Public Company Accounting Oversight Board will attend as observers.
As the level of uncertainty increases, challenges may exist for financial statement preparers to estimate the future outcome of the uncertainties inherent in many business transactions, auditors to verify the subjective judgments about those uncertainties, and investors to understand those uncertainties and assess their potential impact on future earnings or cash flows. Seemingly small changes from a management-selected input used to determine fair value could have a material impact on the reported result at any specific date. For example, when a fair value measure is determined primarily based on a discounted cash flow analysis, use of a discount rate that is 100 basis points different could mean the difference between a material goodwill impairment charge, or none at all.
Some recent accounting standards have increased the extent of measurement uncertainty in financial statements, noted the SEC, citing ASC Topic 825-10, Fair Value Option, which increased the use of fair value measures that may be determined using unobservable inputs, and some standards have attempted to increase the transparency into the measurement uncertainty that underlies financial statement items, citing ASC 820-10, Fair Value Measurement, which defined fair value, established a framework for measuring fair value, and expanded disclosures about fair value measurements.
The roundtable is likely to examine the financial statement effects of uncertain tax positions, recognized when it is more likely than not, based on the technical merits, that the positions will be sustained upon examination and are measured as the largest amount that has more than a 50% chance of being realized. This discussion will likely call into question FIN 48 and recent IRS actions, and possibly the Textron opinion.
The IRS has finalized Schedule UTP requiring companies to report uncertain tax positions on their tax returns starting with 2010 tax returns. The schedule will require the annual disclosure of uncertain tax positions in the form of a concise description of those positions and information about their magnitude. The company does not have to disclose the risk assessment or tax reserve amounts, even though the IRS can compel the production of this information through a summons.
Schedule UTP requires companies to provide a concise description of each uncertain tax position for which they have recorded a reserve in their financial statements, or for which no reserve has been recorded because of an expectation of litigation. These uncertain tax positions are identified by corporations during the process of preparing financial statements for SEC filing under applicable FASB accounting standards, such as FIN 48. In reviewing and verifying financial statements for compliance with FIN 48, independent auditors may ask for copies of legal opinions and other documents in order to understand transactions, to understand the legal bases for the treatment of transactions, and to determine the adequacy of reserves for contingent tax liabilities. Under the codification of accounting standards, the relevant portions of FIN 48 are now contained in Accounting Standards Codification subtopic 740-10, Income Taxes. FASB ASC 740-10.
In Announcement 2010-76, the IRS expanded its policy of restraint in connection with its decision to require corporations to file Schedule UTP and will forgo seeking particular documents that relate to uncertain tax positions and the work papers that document the completion of Schedule UTP. In reviewing and verifying financial statements for compliance with FIN 48, independent auditors may ask for copies of legal opinions and other documents in order to understand transactions, to understand the legal bases for the treatment of transactions, and to determine the adequacy of reserves for contingent tax liabilities.
The issue of whether the IRS can discover tax accrual work papers remains extremely contentious and has now divided the federal courts. A panel of the DC Circuit Court of Appeals ruled that a memo prepared by a company's outside audit firm recounting the thoughts of corporate counsel on the prospect of tax litigation over company partnerships could be protected attorney work product. Similarly, the panel said that a company's disclosure to the independent auditor of a tax opinion on company partnerships by outside counsel did not constitute a waiver of the work product privilege. Disclosure to an adversary or a conduit to an adversary could waive the privilege, noted the panel, but a company's independent outside auditor of its financial statements is neither an adversary of the company nor a conduit to its adversaries. The government sought production of the documents in connection with ongoing tax litigation with the company. (US v. Deloitte LLP, US Court of Appeals for the DC Circuit, No. 09-5171, June 29, 2010).
Earlier, the full First Circuit Court of Appeals, in a 3-2 opinion, ruled that the attorney work product doctrine does not shield from an IRS summons tax accrual work papers prepared by a company’s lawyers to support the calculation of tax reserves for audited financial statements filed with the SEC. The Textron Inc. v. United States, Dkt. No. 09-750. In a 3-2 opinion, the full appeals court held that the purpose of the tax audit work papers was not to prepare for litigation, but rather to make book entries, prepare financial statements and obtain a clean audit.