Readers of recently-issued Securities and Exchange Commission (“SEC”) Form 10-Qs for the quarterly period ended March 31, 2007 will notice a new footnote disclosure to the financial statements of such Form 10-Qs thanks to the Financial Accounting Standards Board’s (“FASB”) issuance of FASB Interpretation No. 48, “Accounting For Uncertain Tax Positions” (“FIN 48”) in July of 2006. FIN 48 makes far-reaching changes in the manner in which companies account for income taxes under generally accepted accounting principles (“GAAP”).
Prior to the issuance of FIN 48, companies reported their income taxes for GAAP purposes under Financial Accounting Standard 109 (“FAS 109”). FAS 109, however, does not provide a strict standard regarding when an income tax benefit should be recognized for GAAP purposes. As a result, companies simply assumed that a position taken on a tax return was reportable for GAAP purposes, except for positions where it was “probable” that a taxing authority would successfully challenge the tax benefit of the position taken. Tax return positions that involved material audit risk were addressed by setting up a tax reserve. Thus, FAS 109 resulted in diverse accounting practices with respect to the criteria used to measure benefits related to income taxes.
FIN 48 was issued to address such diversity by setting forth a two-step process regarding the recognition and measurement of a tax benefit. The first step is to determine whether a tax position has met the recognition threshold. The recognition threshold is met when a company is able to conclude that it is “morelikely- than-not” that the company will sustain the tax benefit taken on a return upon examination by a taxing authority. In satisfying this recognition test, a company must assume that the tax position will be examined by the relevant taxing authority that has full knowledge of all of the relevant information. In other words, in determining whether the recognition threshold is met, FIN 48 does not allow a company to consider the chances that the return on which the tax position was taken may not be audited, i.e., a company may not consider the “audit lottery.”
Satisfaction of the recognition test, however, is only half of the battle under FIN 48. Even if a company clears the recognition hurdle with respect to a particular tax position, the company must still satisfy a second test regarding measurement of the tax benefit to determine how much of the tax benefit should be recognized for GAAP purposes. Under the measurement threshold, a company may only recognize the highest amount of tax benefits that have a greater than 50 percent chance of being realized upon an ultimate settlement with the relevant taxing authority that has full knowledge of all of the relevant information. Accordingly, under FIN 48’s two-step process, a company may report a tax benefit for GAAP purposes only if the tax position meets the “more-likely-than-not” threshold of being realized if challenged by the relevant taxing authority with full knowledge of the facts, and even if such threshold is met, only the amount of the tax benefit which has a greater than a 50% chance of being sustained may be booked on the company’s GAAP financial statements.
Application of the two-step approach under FIN 48 is a continuous process that requires each tax position to undergo a re-examination for each reporting date. Thus, a company must “derecognize” a previously recognized tax benefit in the first period in which it is no longer more-likely-than-not that the tax benefit would be sustained upon examination by a taxing authority.
One of the most troublesome aspects of FIN 48 concerns its disclosure requirements and the fear that such disclosure may provide the Internal Revenue Service (the “Service”) with a “road map” for attacking certain tax positions. For example, FIN 48 requires a company’s annual financial statements to include a tabular reconciliation of the beginning and ending aggregate unrecognized tax benefits, as well as specific detail related to tax uncertainties for which it is reasonably possible the amount of unrecognized tax benefit will significantly increase or decrease within twelve months of the reporting date. Companies are concerned, for good reason, that such detailed disclosure may assist the Service in the audit process. Indeed, Service Chief Counsel Donald Korb recently made it known that the Service intends to use FIN 48 disclosures contained in companies’ public filings in reviewing the corporate tax returns of such companies, stating that the Service is “not going to turn a blind eye” to such disclosures.21
Although such detailed disclosures will not be required until companies file their 2007 annual reports in 2008, the provisions of FIN 48 must be applied to fiscal years beginning after December 15, 2006, and FIN 48 requires an analysis of all material tax positions for all open tax years. As discussed above, only tax positions that satisfy the more-likely-than-not recognition threshold as of the effective date may be recognized, or continue to be recognized, in GAAP financial statements.
The cumulative effect of applying FIN 48 to all material tax positions must be reported as an adjustment to the beginning retained earnings for 2007. In other words, if a company had recognized a tax benefit on its 2006 financial statements, which now does not merit recognition due to the failure to satisfy FIN 48’s morelikely- than-not threshold, the adoption of FIN 48 would result in a charge to the company’s retained earnings as of January 1, 2007 to reflect the loss of the tax benefit.
Because SEC Regulations require interim financial information to include disclosures of significant changes in accounting principles and practices since the end of the most recently completed fiscal year, companies must disclose the effects of FIN 48 on their financial statements contained in Form 10-Q for the quarter ended March 31, 2007. Thus, taxing authorities will not have to wait until the 2007 annual reports are released in 2008 to observe the effects of FIN 48.
A review of the Form 10-Qs for the quarterly period ending March 31, 2007 reveals a varying impact of FIN 48 on the financial statements of public companies. For example, some companies determined that the adoption of FIN 48 did not impact their financial position and results of operations.22 Other companies, on the other hand, determined that the adoption of FIN 48 resulted in an increase in the net liability for unrecognized tax positions, which, as discussed above, resulted in a reduction to the opening balance of retained earnings on January 1, 2007.23
While the recently-issued Form 10-Qs are providing readers of such Forms, including the Service, with the first glimpse of the effect of FIN 48 on companies’ financial statements, we will have to wait until the annual reports of such companies are issued to obtain a more detailed analysis of the impact of FIN 48. Another issue to consider regarding the implementation of FIN 48 concerns the effects that FIN 48 may have on financial covenants of borrowers. Many lenders impose financial covenants on borrowers to ensure the financial strength of the borrower; such covenants often require the borrower to provide the lender with interim financial statements to allow the lender to monitor compliance with such covenants. One such financial covenant is a minimum net worth covenant, which typically provides that the stockholders’ equity of the borrower will at no time be less than a certain amount.
As previously discussed, the cumulative effect of implementing FIN 48 must be reported as an adjustment to the beginning retained earnings for 2007. Thus, the adoption of FIN 48 may cause a company to reduce the opening balance of its retained earnings for 2007, which would reduce the company’s stockholders’ equity as of January 1, 2007. Such a reduction may be a concern if the company is a borrower that is subject to a minimum net worth covenant.
For example, suppose a borrower is subject to a minimum net worth covenant with respect to a loan and the lender’s review of the borrower’s year-end financial statements for 2006 indicated that the borrower just barely satisfied the covenant. Suppose further that the borrower’s 2006 annual financial statements recognized significant tax benefits which the borrower must now “derecognize” as a result of the adoption of FIN 48. The loss of such tax benefits under FIN 48 would result in a reduction in the borrower’s retained earnings, thereby reducing its net worth. Thus, if the lender were to review the borrower’s financial statements for the first quarter of 2007, the lender may determine that the borrower is in violation of the minimum net worth covenant due to the implementation of FIN 48.
Thus, the Service will not be the only party with an interest in the effects of the implementation of FIN 48 on financial statements for the first quarter of 2007. Indeed, lenders should be focusing on such statements to see if the adoption of FIN 48 has resulted in the violation of a financial covenant of its borrowers.