An article published in Tax Advisor Magazine - AICPA - about the impact of Sarbanes-Oxley on Accounting for Income Taxes under FAS 109

1. TaxClinic
Practical Advice
on Current Issues
Editor:
Terence Kelly, CPA
Partner
BDO Seidman, LLP
Phoenix, AZ
©2005 AICPA

2. 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

3.  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

4. 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

5. 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

6. 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

7. ©2005 AICPA