Income Taxes: The Missing Link in Corporate Performance Management
What is the highest-risk area of financial reporting? What was the top reason for adverse audit opinions and restatements during 2005? What part of Sarbanes-Oxley Section 404 compliance did companies actually have more trouble with in 2006 than in years past? The answer to all of these questions is the same: accounting for income taxes.
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The end result of these problems, along with the exhaustive changes introduced by Sarbanes-Oxley, Canadian MI 52-109, and European Union Directive 8, has been an amplified focus by audit committees on tax accounting and related financial reporting. To make matters worse, starting this year, U.S. companies must adopt FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes," a sweeping change in standards for accounting for income tax. This is why many CFOs, controllers, and tax executives are revisiting their company's process for accounting for income tax, looking for ways to improve the controls, transparency, and accuracy of what is typically one of the largest items on P&L statements and balance sheets.
They cannot move too quickly. The average company that reported Section 404 tax-accounting weaknesses in 2005 saw a 6 percent reduction in its share price as a result. With the stakes this high, companies must give initiatives to remove inefficiencies from their tax accounting process high priority. For many, that means integrating this function into their business performance management (BPM) processes and software.
The Old World of Income Tax Reporting
Historically, the accounting-for-income-tax process was handled by a few specialists with no direct linkage to corporate accounting. CFOs and controllers treated the financial reporting of income taxes as a separate calculation that should be handled by their tax experts and should not complicate or extend the financial-close process. While the bulk of the close cycle was spent on firming up profit before tax, very little time was spent on calculating and reviewing global income taxes. In addition, since the tax numbers were the last numbers generated in closing the books, there was tremendous time pressure to produce the final tax numbers so the books could close and earnings could be released. As a result, tax directors had to rely on high-level estimates, which would then be trued up when the actual tax "chips" fell the next year.
Since tax directors have been using this same process for years, they should be relatively competent at estimating their company's year-end tax numbers, right? That seems to be what finance folks think. In a recent survey by Hudson Financial Solutions and CFO Research Services, 74 percent of tax executives said that improving their accounting-for-income-tax process would be a high-priority improvement initiative for their company in the next two years, while only 26 percent of their finance counterparts said the same.
But companies' 2005 and 2006 Section 404 tax-related weaknesses reveal that the historical method of tax accounting is no longer working for a lot of businesses -- and the problems have gotten the attention of corporate boards. The world of income tax accounting, and tax operations in general, are increasingly becoming a focus in corporate governance discussions. We all know what that means. When the board is focused on an issue, it immediately becomes the focus of the relevant company managers, from CEOs and CFOs to tax directors and staff to global site controllers and their staff. And the message is always the same: Fix it, and fix it now!
The Good News: Tax Performance Management
A close look at the weaknesses in income tax accounting reveals a number of underlying causes. For one, many companies lack people with the required level of tax-accounting knowledge. For another, the tax accounting process is greatly compromised when several disparate systems house the detailed data needed to account for income taxes. And these problems are intensified because most companies are employing older technologies for their tax accounting, applications that don't offer a collaborative and distributed computing environment.
All three points of this people-technology-process triangle can be greatly improved by integrating income tax accounting with business performance management. BPM software has been used for years to address consolidated book and management reporting. But adding tax to the mix -- using the same data and the same process-enabling technology for the planning, budgeting, forecasting, consolidation, and tax processes -- ensures that as soon as the GAAP books close, tax closes. And when integrated with other, more traditional BPM activities, tax accounting gains the controls, transparency, and accuracy required for publicly filed statements.
In this, as in many aspects of life, failure may be a much better teacher than success. Because of reported accounting weaknesses, some companies have recently discovered that their BPM platform is a natural fit for enabling the people, process, and technology improvements they need to shore up their global accounting-for-income-tax process and related public disclosures. By extending their BPM platform to income tax accounting, companies can provide the collaborative, distributed computing environment they need to accurately report on global operations by legal entity, by jurisdiction, on a tax-adjusted basis as soon as the books close.
Some would argue that integrating the tax provision process into a BPM application is not a simple solution to tax-accounting problems. But consider that the data for both GAAP accounting and tax accounting originates from the same financial transactions, that all financial transactions are stored electronically in some software system, and that the owners of this data (global controllers and their staffs) are the same people responsible for both GAAP and tax accounting. BPM solutions bring together financial data from a company's disparate systems and provide the collaborative, distributed computing environment that is needed by -- and already familiar to -- the data owners.
