David Deputy

Mapping the Future of Tax Accounting and Tax Disclosure

How financial reporting technologies can help.

April 28, 2011
by David Deputy

Tax Accounting, short for “Accounting for Income Taxes,” is the financial accounting standard which governs how to account for a company’s global income tax position and expense. It is typically a material item on the balance sheet and statement of income and as a material component of financial reporting comes under the purview of the chief financial officer (CFO) and controller.

In many ways, tax accounting can be thought of as a process of “Tax Consolidation” that mirrors “Financial Consolidation.” However, while there are significant parallels between the two processes, tax accounting differs in two key respects:

  1. It encompasses more geographically diverse tax code-driven business rules.
  2. It supports not just the production of disclosures for financial reporting but also serves as the system of record supporting significant account balances within the general ledger (GL), i.e., a subledger to the GL.

Perhaps most significantly, while it is a process performed as part of the financial reporting close, consuming detailed book trial balance information and providing back one of the last journals before the books close the tax department typically manages this through a separate siloed process.

As a result, the tax department historically has not benefited from the process and technology advances associated with corporate/enterprise performance management solutions. To reap those benefits designers of tax accounting solutions need to be cognizant of current and future trends in financial reporting technologies. This will allow them to design systems that can respect the boundaries yet enhance the capabilities of financial systems to better integrate the tax accounting process.

The Financial Reporting Framework

It’s important to understand the framework of financial reporting, and then contrast the role of tax and the differences therein with traditional financial reporting.

Financial reporting consists primarily of three elements:

  1. Pre-Consolidation Tasks
  2. Financial Consolidation
  3. Financial Disclosure

Technology’s Role

To date, the mainstream financial-reporting vendors have focused on financial-consolidation solutions (Oracle Hyperion HFM, SAP Business Objects Planning and Consolidation, Cognos Controller) with little regard for tax requirements. Technically, these systems mirror the functionality of tax provisions systems closely — through an ownership hierarchy, they roll up entity-trial balance information and apply book-accounting adjustments and rules along the way. These systems, however, are not designed to deal with the jurisdictional diversity or the complexity of tax accounting rules.

Led by boutique vendors, mainstream financial reporting vendors are starting to address pre-consolidation tasks and disclosure management. Solutions are that are offered in these areas generally include workflow and eXtensible Business Reporting Language (XBRL)/document production/management systems respectively.

The tax accounting and provision solutions historically have augmented these financial-reporting technologies. An ownership hierarchy rolls up entity trial balance information in the tax accounting and provision systems and applies tax-accounting adjustments and country-specific tax rules tailored to address the jurisdictional diversity and complexity of tax.

Financial consolidation and tax accounting and provision solutions historically interacted with each other through manual entry or data exports along the following lines:

  • The trial balance information is the starting point for both systems.
  • Late or “top-side” adjustments and eliminations made in consolidation systems need to be reflected in provision systems.
  • The results of provision calculations need to be incorporated into the consolidated financials.

Tax Accounting vs. Provision

What distinguishes tax-accounting solution from a simple provision system is that tax accounting systems are designed to provide subledger quality support for the summary balances in the deferred tax balance sheet accounts. Provision systems are designed to produce the tax-related financial-statement disclosures and they do a good job of providing the information necessary for this task. However, they fail to provide the level of detail, consistency, integration, security and Sarbanes-Oxley (SOX) controls generally associated with GL subledger systems.

Since deferred taxes can represent billions of dollars of exposure for a typical Fortune 500 company, external auditors are increasingly asking to see the supporting details and controls around deferred tax GL accounts.

Therefore, a new class of tax accounting application is emerging to fill the gap. These systems are tightly integrated with the existing systems resident in the financial accounting and reporting value chain.

Key Differences and the Future

While parallels can be drawn between the process of income tax accounting and that of financial consolidation, significant differences exist across the four key elements below:

  1. Pre-Consolidation Tasks: Jurisdictional diversity adds significant complexity.
  2. Financial Consolidation: Need to synchronize to book balances so tax and finance start with the same numbers adds risk. Different tax accounting treatments across accounting standards adds complexity.
  3. Financial Disclosure: Sub-process nature of tax disclosures dictate flexibility needed to feed finance last mile systems.
  4. Tax Content: Incorporating evolving tax code rule changes and creating a system that can trace the application of a particular effective date for applying the tax code to the close.

In addition, while financial consolidation systems are typically only downstream from operational accounting systems like the GL, a tax accounting system must be both a downstream recipient of book trial balance information and an upstream subledger providing journals supporting changes in GL tax account balances.

In moving beyond tax provision and into tax-accounting solutions, tax-software vendors need to be mindful of the background, recent developments and future plans of major players in the financial reporting landscape. This understanding needs to be reflected in the functional requirements of the products and solutions produced as well as in the partnership, marketing and thought leadership activities in which they choose to engage.

As such, tax-accounting-solution providers who can leverage the significant foundation in terms of best practices as well as technologies laid down by corporate performance management vendors are likely to garner market share in the emerging tax performance management and tax governance landscape.

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David Deputy, director of tax data management for Vertex Inc., brings over 20 years’ experience in ERP, Tax Analytics and Business Intelligence software solutions.