Having audited captive insurance companies for many years now, most of which fall into the category of being small-or-medium enterprises, I have been witness to the pains that most of these companies have experienced in keeping up with and adopting the numerous changes in accounting standards over the past few years. The simple fact of the matter is that many of these changes have been targeted at larger and/or publicly-accountable companies, with SMEs being the unfortunate collaterally-damaged.
To a large extent, these accounting developments have come fast and furious and left even the bigger public companies struggling to adapt their systems in time to facilitate the adoption of the new standards. In certain cases, standard setters have been more accommodating to SMEs by allowing for deferrals and exemptions to certain new standards, or portions thereof, in order to ease the burden of transition for these entities. That was certainly the case for Financial Interpretation No. 48 (“FIN 48”), which is now included within various paragraphs of ASC 740, the new relevant US GAAP standard. (Despite the recent US GAAP codification exercise, the FIN 48 label has managed to stick to this particularly troublesome standard.)
The main purpose of FIN 48 is to require certain financial statement disclosures and, where appropriate, accruals related to income tax uncertainties (of any and all tax jurisdictions, not just US) for all entities reporting under US GAAP. FIN 48 affects the accounting policies, financial statement disclosures, data gathering processes and/or internal controls of a company. Some have argued that it essentially amounts to disclosing red flags to the US Internal Revenue Service in the financial statement notes.
FIN 48 was first released by the Financial Accounting Standards Board in 2006 and was originally intended to become effective for all reporting entities starting in fiscal years commencing after 15 December 2006. Subsequent amendments ended up postponing that effective date, in the case of most non-public companies, to fiscal years commencing after 15 December 2008.
While these delays did serve to fray the nerves of those involved in the financial reporting function of SMEs, they also presented an opportunity for all of us (accountants and auditors alike) to understand what was going to be involved in adopting this standard and also auditing the various management analysis and resulting financial statement disclosures. Despite this being the case, it has been this auditor’s experience that FIN 48 implementation has caused more headaches than any other new standard that I can remember.
Where did it all go wrong?
There are a number of answers to that question.
Being involved in the audit of offshore (ie non-US domiciled) insurance captives, many of which are owned by not-for-profit healthcare or similar organisations, I have found that a major hurdle to overcome in this first year of applicability for non-taxable SMEs was the fact that many clients were of the assumption that FIN 48 did not apply to them. While it is true that such entities most often are not as affected by FIN48 as are taxable entities, there is not any less of a requirement for them to perform a thorough analysis of the possible issues and come to a reasoned and supported conclusion on what effect FIN 48 does or does not have on their financial statement figures and disclosures. I have found there to be a general underestimation by most companies as to what is required in terms of FIN 48 documentation and analysis.
Another source of FIN 48-related headache has been the interplay between the dual concepts of certain and uncertain tax positions, as defined by FIN 48, and the concept of tax positions which are ‘more likely than not’ to be upheld upon examination by the IRS. FIN 48 analysis is a two step process. The first step is to ascertain the level of comfort on a tax issue. That is, the determination of whether a tax position taken is a certain, or uncertain, position.
If it is determined to be a certain tax position then an adverse tax exposure does not exist and there would be no further analysis required. If it is determined to be an uncertain position, the second step (measurement) must then be considered. This has been a common oversight by some clients when performing the FIN 48 analysis, with many simply jumping to step two without due consideration to the certain/uncertain tax position assessment.
Many clients have done a fine job of analysis from the standpoint of addressing potential US federal tax issues but have missed potential US state tax and nexus issues in instances where such issues may reasonably arise.
In many situations, FIN 48 requires an inordinate amount of work relative to the ultimate results of that effort. That is, the end effect on the financial statements is often fairly mundane in the case of offshore SMEs – at least, those which have been properly planned and executed upon inception from a tax planning perspective. It has, therefore, not been a widely-held view that the types of questions now being asked by auditors are value-added or even relevant.
While there is generally a high percentage of questions asked during the FIN 48 portion of the audit to which the answers do not end up revealing an issue, I still defend the necessity of auditors asking these types of questions in the interest of being thorough in our work. Naturally, some clients do not always see it that way and have often viewed the exercise as being a waste of time.
The onset of FIN 48 has necessitated that entities document the answers to certain relevant questions, regardless of how obvious the questions or answers themselves may be, and that has been a hard concept for many to grasp.
Without a doubt, there have been significant inconsistencies between audit firms in terms of what we have done to prepare clients and what we have deemed to be sufficient FIN48 analysis and documentation now that it has finally taken effect. I have taken the position that blanket representations from management as to the lack of any FIN 48-related contingencies existing do not meet the requirements of sufficient and appropriate audit evidence for purposes of the relevant auditing standards by which we are bound.
This stance appears to be contrary to the position that some other firms have taken on the matter and this has lead to some difficult conversations where we have had to justify our position. To assist, we have prepared a checklist for clients to complete, which points our clients to consider some of the more commonly encountered issues in order to force the analysis being done and facilitate the documentation.
Yes, this year has definitely presented some significant challenges in implementing FIN 48 for the first time. However, I still believe that the exercise has provided some value by requiring our clients to revisit the various tax positions taken in more depth and to serve as a ‘stress test’ for a number of structures and fact sets which might be challenged by the IRS.
Although rare, I do know of circumstances where the exercise has directly resulted in structure or program changes in order to strengthen a captive’s argument and, in at least one case, the voluntary unravelling of a captive structure which was originally not structured appropriately to accomplish the tax position which was intended. While voluntarily unravelling a captive structure can be costly, it is much preferable to an unfavourable IRS audit result and the potential interest and penalties which could ensue.