When you hear the phrase “tax due diligence,” you probably think about investigating the tax situation of a target company in a potential acquisition transaction. But what about performing due diligence on your own management’s ability to accurately administer, account for, and report your company’s tax positions? Taxes are typically one of a bank’s largest expenses. Deferred tax assets are often a sizable balance sheet asset and regulatory capital component. Taxes also are a key focus of Securities and Exchange Commission financial statement reviews and a frequent cause of financial statement restatements and material weakness citations. So perhaps a bank’s board of directors, or at least its audit committee, should perform periodic tax due diligence on its own organization.
But what questions would you ask, particularly given a board’s role is one of policy-setting, strategic direction, and high-level oversight rather than daily management? If you understand what management should be doing to control risk in this area and where or why controls malfunction, you can tailor your queries to effectively address your organization’s tax complexity profile.
What Should the Controls Be?
Consider these four areas of risk and control in the administration and financial reporting of income taxes:
- Are the bank’s tax expense and balance sheet positions accurately computed?
- Are these positions recorded in the general ledger and reported in financial statements accurately and adequately?
- Are tax payments and tax filings made timely and accurately? Are tax notices responded to promptly?
- Are the individuals involved in tax administration staying abreast of and adequately addressing developments in tax law, accounting rules, and the company’s own activities?
Critical to the first three items are adequate checks and balances. That means management should be making sure that tasks are actually completed and completed correctly, and that there is a reconciliation of general ledger tax activity to the financial statement computations and to the return filings, particularly if the three areas are handled by different people or groups.
Vital to the fourth item is knowledge about changes in tax or accounting rules and the firm’s activities. For instance, the bank might have opened a loan production office in a new state or bought an investment banking firm in a new country that will affect the company’s taxes. Do the relevant people have a process to discover the event, the requisite skills and resources to understand how it affects the company’s taxes, and the ability to incorporate those effects into tax computations and returns?
Another due diligence focus for the board is oversight of the company’s internal controls.
Where or Why Do Internal Controls Malfunction?
There are myriad reasons controls break down, but consider these three factors:
- Personnel turnover might lead to replacements who might not bring the same level of tax knowledge and who need time to learn the company and establish internal communication channels. Additionally, balls could drop while vacated positions are being filled.
- The company is large and dynamic, has many personnel in many divisions and locations, is taxable in many jurisdictions, and undertakes numerous acquisitions or other changes in processes, service offerings and markets. It has a complex tax profile where application of the law is not always clear and tax authorities could easily disagree.
- Internal auditors, whose job it is to test the effectiveness of company processes and controls, might lack the requisite specialized tax knowledge to adequately assess the tax function and controls, thus missing potential warning signs.
Tailoring Queries to Your Organization
For a smaller community bank, the personnel issue might be most critical and the board more hands on about tax matters. Ask about the tax qualifications of the people performing the work, particularly those reviewing it, and what management’s process is for making sure there is adequate internal tax knowledge and coverage. Ask whether outside experts are involved if needed.
For a large organization with sizable tax and finance departments, the ever-changing and complex environment might lead you to ask about management’s process for identifying and determining whether to take any aggressive tax positions and how tax personnel learn of corporate developments.
For an organization of any size, you might inquire how comfortable the internal auditor is with assessing the effectiveness of the tax function and its controls and whether a third-party expert should be used for this purpose. Don’t hesitate to ask the financial statement audit team for comments on management’s tax processes and abilities.
Consider the potential for sizable error in your company’s tax positions, and don’t hesitate to perform a little in-house tax due diligence.