U.S. Tax Reform: Financial Reporting and Audit Considerations

Tax Reform: Reporting and Audit Considerations

The enactment of U.S. tax reform is imminent. It has passed both the House and Senate and is now on its way to President Trump to be signed into law. 

The bill contains significant legislative changes to the tax system, including substantial international tax reform. This is a major overhaul of the Internal Revenue Code (“IRC”) that will impact every taxpayer in the U.S. The implications are far reaching, and include considerable impacts on financial statement reporting. 

It is now time to start planning and properly preparing to account for all the implications tax reform will have on financial statements. We have summarized in this Insight the key considerations for financial reporting. A more detailed analysis is forthcoming.   

Tax Law Implications

The “Tax Cuts and Jobs Act” changes the current tax system for corporations, generally beginning with taxable years starting after December 31, 2017. The bill reduces the corporate tax rate from a graduated set of rates with a maximum 35 percent tax rate to a flat 21 percent tax rate. Additionally, the bill introduces many changes that impact corporations, such as a net operating loss (NOL) deduction annual limitation, an interest expense deduction annual limitation, elimination of the alternative minimum tax, and immediate expensing of the full cost of qualified property. 

The bill also introduces a substantial international tax reform that moves the U.S. toward a territorial system, in which income earned in other countries would generally not be subject to U.S. taxation. However, the accumulated foreign earnings of U.S. shareholders of certain foreign corporations would be subject to a one-time transition tax. Amounts held in cash or cash equivalents would be subject to a 15.5 percent tax, while amounts held in illiquid assets would be subject to an eight percent tax. Taxpayers can elect to pay the transition tax over an eight year period using specified percentages (eight percent per year for the first five years, 15 percent in year six, 20 percent in year seven, and 25 percent in year eight), or chose to pay the amount in one lump sum. Also, taxpayers can use NOL and foreign tax credit (FTC) carryforwards to offset the transition tax liability (an election can be made to utilize FTC carryforwards before NOL). 

Going forward, foreign earnings of U.S. shareholders of certain foreign corporations would be exempt from U.S. taxation, except for certain foreign income that would still be subject to the U.S. anti-deferral rules (i.e., subpart F of the Internal Revenue Code) and new anti-base erosion rules that are designed to ensure U.S. corporations do not shift income to jurisdictions with no or a very low tax rate (e.g., Cayman Island). 

Tax Accounting Implications

U.S. accounting standards under Topic 740 (Accounting Standards Codification or ASC 740) require remeasurement of all U.S. deferred income tax assets and liabilities for temporary differences and NOL carryforwards from the current rate of 35 percent to new corporate rate of 21 percent. The cumulative adjustment will be recognized in income tax expense from continuing operations as a discrete item in the period that includes the enactment date. Consequently, a calendar year-end company will need to adjust its deferred taxes in the December 31, 2017 financial statements. Further, SEC registrants would need to file their year-end financial statements 60-90 days after year-end. 

The transition tax on accumulated foreign earnings would cause many U.S. corporations to recognize a U.S. tax on foreign earnings that were previously deemed permanently reinvested outside the U.S. The repatriation tax would also be recognized in income tax expense from continuing operations of the period of enactment. The tax calculation is complex and involves many variables and considerations (e.g., earnings and profits since 1986 and cash and cash equivalent balances at two particular dates). Foreign withholding tax that would be incurred on cash repatriation and foreign exchange translation effects would also be considered in the measurement of the repatriation tax and reflected in the enactment period accounting. The transition tax can be offset by NOL and FTC carryforwards and therefore would be considered a source of income for valuation allowance accounting purposes. Valuation allowance changes due to the transition tax would also be recognized in the enactment period accounting.      

Going forward, the various changes affecting corporations will have significant ASC 740 implications. For example, a new annual limitation on NOL utilization could result in more complexity and unfavorable valuation allowance consequences. A new annual limitation on interest deduction would introduce complexity, judgement and uncertainty into the determination of interest deducibility. New proposed international tax rules designed to eliminate incentives to keep foreign income in low tax jurisdictions would also create new challenges and complexities for ASC 740 purposes. A provision to encourage U.S. export of intellectual property (IP) provides a deduction for IP derived income, likely to be accounted for as a permanent benefit in a company’s effective tax rate instead of being reflected in deferred income taxes. All these will have corollary impacts on valuation allowances and uncertain tax benefits (FIN 48 liabilities) and will ultimately impact the effective tax rate. 

Income tax disclosures should not be overlooked. The tax footnote disclosures included in annual financial statements of the enactment period would have to provide sufficient information on the cumulative effect of the tax reform enactment. There is a requirement to disclose significant components of income tax expense from continuing operations including the effect of a tax law and tax rate changes. This disclosure would also include the effect on the valuation allowance due to tax reform enactment. For many public companies, the income tax footnote’s effective tax rate disclosure which reconciles the statutory rate to the effective rate would have a reconciling item or items for the cumulative effect of the tax reform enactment. The various balance-sheet related disclosures of deferred taxes, NOL and credit carryforwards, and uncertain tax benefit liabilities would also be affected.

Audit Considerations

The passage of this major U.S. tax reform so close to year end will create disruption to the audit process and work expected for the 2017 financial reporting season. Being proactive in addressing the changes will be critical to easing the process. Preparers should learn the significant changes and understand the impact these will have on reported balances. The learning and assessment should begin now given a compressed timeline to avoid the possibility that tax balances may not be accurately accounted for in 2017 financial statements. 

Auditing standards require an assessment of the overall risk of material misstatement to plan and perform an effective audit. This legislation will likely result in additional audit risk considerations to all preparers and their external auditors. Preparers should expect targeted audit procedures to address these additional risks and to provide audit evidence necessary to support reported amounts. This will include providing detailed calculations and documentation. Importantly, early discussion and sharing of information with external auditors concerning the underlying accounting impact in advance of management’s final assessment will help prevent last minute audit surprises. 

The internal control framework or environment within an organization will also be affected by this major U.S. tax reform. New controls or revisions to existing controls might have to be designed and implemented. Auditors will need to evaluate the design of these controls and when applicable, test the operating effectiveness of such controls. If management intends to use certain permissible estimates within its calculations, it should be clear how the estimates were developed, the contradictory information that was considered and how management concluded the estimate was materially accurate. 

SEC Reporting Implications

Registrants will need to consider the impact of the Act on the disclosures within Management’s Discussion and Analysis (“MD&A”), specifically as it relates to liquidity, the results of operations, and critical accounting estimates. 

A discussion is required of known trends, commitments, events, or uncertainties associated with the Tax Reform that are reasonably likely to result in liquidity increasing or decreasing in any material way, on both a short-term and a long-term basis. A registrant with significant foreign earnings must consider the impact of the one-time transition tax, including any changes to its contractual obligations table if the liability is to be paid in annual installments. Furthermore, the ongoing effects of other changes (e.g., the reduced corporate tax rate, among others) should be discussed. 

A discussion of the impact of the Tax Reform on the results of operations should include (i) the one-time impact of the change in the corporate tax rate on deferred tax assets and liabilities (DTAs and DTLs), (ii) the one-time transition tax if the registrant has material foreign operations, and (iii) the ongoing impact of the reduced corporate tax rate and other changes. The first two items above should be consistent with amounts reflected in the effective rate reconciliation in the footnotes to the financial statements. 

A discussion will need to be updated to address the material uncertainties associated with the estimates made within the tax provision, including a discussion surrounding the estimate of the one-time transition tax if the registrant has material foreign operations and there are significant uncertainties around the amount reflected in the financial statements. 

Additionally, registrants will need to consider the income tax disclosures required under Regulation S-X, Rule 4-08(h), including disclosure of the amounts of income tax expense (benefit) applicable to United States Federal income taxes, foreign income taxes, and each other major component of income taxes as well as a reconciliation between the amount of reported income tax expense (benefit) and the amount computed by multiplying the income (loss) before tax by the applicable statutory Federal income tax rate including detail of the underlying causes for the difference in the two amounts. 

If the Tax Reform is signed into law after the balance sheet date but prior to the issuance of interim or/and annual financial statements, the passage would be a known event that is reasonably likely to materially affect operating results and liquidity. Therefore, a registrant should discuss the expected effects on future operating results and liquidity. A registrant should also consider disclosing (via a footnote to the contractual obligations table) the material change in other long term liabilities that occurred after year-end. 

MFA Observations
Preparers of financial statements face a daunting task of having to learn, understand, and react to a monumental corporate tax overhaul within a compressed time period, as the enactment of the Tax Reform will occur very soon (at the present moment, it’s unclear whether President Trump will sign the tax bill by December 31, 2017 or early in 2018). This development comes at the time when many preparers are still working toward the January 1, 2018 adoption of a new revenue recognition standard (ASC 606). Successful implementation and financial reporting (accounting and SEC) for all of the anticipated Tax Reform effects requires a multidisciplinary approach, drawing on people from finance, accounting, tax, and human resources. Preparers will have numerous operational challenges and risks from having to determine, within a short period, all of the effects stemming from the Tax Reform and account for them in their financial statements which include the enactment period. They are required to demonstrate a clear understanding of complex tax and accounting rules to accurately account for, and disclose, the company’s income tax accrual.

MFA is well equipped to help preparers navigate the myriad of complex tax, accounting, SEC reporting, and audit considerations to be addressed by the enactment of the Tax Reform. For more information on the matters discussed above, please contact us.

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