For tax professionals charged with calculating tax provision, the annual audit can be a headache at best, and a source of existential stress at worst. But it doesn’t have to be that way. Here, we show you how to build trust with your auditor, understand their perspective—and ultimately use that perspective to help your company make shrewd business decisions for the future.
Tax provision errors under ASC 740 remain a leading cause of financial restatements: hardly a surprise when you consider how this one number—the estimated amount of income tax that a company expects to pay—directly impacts its reported earnings (and, if a public company, its EPS). That’s why the external auditor, whose role is to validate that there are no material errors or misstatements in the company’s financial statements, is such a key player.
But how do you, a smart tax executive, approach that player? As an arbiter, an adversary, or an ally?
As one who has worked on both sides of the audit fence, I would argue for a strategic, cooperative approach that weaves the auditor’s perspective into the fabric of your work at every stage of the process. You want to know what they are looking for, what they are looking at, and why. And you should feel free to consult your auditor for an informal opinion in advance if you’re wondering about the tax treatment of a particular item or issue. (Spoiler alert: They want that, too.)
Bottom line: To get to a clean audit, you don’t need to hand off your provision calculations on a wing and a prayer. Here, we’ll demonstrate how you can be both prepared and proactive.
Where the rubber meets the road
Finalizing your tax provision under almost impossibly tight timeframes is no walk in the park. It requires oceans of data, a deep knowledge of ever-changing tax rules, technical expertise—and, crucially, plenty of judgment calls—all on a compressed timeline. Your auditor will verify that all your provision calculations are accurate and that they are supported by every underlying statement, schedule, and document.
Four main calculations get funneled into the annual tax provision: The current provision; the deferred roll-forward; the state provision; and the total provision, and rate reconciliation. While the auditor will not check each stage in real time, there are key issues in each of those calculation stages that an auditor will examine.
The provision process can’t even begin until the finance team hands over the trial balance: a final schedule of the company’s complete financial activity over the period before taxes, itemized on the balance sheet (assets, liabilities, and shareholder equity) and income statement (revenue, expenses, gains, and losses). Schedules on areas like fixed assets, intangibles, and stock compensation, may dribble in over a few days, but the trial balance is the obligatory starting point.
The current provision is an estimate of the company’s income tax liability in advance of its current-year tax return. It’s arrived at by converting the company’s net book income from the trial balance (calculated under GAAP or IFRS rules) to income tax (following ASC 740 rules and all other relevant tax laws)—a process that involves adjustments to the former, plus adding net operating losses and credits to the latter. Those adjustments are either permanent (booked items like meals or fines that will never be tax-deductible) or temporary (booked items like depreciation or accruals that aren’t yet includable as income or deduction, but that will be at a future date). After these calculations, you apply the current statutory tax rate(s) to arrive at the current provision.
The auditor will not only check the accuracy of your current-year calculations, but they’ll also verify that the prior year’s provision roll-forward you are using this year matches last year’s tax return (the so-called “true-up”). They’ll use that to tie your current provision back to the rest of your pre-tax accounting financial statements, before looking at your adjustments—temporary and permanent—and checking that they all line up with your trial balance and supporting work papers. (Hopefully, long before year-end, you’ve made triple-sure that your true-up calculations, typically a manual process, are waterproof. Otherwise, you’re just starting a marathon with one shoe untied.)
The deferred roll-forward is a balance-sheet concept whose purpose is to quantify future tax assets and liabilities. You’ll want to take extra care in navigating this neighborhood because when companies get tripped up by an audit, it usually happens here. (Auditors are generally far more lasered in on these issues than tax executives, under the press of their crushing workload and tight deadline.)
Deferreds—be they deferred tax assets or liabilities—are the product of temporary differences between tax and accounting and include tax attributes like net operating losses and tax credits which accumulate and are rolled forward. What all these items have in common is that they’ll be realized at some point in the future. Timing differences can easily throw a wrench in this calculation: it’s far too easy to exclude or misstate a temporary difference that arose during the year. Also, remember that these calculations rest on a continuum of other calculations—so if what you’ve been rolling forward from past years contains an error, that could bubble up this year, causing a string of headaches.
The auditor will prove out your ending balances—comparing net tax value to net book value against your supporting work papers—to ensure they tie accurately to your deferred tax assets and liabilities. One issue in particular that auditors are keen to dive into is valuation allowances, a company’s determination (under US GAAP and similarly, though not exactly, under IFRS), that there is a greater than 50-50 chance that some or all of that deferred tax asset will not be realized due to insufficient future taxable income. Given that auditors know that companies have a natural incentive to overstate assets and understate liabilities, you can expect supporting evidence to be scrutinized. (In fact, it’s not a bad idea to ask for an opinion in advance.)
Once the federal provision has been figured out, it’s time to calculate the state provision—a series of adjustments based on each individual state’s rules and rates. This requires figuring an apportionment factor in order to divvy up the income among those states, before applying each state’s income tax rate. As with deferreds, the more moving parts, the more manual entry, and the more potential for error, so you’ll want to be careful here. The auditor will verify all of the components of your apportionment and make sure you’ve chopped up the income correctly and tied out the tax rates accurately to published guidance. Then they’ll take another look through that entire calculation for material issues.
Unfortunately, some companies relegate the state provision to second-tier status and take shortcuts, like simply using the prior-year amount apportionment based on the prior-year tax return. This can lead to red flags as auditors recommend that the state provision be updated every year. At the very least, refresh your apportionment factor annually.
Total provision and rate reconciliation. Look at this stage as putting a ribbon on all your work. You add up your current and deferred provisions to get your total provision. From there, you will calculate your effective tax rate (ETR) — the total provision, divided by the company’s pre-tax book income, or trial balance. And then you declare it to the world in your footnote disclosures.
To reconcile that ETR with the relevant statutory rate(s) on the books, you have to detail all the factors (or “rate drivers”) that account for the difference. These include not only the permanent adjustments discussed above but also items like the “foreign rate differential” (overseas tax schedules which vary from the U.S. statutory federal rate of 21%).
For the auditor, the rate reconciliation serves as a checkpoint to ensure your provision calculation is correct—that your total tax expense per the rate reconciliation equals your total tax expense per the provision calculation (current + deferred)—and that every component of that provision has been accurately tied to every other. Expect them to verify every detail of your journey from statutory to effective tax rate.
Know before you plug
Because of all the moving pieces that go into the provision process, companies will sometimes need to “plug” (artificially adjust) their rate reconciliation in case of a seemingly minor discrepancy. In other words, they’ll fill in what looks like a small gap to make the numbers balance.
Fair enough. But what exactly caused that discrepancy? Something, somewhere, is off. Let’s say it’s $100, and you simply plug that amount. In actuality, you could be off by $1 million one way and $999,900 the other way. Auditors know that there could be multiple issues contributing to the gap and may well ask to dig deeper. Best to be prepared with an answer and know what’s really going on.
Your ETR: The tax department report card
While it doesn’t show up as a line item on your final statements, the effective tax rate is obviously considered the focal point of the whole provision process—the most scrutinized number you will publish. That’s because it tells the story of your entire tax operation and, by extension, of the company itself. It reveals how tax-efficient you are, compared not only to your peers—companies in your sector and/or of your size—but also with your own performance in quarters and years past. Companies typically engage in continuous tax planning to bring their ETR down.
Auditors, too, will take a keen interest in this figure, running analytics to examine the company’s ETR over time, and seeking to understand the change in your underlying financials. If the story your ETR tells seems to stand out (for better or for worse), you may be asked to tell the back story. There’s nothing intrinsically wrong if, for example, your effective tax rate has changed relative to the previous quarter, or if it is significantly higher or lower than your competitors’. You just need to be able to explain why—not only to your auditor, but also to the C-suite, audit committee, shareholders, market analysts, and perhaps, the press.
The ETR is a sensitive metric, and an especially useful yardstick for the company when it comes to tweaking operations or planning future strategies. A truly strategic tax department will keep an ear to the ground for legislative changes around the world that could impact not only reporting requirements but the company’s ETR.
And if a new tax rate or law (federal or state) is in the offing, that throws new light on how you might value (or revalue) your deferreds—and your ending assets and liabilities. Tax needs to be ready to jump in the fray and offer its expert input. Having that 30,000-foot perspective will also give you a leg up at the next audit.
Get it right from the start
The tax provision is likely the most scrutinized process the tax department will undertake. It’s obviously much easier to get it right from the beginning than it is to have to backtrack under unwelcome scrutiny.
The benefits of being prepared and proactive for the audit go well beyond not getting flagged on a material issue. There’s no reason why, in the midst of calculating your provision, you can’t seek an advance opinion or even a sign-off on a potentially thorny valuation question. If you update your provision model quarterly (an excellent practice), you could ask for a professional opinion on its suitability well before year-end. If your company is contemplating a transaction, you could run scenarios and tax treatments by your auditor in advance to see if they would pass muster. Such discussions could even lead to ideas on how to structure transactions for optimal advantage.
Technology, too, can help avoid manual errors, which are sure to catch the eye of auditors. Software can help you optimize ETR against what-if scenarios like new business transactions. Technology can also trace issues back to their source and correct them fast—minimizing the possibility of financial restatements.
If there’s one takeaway here, it’s that it’s essential to keep the perspective of the auditor top-of-mind as you do your work. See that person as an ally with the same goal as you: ensuring the accuracy and transparency of your company’s financial statements.
Following these practices can mean the difference between celebrating a clean audit…and scrambling to explain what went wrong.
