New legislation can significantly impact tax laws and regulations. Major examples in the past few years include the 2017 Tax Cuts and Jobs Act, which famously created the “retail glitch,” and the 2020 Coronavirus Aid, Relief, and Economic Security (CARES) Act, which fixed it. When such sweeping changes arise, it begs the question of tax professionals: Are your financial reporting systems capable of handling a sudden change without creating a material weakness?
What Is a Material Weakness?
Revalued tax assets and liabilities as a result of tax law changes can expose material weaknesses or controls issues that must be addressed. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis.
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What is an Example of a Potential Material Weakness?
Asset-intensive companies often have large deferred tax liabilities because of differences in depreciation between generally accepted accounting principles (GAAP) and income tax reporting methods. In order to see how this works, let’s look at the following example:
Company ABC 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).
Company ABC records the following journal entry:
Tax Expense – Deferred
Deferred Tax Liability (DTL)
Section 2307 of the 2020 CARES Act 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.
Because of the technical correction to QIP, a company with $21 million deferred tax liability (DTL) would need to increase their DTL to $60.9 million, resulting in a $39.9 million balance sheet increase, and a $39.9 million earnings decrease.
Post-CARES Act QIP Depreciation: $195,000,000 (100% of $195 million)
Increase DTL: 21% x $190 million depreciation increase = $39.9 million
Federal tax/GAAP depreciation differences are just one example among many possible issues. The limitation on business interest expense deductibility creates a tax attribute that must be tracked as a deferred tax asset. Changes to net operating loss (NOL) rules create a demarcation point for associated valuation allowances.
Tax reform is most likely to test systems that are not tax-sensitive and break existing workflows, especially if they are manual. Companies should ensure their operational systems are able to keep pace with the dynamic tax landscape. In hindsight, missing a seemingly small but important operational detail can have devastating impact.
How Can Automation Help Tax Professionals Manage Risk?
Automatic tax law updates to keep you one step ahead
Manual mistakes in spreadsheets
Automated calculations and easy data manipulation
Lack of controls across departments
Cloud platform solutions with user permissions
Financial close pressures; M&A
Flexible system to allow modeling and accuracy
ERP system inadequacies
Integration with flexible tools to make workflow and processes seamless
Not all fixed assets software is the same. When changes are made to assets, many fixed assets software packages fail to track the changes and the corresponding impact of the changes – making it impossible to support them during an audit.
Bloomberg Tax Fixed Assets understands the challenges faced by corporations. The application offers a solution for manual mistakes in spreadsheets, financial close pressures, and ERP system inadequacies by automating calculations, protecting closed periods, and providing flexibility if revisions are needed.