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Just when tax and accounting executives were getting a handle on the massive changes resulting from the 2017 Tax Cuts and Jobs Act, the global pandemic threw another wrench into an already dynamic tax and accounting landscape. The passing of the 2020 CARES Act in response to the economic impact of Covid-19 created the kind of rapid change and uncertainty that if not carefully handled, could make a company ripe for material weaknesses. While the impact of tax law changes on financial reporting has rarely been covered in the news, executives know that revalued tax assets and liabilities can expose material weaknesses or controls issues that must be addressed.
Material Weakness in the Making
A typical asset-intensive organization has large deferred tax liabilities resulting from differences in depreciation between generally accepted accounting principles (GAAP) and income tax reporting methods. Consider this common scenario:
Company XYZ has federal tax depreciation of $350 million and GAAP depreciation of $250 million. The difference in depreciation is $100 million. Assuming the tax rate is 21%, the difference in tax is $21 million (21% x $100 million).
Simple enough at face value. But under Section 2307 of the 2020 CARES Act, this common scenario becomes much more complex. Section 2307 provides a technical correction to the depreciation treatment of qualified improvement property (QIP). The technical correction assigns a 15-year instead of 39-year recovery period to QIP placed in service after December 31, 2017, making QIP eligible for bonus depreciation.
Assuming Company XYZ has $195 million of QIP.
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Post-CARES Act QIP Depreciation:
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$195,000,000 (100% of $195 million)
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Pre-CARES Act QIP Depreciation:
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$5,000,000 ($195 million/39 years)
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Depreciation Increase:
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$190,000,000
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Because of the QIP technical correction, Company XYZ’s $21 million deferred tax liability (DTL) would need to increase to $60.9 million, resulting in a $39.9 million balance sheet increase, and a $39.9 million earnings decrease (i.e. $190 million x 21%). Neglecting to make this income statement and balance sheet correction is just one example of the many potential issues that arise when rapid tax law changes are made.
Other business tax provisions from the 2020 CARES Act to be considered include:
- Section 2303 allows a five-year carryback for net operating losses (NOLs) arising in the 2018, 2019, and 2020 tax years; the NOL limit of 80% of taxable income is also suspended for tax years beginning before 2021, allowing companies to utilize NOLs to fully offset their taxable income.
- Section 2305 accelerates the corporate AMT credit refund schedule, allowing corporations to claim the refund in full in 2018 and 2019; taxpayers wishing to claim the entire AMT credit in 2018 can either file an amended return for 2018 or file for a tentative refund on Form 1139 – this provision allows companies to obtain additional cash flow during the Covid-19 economic crisis.
- Section 2306 expands the business interest expense limitation from 30% of adjusted taxable income (ATI) to 50% of ATI for the 2019 and 2020 tax years.
State Taxation Adds to the Complexity
Beyond federal-level tax changes, state taxation is yet another issue to consider. States vary on whether they conform to federal tax laws creating the potential for large variances in state taxable income, which can create another material vulnerability if not calculated correctly. Staying abreast and implementing each state’s response to tax reform, such as the 2020 CARES Act, is a massive undertaking, exasperated even further by non-tax-friendly accounting systems. That is why spreadsheets are so often used by tax and accounting executives despite the well-known risks such as calculation and human errors.
Getting to the Root Cause
Examining how material weaknesses can emerge in the first place is one way to take corrective action. Consider this real-life example of how a material weakness can easily come to fruition through tax-related disclosures.
- A corporation is under pressure to reduce cash tax as a normal part of achieving financial goals for margin, earnings, or cash flow
- A tax analyst comes up with the idea to conduct a cost segregation study to accelerate depreciation expense
- The tax department goes to the IT department and asks for the updated fixed assets data to be uploaded into the ERP system
- But there are a few problems …
- One asset has now been split into many assets
- Assets will be depreciated using new methods and class lives
- The IT department tells the tax department to fill out a project request form and to submit as part of next year’s budget cycle because of other high-priority projects
- The tax department is forced to abandon their automated ERP solution and resort to manual spreadsheets for the tax aspects of fixed assets
- Six months later, the tax department discovers that formula errors and syncing issues make it impossible to reconcile the book and tax versions of their fixed assets
In this example, the material weakness was not because of the decision to implement a cost segregation study, but rather the failure to understand the operational impact of a business decision. What is a company to do?
A Simple Step to Preventing Material Weaknesses
One easy way to mitigate your company’s material weakness risk is to have early and ongoing communication with your IT department and software vendors about upcoming projects, such as implementing CARES Act tax law changes. This is especially important if your project includes software code changes. While this may sound obvious, it is surprising how often accounting and tax teams do not involve IT until late in their project’s process.
Ask your IT team and partners if your systems automatically update new tax laws and are tax sensitive. If your systems lack these critical features and it is not feasible to switch over to a more robust accounting system, consider hiring a tax technology expert (either in-house or outsourced) to ensure the latest tax law changes are reflected in your tax planning efforts. Key to success is providing visibility and prioritizing issues that could lead to material weaknesses. Don’t be afraid to get your entire team involved, from tax advisers to IT vendors to internal IT and, of course, your key tax and accounting staff.
Just like the 2017 Tax Cuts and Jobs Act challenged your tax and accounting software systems, processes and financial reporting, the 2020 CARES Act is poised to have the same impact. If historical events are indicators of the future, swift and significant tax law changes are the new normal. As a result, progressive companies should ensure their operational processes and systems are able to keep pace with a dynamic tax landscape now and in the future.
Ellen Barker, CPA, is a Subject Matter Expert at Bloomberg Tax & Accounting.