”
Accounting Horizons
Vol.
21, No. 1

March
2007 pp. 103112

A Response to the FASB Exposure Draft on Accounting for Uncertain Tax Positions: An Interpretation of FASB
Statement No. 109

American Accounting
Associations
Financial Accounting Standards Committee
Hollis A. Skaife, Chair (principal co-author); Mark T.

Bradshaw; Paquita Y. Davis-Friday;
Elizabeth D. Gordon (principal co-author); Patrick E. Hopkins; Robert Laux;
Karen K. Nelson; K. Ramesh; Shiva Rajgopal; Robert Uhl; George Vrana

INTRODUCTION

The
Financial Accounting Standards Committee of the American Accounting
Asso-ciation (the Committee) is charged with responding to requests for comment
from standard setters on issues related to financial reporting. This paper
summarizes the Committees response to the Financial Accounting Standards
Boards (FASB) exposure draft, Accounting for Uncertain Tax Positions: An
Interpretation of FASB Statement No.
109
(hereafter, the ED).

An uncertain tax position is one where some
ambiguity exists in tax treatment under the tax code; therefore, an uncertain
tax position requires judgment by companies as to whether to recognize any tax
benefits or costs, and what amounts to record. According to the ED, a variety
of recognition methods and measurement bases are currently being used to
account for uncertain tax positions, resulting in the lack of comparability
across com-panies (paragraph B2).1
The ED defines the recognition (and derecognition) criterion, mea-surement
basis, and disclosure requirements for uncertain tax positions.
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The
opinions stated in this manuscript reflect the views of the individuals on the
Committee and not necessarily those of the American Accounting Association.
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1
For example, the ED notes that tax
positions are sometimes recognized in the financial statements on an as-filed
or to-be-filed tax basis, such that current or deferred tax assets and
liabilities are immediately recognized when the related tax position is taken
(or anticipated to be taken). The ED also states that some companies recognize
uncertain tax positions based on a predetermined threshold of whether the
positions would be sustained on audit, and a liability for a contingent loss is
recorded when either the threshold is no longer met or it becomes probable a
payment would be made to the taxing authority.

Submitted:
May 2006
Accepted:
September 2006
Corresponding
author: Hollis A. Skaife
Email:
[email protected]

103

104 AAA FASC

Specifically, the ED requires that an uncertain
tax position be recognized when the position is probable of being
sustained on an audit by taxing authorities based solely on the technical
merits of the position.2 The amount
reported is equal to the best estimate of the amount that is probable of being
sustained upon audit by the taxing authority, including final resolution of any
related litigation or appeals process. Individual tax positions that fail to
meet the probable recognition threshold will generally result in either (1) a
reduction in the deferred tax asset or an increase in a deferred tax liability
or (2) an increase in a liability for income taxes payable or a reduction of an
income tax refund receivable.

The criterion set out in the ED for derecognition
of an uncertain tax position differs from that required for recognition. An
uncertain tax position must be derecognized in the period in which it becomes more
likely than not that the tax position would not be sustained on an audit.
Required disclosures related to the uncertain tax position are based on the
disclosures of a gain or loss contingency within Statement of Financial
Accounting Standard (SFAS) No. 5, Accounting for Contingencies. The ED
also addresses the accounting for interest and penalties, where firms will be
required to recognize interest and penalty costs in their financial statements
in the period in which these costs are incurred. However, the Board does not
propose any guidelines on the classification of interest and penalties in the
ED because the classification of interest and penalties in the income statement
is not ad-dressed in Statement No. 109. The ED will be applied to all tax
positions for which the statute of limitations remains open upon initial
adoption of the ED.

While
not explicitly stated in the ED, concerns about aggressive tax accounting and
the overstatement of tax benefits appear to drive the FASB to take action on
this issue. Prior to the ED, the U.S. Securities and Exchange Commission (SEC)
also expressed in-terest in and concern about the accounting for tax benefits.
The impact of the ED both in the number of companies affected and the dollar
amounts involved is believed to be exten-sive although difficult to quantify. Current
reporting and disclosure requirements do not expressly detail disclosure of or
amounts of uncertain tax positions. Mills (1998), however, provides a rough
estimate of the consequences of aggressive tax accounting, which includes the
overstatement of tax benefits related to uncertain tax positions. She reports
that proposed IRS audit adjustments are about 0.8 percent (0.3 percent) of
total assets at the mean (me-dian) for a sample of 1,545 firm-year observations
between 1982 and 1992 (Mills 1998, 349).3

In this commentary, the Committee summarizes the
relevant literature on and our com-ments pertaining to three components of the
ED: (1) the probability thresholds driving the recognition and derecognition of
tax positions, (2) the best-estimate method of measuring the benefit of a tax
position, and (3) the requirement that the tax benefit be sustained in an audit
by the taxing authority. We also comment on several other issues discussed in
the ED. We conclude our commentary with a summary of the FASBs re-examination
of its decisions on the accounting for uncertain tax positions and a discussion
of our view of the potential effects of the ED on the alignment of tax and
financial reporting.
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2
The final ruling, Accounting
for Uncertainty in Income Taxes: An Interpretation of FASB Statement No. 109,
Financial Interpretation No. 48, issued in June 2006, defines tax technical
merits as being derived from sources

of
authorities in the tax law (legislation and statutes, legislative intent,
regulations, rulings, and case law) and their applicability to the facts and
circumstances of the tax position (FASB 2006, paragraph 7b).

3
While a seemingly small percent of
total assets, these adjustments are about 8 percent (3 percent) of net income
at the mean (median) if the return-on-assets averages 10 percent. In addition
to uncertain tax positions not being disclosed, databases like Compustat
usually do not separately report deferred tax assets and deferred tax
liabil-ities, making a systematic, large-scale assessment of the financial
reporting impact of the ED particularly difficult.

Accounting
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MAJOR COMPONENTS OF THE PROPOSED
INTERPRETATION Recognition and Derecognition Thresholds
ED
Summary

The ED requires initial recognition of the
financial statement effects of a tax position when for that position it is
probable that it will be sustained on an audit by taxing authorities based
solely on the technical merits of the position. The Board concludes that the
imple-mentation of the term probable should be consistent with its use
in SFAS No. 5, Accounting for Contingencies, to mean that the
future event or events are likely to occur. In addition,the ED
notes several examples of facts and circumstances that warrant that the tax
benefit is likely to occur (paragraph 9). These include:

Unambiguous tax law supporting the tax position.

An unqualified should prevail
tax opinion from a qualified expert for which all conditions are objectively
verifiable.

Similar positions in prior years
tax returns that have been obviously presented in the tax returns and have been
either accepted or not disallowed or challenged by taxing authorities during an
examination.

Legal precedent from similar
positions taken by other taxpayers, where analogy is appropriate, that have
been favorably resolved through litigation with taxing authorities.

The criterion for derecognition differs from that
of recognition. Derecognition occurs in the period in which it becomes more
likely than not that any previously recognized benefit would not be
sustained on audit.

Comments

There is a rich literature that examines judgment
and decision making in accounting settings that is relevant to understanding
how managers, or more generally accounting professionals, make their judgments
and how their judgments of probabilities and outcomes affect their financial
reporting choices.4
Specifically related to the tax setting, Cuccia et al. (1995) conduct two
experiments to investigate whether tax professionals engage in aggres-sive
reporting conditional on their incentives and the stringency of the reporting
standard, where stringency is defined by the level or precision of the
threshold for reporting. They provide evidence that suggests that replacing
vague thresholds (e.g., more than likely) with more stringent thresholds (e.g.,
probable) does not always diminish the aggressiveness of tax professionals
reporting decisions. The work of Alm (1991) and Beck and Jung (1989) suggests
that aggressive tax reporting declines in settings where tax preparers judge
there is less uncertainty of a tax position due to greater legal precedence.
The literature suggests that decision-makers risk perceptions are conditional
on their knowledge about the setting and control over the outcome (Koonce et
al. 2005).

A number of studies focus on the correspondence
between the three probability terms used in SFAS No. 5 (probable,
reasonably possible, and remote) and numerical probability assessments
to understand the judgment exercised in applying these terms. Using
experimental settings, several studies find auditors assess similar numerical
probability thresholds for reasonably possible to probable, implying a
consistent interpretation of recognition thresholds (see, e.g., Amer et al.
1994). However, Aharony and Dotan (2004)
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4 See Libby et al. (2002) for a review of this
literature.

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106 AAA FASC

provide
evidence that suggests that preparers and users assessments of SFAS No. 5
prob-ability thresholds differ. They interpret their findings as evidence
support[ing] the exis-tence of an interpretation gap between users and
preparers of financial statements, with the implication that preparers may omit
loss contingency information valuable to users for assessing the enterprises
prospective net cash flows (Aharony and Dotan 2004, 21).

While the literature suggests that interpretation
of the proposed recognition threshold criterion appears consistent among
auditors, there is little evidence that other accounting professionals
consistently interpret and implement the probable threshold. Assessing the
probability of an actual uncertain tax position remains a matter of judgment.
The literature indicates that judgment is influenced by behavioral factors such
as the newness of the setting or the controllability of the outcome (Slovic
1987). Consequently, while the stated objective of the ED is to improve
financial reporting comparability by requiring a consistent criteria by which
to recognize (and derecognize) all uncertain tax positions, it is not clear
that increasing the level or precision of the threshold for recognizing an
uncertain tax position will increase the comparability of firms financial statements.
This is because the feasibility of managers judgments will vary across firms.
In addition, the feasibility of a managers judgments potentially differs
across tax settings.5

Gleason and Mills (2002) illustrate differences
across firms in implementing SFAS No. 5. Using archival data, they investigate
whether companies provide SFAS No. 5 disclosures when they report a potential
liability to the IRS for underpayment of federal income taxes. They find that
only 27 percent of firms make any disclosure of contingent tax liabilities in
financial statements, and only 30 percent of these firms disclose the detailed
information required by SFAS No. 5. They find that the likelihood of disclosure
increases with the amount of claim or expected loss, suggesting firms gauge
materiality when making the decision to report. Their results also show that
companies operating in a more litigious environment are more likely to
disclose, suggesting that such companies seek to reduce potential litigation by
revealing more information about tax uncertainties.6
Based on Gleason and Mills (2002), it appears that different companies facing
similar circum-stances provide vastly different disclosures under SFAS No. 5.

The ED proposes a dual threshold approach to
recognizing and derecognizing uncertain tax assets and liabilities, where the
recognition criteria of probable is deemed to be more stringent than the
derecognition criteria of more likely than not. The ED states that the
Board drafted this proposal under the belief that a dual recognition threshold
will be easier to apply than a single threshold for both recognition and
derecognition, and that there will be greater consistency in application of a
dual threshold. In addition, the ED states that the Board believes that preparers,
auditors, and regulators would be less likely to disagree about the judgments
needed in applying the dual threshold.

The Committee notes that there are potential costs
to the dual threshold approach. The dual threshold increases the complexity of
the standard, which can result in additional reporting costs being imposed on
the preparers and the users of financial statements. These reporting costs are
both explicit and implicit. The explicit costs are the additional out-of-pocket
costs required to monitor and document differences between the recognition
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5
Large publicly traded firms can
have upward of 1,000 uncertain tax positions across numerous U.S. and
inter-national tax jurisdictions, suggesting that more than one manager will be
responsible for assessing the proba-bilities and outcomes of a firms tax positions.

6
The term more likely than not
is not used in SFAS No. 5, and thus the SFAS No. 5 literature is not directly
applicable to the derecognition criterion suggested by the proposed
Interpretation.

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versus derecognition of the
uncertain tax assets and liabilities.7
The implicit costs include the possibility that the complexity of the
accounting standard can result in less consistent implementation when managers
are unable to put into practice the standard requirements because of a lack of
understanding or expertise. Furthermore, accounting standard com-plexity can
result in less consistent implementation when auditors are unable to attest to
the reasonableness of managers implementation of the standard. Finally,
investors face additional learning costs when standards are more complex.8

The Committee recognizes that the FASB is aiming
to provide consistent thresholds for recognition and derecognition (when
none existed before). However, we disagree with the Boards belief that a dual
recognition threshold will be easier to apply than a single threshold.
Furthermore, research suggests that parties will interpret the dual recognition
thresholds differently, resulting in less consistent financial reporting.
Therefore, we rec-ommend that the Board adopt a single threshold criterion to
recognize and derecognize uncertain tax positions. The threshold could be
consistent with SFAS No. 5, which defines the term probable to mean
[t]he future event or events are likely to occur, or, for the sake of
international convergence, be consistent with International Accounting Standard
No. 37, Provisions, Contingent Liabilities and Contingent Assets, that
defines probable as more likely than not(IASB 2005).

The ED
explicitly states that a valuation allowance as described in SFAS No. 109 or a
valuation account as described in FASB Concepts Statement No. 6, Elements of
Financial Statements, should not be used as a substitute for
derecognition of the benefit of a taxposition. Although the evidence
that suggests managers use the deferred tax asset valuation allowance as an
earnings management tool is mixed (Miller and Skinner 1998; Bauman et al. 2001;
Schrand and Wong 2003), we support this conclusion.

Measurement of
Tax Benefit

ED
Summary

Once the
probable recognition threshold has been met, the amount recorded is the best
estimate of the amount that is probable of being sustained upon audit by the
taxing authority, including the final resolution of any related litigation or
appeals process. Here, the term best estimatemeans the single
most-likely amount in a range of possible estimated amounts,consistent
with FASB Concepts Statement No. 7, Using Cash Flow Information and Present
Value in Accounting Measurements.

Comments

We know of
no research that directly addresses the measurement of an amount at a best
estimate.9The
best estimateapproach fundamentally differs from other measurementmethods
currently employed in financial reporting (e.g., fair value or historical
cost). The Committee points out that by recommending the use of the best
estimate approach in the accounting for uncertain tax positions, the ED
will result in more inconsistent measurements
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7
The out-of-pocket costs for firms
are nontrivial as evidenced by the upstart in consulting services dedicated to
the documentation and assessment of uncertain tax position by public accounting
firms and tax professionals.

8
The work of Fishman and Hagerty
(1989) points out that while investors incur relatively low costs to access
firm financial information, it is not costless for investors to process and
understand the information.
9
Accounting for pensions and other
post-retirement benefits requires the use of the best estimate within a set of
assumptions. Likewise, certain accounting for financial instruments requires
the use of the best estimate of the fair value for instruments that do not
trade regularly. However, research in these areas does not directly address the
use of best estimates. For discussions of research in these areas, see
Committee responses to recent exposure drafts to proposed changes in fair value
accounting (AAA 2006a) and pensions and other post-retirement benefits
accounting (AAA 2006b).

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108 AAA FASC

within
a companys financial reports. Some members of the Committee question the need
for what may be a short-term solution to this problem when the FASBs efforts
could more fruitfully be directed at addressing the long-term solution of a
consistent measurement framework.10

Additionally, in its Short-Term Income Tax
Convergence Project, the FASB addresses another tax measurement matter that
also will potentially result in further inconsistent mea-surements within a
companys financial reports. The FASB is advocating a different point at which
deferred tax assets and liabilities should be adjusted for the effect of a
change in tax laws or rates. For operations in U.S. tax jurisdictions, the
proposal is to use the guidance in SFAS No. 109, Accounting for Income Taxes,
which requires the effect of the change in tax laws or rates be recognized in
the period of enactment. For operations other than those in U.S. taxing
jurisdictions, the proposal is to amend SFAS No. 109 to an approach con-sistent
with International Financial Reporting Standards, requiring measurement based
on tax rates (and tax laws) that have been enacted or substantively enacted by
the balance sheet date. It is disconcerting that in an effort to converge
financial reporting standards, financial reporting practices would have clear
differences in measurement of the uncertain tax position across jurisdictions.

The FASB indicates that an exposure draft
addressing the use of distributed tax rates will be issued after a final
document for uncertain tax positions is issued. The Committee questions whether
the topics should be addressed sequentially or concurrently. Some Com-mittee
members suggest that no ruling on the measurement of uncertain tax assets be
made until the public has an opportunity to comment on the Short-Term Income
Tax Conver-gence Project.11

Presumption of
a Tax Audit in Order to Recognize the Tax Asset or Liability

ED
Summary

Integral to the recognition criteria is the
premise that the financial statement effects of a tax position be recognized
when that position is probable of being sustained on audit by taxing
authorities based solely on the technical merits of the position. In
assessing theprobability for recognition, the ED requires the
presumption that the tax position will be examined by the relevant taxing
authority.

Comments

We know of no research that directly addresses the
recognition criteria related to un-certain tax positions being validated by
presumed tax audits. Accounting researchers, how-ever, have examined incentives
related to tax and financial reporting treatments of uncertain (ambiguous)
treatments in the context of affecting the likelihood of an audit.

The general view is that a firm faces an immediate
incentive to reduce taxable income, resulting in the benefit of increased net
cash flows. When the tax treatment is uncertain, a firm weighs the benefit of
taking an aggressive tax position against the potential costs that include
additional future taxes, interest, and penalties. Importantly, the firm faces
the de-cision of whether or not to align the tax treatment with financial
reporting treatment.
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10
We note that uncertainty can enter
the financial reporting process along two dimensions: recognition or
mea-surement. In the ED, uncertainty enters the financial reporting process
along both dimensions as the ED addresses when to recognize an uncertain tax
position and how to measure the tax benefit or cost. Many of the recent FASB
deliberations are more focused on uncertainty in the context of the measurement
dimension (i.e., fair value accounting). While discussing the role of
uncertainty is beyond the scope of this response, we acknowledge the importance
of addressing the accounting for uncertainty in the standard-setting process.
11
Updates on the project can be
obtained at: http://www.fasb.org/project/short-term intl convergence income
tax.shtml.
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One line of research posits that a firm may choose
a financial accounting method that conforms to the tax choice in an effort to
increase the probability that the taxing authority will allow the tax treatment
presumably after a tax audit. For example, in experimental work, Cloyd (1995)
and Cloyd et al. (1996) find that tax advisors and corporate tax man-agers
assess a higher probability that the taxing authority will scrutinize their tax
position, and the firms tax position will be weakened in an audit when tax and
financial income diverge. Consequently, one expects managers to choose a
financial accounting method that (usually) lowers reported income to increase
expected tax savings and cash flows. Addi-tionally, positive accounting theory
suggests that differences between tax and book income potentially increase
scrutiny and political costs to the firm (Watts and Zimmerman 1986; Guenther et
al. 1997). If these costs are believed to be higher than the cash savings, a
firm would choose to reduce them through conforming tax and financial
accounting.12

In summary, the relevant research suggests that in
the presence of the requirement to presume a taxing authority will, during an
audit, evaluate a tax position taken or expected to be taken when assessing
recognition of an uncertain tax position, managers will likely continue to
weigh the costs and benefits of their tax and financial reporting choices.

OTHER ISSUES

Interest
and Penalties
ED
Summary
The ED
specifically excludes guidance on the classification of interest and penalties.

Comments

Research suggests that investors recognize
different expense categories and weight in-dividual line items within the
income statement differently, and that managers respond by using their
discretion in income statement classifications to influence investors
perceptions of the profitability of core operations (Lipe 1986; Davis 2002). If
the accrual of interest and penalties on uncertain tax positions is necessary
to achieve relevant and reliable balance sheets, then the Committee recommends
that the FASB provide guidance on the classifi-cation of the interest and
penalty costs on the income statement. Guidance intended to promote the
consistent classification of such costs will increase financial statement
comparability.

Implementation
Date

ED Summary

The effective date of the ED is the end of the
first fiscal year ending after December 15, 2005.

Comments

The
Committee suggests that the implementation date of the ED be extended to the
fiscal year ending on or after December 15, 2006, for two reasons. First, the
Committee notes the potential volume of transactions and number of
jurisdictions that a publicly traded firm embraces in its tax strategy.
Furthermore, many of the reported material weaknesses in internal control are
due to inadequate tax documentation. This suggests that firms will have a hard
time implementing the ED in the short time horizon of the ED. Second, the
Committee suggests that the FASB extend the implementation date conditional on
the tim-ing of the issuance of the exposure draft on the Short-Term Income
Tax Convergence Project.
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12 A consistent treatment also can reduce
record-keeping costs.

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110 AAA FASC

CONCLUDING COMMENTS

Changes to the
ED

In November 2005, the Board re-deliberated the
accounting for uncertain tax positions and made several important decisions on
the project. First, the Board decided to apply a single threshold approach to
recognizing and derecognizing uncertain tax positions in re-sponse to
constituents concerns about potential decreased comparability, difficulty in
im-plementing the dual threshold, and the potential overstatement of income tax
expense under the more stringent recognition criteria (see Interpretation No.
48, paragraphs B3033). Specifically, the Board decided that the tax position
will be recognized if the weight of available evidence indicates it is more
likely than not, based solely on the technical merits, that the tax position
will be sustained on a tax audit. The amount to be recognized will be measured
as the maximum amount that is more likely than not to be realized. A tax
position will be derecognized when it is no longer more likely than not of
being sustained on a tax audit.

The Board also decided that while the final
Interpretation will require the recognition of a liability for interest or
penalties or both as deemed to be incurred based on the pro-visions of the tax
law, the final Interpretation will not provide guidance on the classification
of interest or penalties in the income statement. Rather, the Board expects
that the final Interpretation will require companies to establish a policy for
classification of interest and penalties, and to disclose that policy in the
summary of significant accounting policies as well as the amount of interest or
penalties or both recognized in the financial statements.

In response to the concerns of constituents that
the ED could not be effectively imple-mented in the short horizon proposed by
the ED, the Board tentatively decided to extend the implementation date to the
onset of the first annual period beginning after December 15, 2006.

Effects of the
Interpretation on the Alignment of Tax and Financial Reporting

There is an extensive literature on how taxes
influence firms financial and operating decisions.13
This literature examines the effect of taxes on financing choices,
organizational form and restructuring decisions, compensation policy, and risk
management decisions. In their survey of empirical tax research in accounting,
Shackelford and Shevlin (2001) note the decision of whether to align tax
reporting to financial reporting has been studied in a number of different
settings (e.g., see Mills and Newberry 2001).14
They conclude that the body of tax research suggests that tax rules influence
firms financial reporting choices. In addition, they note that firms and tax
authorities are concerned with book-tax differences, and managers align book
numbers to tax numbers when necessary to save taxes.

Some Committee members believe that the ED takes a
step toward increasing the alignment between tax and financial reporting
because the criteria for recognizing an asset or liability for financial
statement reporting is defined based on the likelihood that the asset or
liability will be recognized by tax authorities. To the extent divergent tax
and financial reporting practices result in competing and potentially perverse
reporting incen-tives for managers, these Committee members believe the
potential additional alignment of tax and financial reporting induced by the ED
will be beneficial to firms stakeholders. Future research can explore this
assertion. Regardless of the impact of the ED on the
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13
For a review see Graham (2003).

14
For example, the settings include
inventory accounting, compensation, intertemporal income shifting, capital
structure, divestitures, asset sales, regulated industries, and other settings
(Shackelford and Shevlin 2001).

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111

alignment
of tax and book income, however, the Committee supports firms disclosing the
reconciliation between taxable income and book income that is currently
reported in the corporate tax return, given the sometimes competing incentives
for tax and financial reporting.

REFERENCES

Aharony,
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financial analyst interpretations of SFAS No. 5 disclosure guidelines. Journal
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Alm, J.
1991. A perspective on the experimental analysis of taxpayer reporting. The
Accounting Review66: 577592.

Amer, T.,
K. Hackenbrack, and M. Nelson. 1994. Between-auditor differences in the
interpretation of probability phrases. Auditing: A Journal of Practice &
Theory 13: 126136.

American
Accounting Association (AAA), Financial Accounting Standards Committee (FASC).
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assets and financial liabilities, including an amendment of FASB Statement No.
115. Accounting Horizons (forthcoming).

. 2006b.
Response to FASB exposure draft: Employers accounting for defined benefit
pension and other postretirement plans: An amendment of FASB Statements No. 87,
88, 106, and 132(R). Accounting Horizons (forthcoming).

Bauman, C.,
M. Bauman, and R. Halsey. 2001. Do firms use the deferred tax asset valuation
allowance to manage earnings? The Journal of American Taxation Association
23: 2748.

Beck, P.,
and W. Jung. 1989. Taxpayer compliance under uncertainty. Journal of
Accounting and Public Policy8: 127.
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