Four Reasons to Strengthen Income Tax Accounting Internal Controls

Article two of a four-part series discussing ways to reduce risk and increase controls related to income tax accounting.

As discussed in Three Ways to Reduce Income Tax Reporting Risk, recent reports show that income tax-related restatements account for approximately 12% of all restatements and income taxes contribute to adverse internal control over financial reporting (ICFR) disclosures. The reason behind weaknesses related to income tax may seem obvious: Tax is inherently complex, changes in accounting guidance and tax law can be difficult to implement and coordinate, most tax departments are understaffed, and income taxes represent a significant portion of a company’s financial statements. We might not know whether these tax-related material weaknesses and adverse ICFR opinions require remediation but not a restatement. Regardless, not addressing material weaknesses could lead to a restatement, which can be very costly.

Because of the ongoing identification of material weaknesses, it is important for management to understand the overall burden those weaknesses place on the company and thus the need to strengthen internal controls related to income tax accounting. Despite being an ever-increasing focus of the Public Company Accounting Oversight Board (PCAOB) and public accounting firms, deficiencies in income tax accounting and internal controls continue to be a problem for many companies.

1. Consulting Fees

The direct cost of remediating a material weakness — with or without a restatement — can be particularly burdensome on an organization. Costs incurred often include:

• Third-party advisors to assist in the development and execution of the remediation plan, including the training of process and control owners.
• Additional audit fees for enhanced testing procedures.
• Remediation monitoring and auditing of restated financial statements.
• Legal fees to assist in any pending actions taken and additional oversight of communications.

The costs may not be insignificant. For example, a Houston-based public company recently disclosed income tax remediation expenses in excess of $170 million and additional governmental fines of $140 million. While not all remediations come with such a hefty price tag, any costs incurred may have significant financial and operational effects on the company.

2. Investor Confidence and Market Capitalization

A material weakness can spark worries from investors about reduced future performance due to significant remediation costs, doubt related to other areas of the financial statements, and questions regarding management of the organization. Regardless of their validity, investor concerns are often demonstrated by a drop in stock price. A well-known brewing company reported that its stock “tumbled” following its material weakness disclosure related to income tax. The Houston-based company mentioned above realized a more than 10% drop in stock pricing following its first restatement. With possible declines in stock prices that could be caused by restatements, the impact on market capitalization for any given company could be in the billions.

3. Resource Capacity

An internal tax department with ample resources available to accurately address controls issues is rare. With already-strained resources, focusing on a remediation and/or a restatement of a past event is not a value-added use of those resources. Capacity within the tax department (or any department involved) could be used more effectively to generate cost-saving ideas, improve and streamline processes, and focus on managing risk and delivering value. 

4. Reputational Risk

Possibly the largest burden to measure is the reputational impact on an organization and its management team that comes from being associated with a material weakness.

The Sarbanes-Oxley (SOX) Act, intended to protect investors from accounting errors and fraudulent financial reporting, requires the establishment of internal controls and reporting methods to ensure those controls. Corporations often view SOX compliance as onerous and expensive; however, the cost and effort to remediate can be far greater than the cost to implement and execute strong controls.

In addition to better preparing your company for the provision of income taxes, proper internal controls will allow your tax department to increase operational accuracy and be a strategic driver of revenue.