I want to go down a tangent a bit and talk about accounting for taxes. This topic is in the media this week because on July 13 the Financial Accounting Standards Board changed the rules, effective next year. (It is funny that the interpretation released on July 13 says right on the the front that it was issued in June. Backdating may be in the air these days.)
Accounting for taxes is tricky for two reasons: First, the accountants want tax expense shown on the financial statements at the same time that the associated pre-tax profit is reflected. For a number of reasons, tax payment timing varies considerably from the timing of accounting profits. Second, the concern here, a company’s ultimate tax liability is uncertain. Firms take favorable positions on returns and then end up paying more after audit, and perhaps after having to go to court against the IRS.
Whether companies show low tax expense on their financial statements based on aggressive positions and force investors to gamble with the tax man is discussed below.
Prior to the July 13 interpretation, most companies only showed an uncertain tax liability if it was about 70% likely that they both would be caught and then lose. Footnote disclosure was non-existent, as that would be a roadmap for an IRS audit, perhaps even supporting tax penalties on aggressive positions. This was not a big deal until the growth of corporate tax shelters in the 1990s dragged companies into very aggressive tax planning. Big companies were buying crap. As these companies started losing cases that resulted in huge tax liabilities, shareholders got a surprise. For example, in the first big case, shareholders of Colgate got hit indirectly with a $30 million tax bill.
So, the new rule. As to a given tax position, a tax liability must me shown unless, assuming that the relevant tax authority identifies the issue, it is over 50% likely that the company will win. What a change! Very pro government. An IRS agent need only compare the taxes on the financial statements with those on the tax return (adjusting for timing) and ask for the difference. Very pro investor. As to any other liability, say for a toxic waste spill, the company takes likelihood of getting caught into account in evaluating the risk to the company. Now, not with taxes! I understand that pressure from Treasury was partially responsible for tax liabilities being treated so specially.