Unwinding FIN No. 48

Raymond Thompson, PhD, CMA
Pursuit, September 2007

The Financial Accounting Standards Board’s Interpretation No. 48 (FIN No. 48), Accounting for Uncertainty in Income Taxes: An Interpretation of FASB Statement No. 109, clarifies when the benefits of tax positions may be recognized on financial statements. It applies whenever there is uncertainty surrounding a tax position adopted by an entity. The interpretation uses a two-stage approach based upon a “more-
likely-than-not” criteria.

FIN No. 48 is effective for fiscal years beginning after Dec. 15, 2006. All material open tax positions must be reevaluated in light of the new standard, and only tax positions that meet the more-likely-than-not threshold can be recognized in financial statements.

The interpretation is likely to increase the number of differences between an entity’s tax return and financial statement amounts. This will create an additional set of book-to-tax differences that may result in the following:

• An increase in the liability for current taxes payable
• A reduction of an income tax refund receivable
• An increase in a deferred tax liability
• A reduction of a deferred tax asset
• A combination of the above

FIN No. 48 does not alter procedures or classification requirements for deferred taxes. Rather, it introduces a new type of account—a FIN No. 48 liability—that is closely related to SFAS No. 109. Liabilities for unrecognized tax benefits are classified as “current” when payment is expected within one year or within the operating cycle, and “noncurrent” or “deferred” when the above time periods are exceeded. Income tax liabilities are classified as “deferred” when they result from taxable temporary differences. These differences are defined as the differences between the FIN No. 48 tax basis of an asset or liability, and its reported amount in the statement of financial position.

Below is a highlight list of some of the important points of the interpretation. FIN No. 48 changes the reporting for tax positions through the following:

• Establishing a recognition threshold. Unless more-likely-than-not to be sustained, no benefit may be recognized.

• Creating standards for measurement based on expected value. The amount to be reported is greater than 50-percent-likely to be realized on ultimate settlement.

• Requiring evaluation of positions based solely on technical merits. This must assume consideration by a taxing authority with full knowledge of all relevant information. Note, this is not the amount the taxpayer is likely to pay
at the end of the filing and examination process.

• Creating a new type of account, a FIN No. 48 liability. This will appear on financial statements and will represent future taxes payable resulting from recognition or measurement differences between book and tax amounts.

• Requiring that, at implementation date, the standard is applied to all open tax positions to estimate transition amounts. For calendar year corporations, this will require a “clean starting point” beginning Jan. 1, 2007. At that point, a cumulative, or catch up, adjustment creating an initial FIN No. 48 liability is required.

• Requiring that tax positions be reassessed each reporting period as new evidence emerges. This may result in subsequent recognition or derecognition of previous amounts.

• Indicating that interest and penalties are accrued as required by tax law on the financial statements for these differences.

• Requiring extended qualitative and quantitative disclosures of these differences.
 
AICPA issued a Practice Guide for FIN No. 48, advising financial statement preparers to consult with outside auditors and tax advisors without delay. The implications for auditors and tax advisors are summarized below.

Auditors
Auditors must maintain an inventory of all tax positions: recognized, unrecognized, and derecognized. Auditors will need to develop an understanding of how management arrived at these accounting estimates. This usually involves either, or both, of the following procedures:

• Reviewing and testing the process used by management to develop their estimate

• Developing an independent estimate of the amount to corroborate the reasonableness of management’s number

Arriving at FIN No. 48 liability is a complex process that requires extensive interaction among management, tax advisors, and auditors. Auditors should do the following:

• Understand how the entity obtained the outside expertise to develop and evaluate the estimate.

• Understand the controls affecting the estimate. This requires ensuring that the amount and related disclosures conform to GAAP; that sufficient relevant and reliable data supporting the estimate is collected; and that preparation and review is performed by qualified personnel.

• Test assertions related to the estimate. This involves identifying the facts, data, and assumptions related to the estimate; evaluating the reasonableness and consistency of assumptions; and considering evidence from legislation, statute, legislative intent, regulations, rulings, and case law to ensure they are applicable to the case. It will also involve understanding past administrative practices and precedents in dealing with the entity or similar companies.

• Examine evidence supporting the timing and recognition of tax benefits including more-likely-than-not thresholds; settlements through negotiation; and situations where the time permitting authorities to challenge a position has expired.

Tax Advisors
AICPA’s Practice Guide also describes how FIN No. 48 may affect the tax preparer. Although entitled, IRS auditors do not typically request tax accrual workpapers, which include FIN No. 48 analysis. At the time of this writing, it is unknown whether the IRS will be tempted to take advantage of the increased detail required by FIN No. 48. They could, for example, modify Schedule M to require fuller disclosure of the book-to-tax reconciliation. A number of authors believe this will deter aggressive, but legitimate, strategies. The more-likely-than-not standard is a higher threshold than for most tax returns and is certainly higher than that required to avoid penalties under current tax law. Consequently, some clients may hesitate to pursue tax-planning strategies that conform to IRS regulations, but are likely to require more disclosure that could result in extended scrutiny.

FIN No. 48 requires a “clean starting point,” typically Jan. 1, 2007, for calendar year corporations. The IRS provided guidelines to assist taxpayers in expeditiously resolving any outstanding uncertain positions. To date, few have taken advantage of this initiative.
Problems could arise in jurisdictions where tax returns have not even been filed, maybe because of limited nexus. The open period for these assessments would need to be considered on the assumption that the taxing authority would know the relevant facts. Fortunately, FIN No. 48 only requires aggregate, rather than jurisdiction-by-jurisdiction, disclosure.

Tax advisors will now provide written advice to statement preparers and auditors on the likelihood that an uncertain tax position will prevail. At a minimum, IRS will likely request copies of financial statements and disclosures. Taken together, the Schedule M and FIN No. 48 disclosures will provide the IRS with an unprecedented level of information about a company’s tax position.