Tax and financial reporting

Third parties need to know that they can rely on the information in your company's financial statements and that is the job of an accounting firm when they audit your business.

Since third parties will be looking at the statements and relying on them to make decisions on loans or investments, a high degree of trust is put in the accounting firm's opinion.

For this reason, a financial statement auditor can sometimes act like an investigator and may need to disclose information in the statements and footnotes that relates to tax positions taken by the company.

There are three types of financial statements:

1. Compilation

A compilation is strictly a restatement of the financial numbers as presented by the company. The CPA may not conduct any independent verification of the numbers, but simply makes normal adjustments to the statements, presents the numbers in a standard format and challenges numbers only if he believes them to be materially incorrect.

Sometimes financial statements contain footnotes, which are often the most important part of a statement, reporting the assumptions and methodologies that were used to arrive at the numbers. Compilations sometimes present the numbers on the accrual basis, regardless of the accounting method used for tax returns. In other cases, a compilation is presented on the "tax basis," which reflects the accounting method used on the company's tax returns and may not be in accordance with generally accepted accounting principles (GAAP).

2. Review

A reviewed financial statement is presented in accordance with GAAP and with footnotes. It is significantly more comforting to an outside reader than a compilation and is less expensive than a full audit. The verification is done internally, generally without contacting any outsiders. And the level of internal review is much higher than a compilation.

Many banks, bonding companies and other third parties relying on the statements have become comfortable with reviewed financial statements for middle market family-owned businesses.

3. Audit

An audit is the highest level of independent verification of the financial statements and is often lengthy, cumbersome and expensive. A major difference between an audit and a review is that in an audit, verification of the account balances is done by contacting third parties that deal with the company. The auditor also looks for items that need to be disclosed, such as items that a third party might rely on in dealing with the company.

Differences between financial statements and tax returns

Two places where the financial disclosures and the tax returns may collide are in the tax accrual workpapers and in the footnote disclosures.

Tax accruals

An auditor has to estimate the amount of tax that needs to be set aside as a liability. This amount has a negative impact on the financial statement and is often, in part, speculative. For example, a family business may have deducted an item that the IRS might require to be capitalized. Tax positions taken on prior open tax returns may be affected by subsequent tax cases.

The auditor must factor in these issues along with the likelihood of the company's success and accrue an appropriate amount of liability for tax. The tax accrual, however, may create a road map to an IRS auditor on audit. The tax accrual workpapers are discoverable by the IRS Restructuring Act of 1998. IRS agents, however are instructed to get these workpapers only in rare circumstances.

Footnotes disclosures

Certain footnote disclosures may have a tax effect. For example, you discover that over the past 10 years one of your employees has been illegally securing contracts for the company, paying kickbacks that the company has deducted as ordinary and necessary business expenses and skimming part of the contract price off the top.

The auditor may be required to disclose this in a footnote, which may have a material effect on the way outside parties view the company. In addition, the company may received tax advice on a strategy to unwind the problem, but the auditor may want to disclose it in a way that the IRS may call into question.

These problems are not limited to audited financial statements. The same may be required on a reviewed financial statement and possibly on a compilation with footnotes.

In summary

It is always best to confront these types of situations head on. Usually, the disclosure can be worked out so it discloses all aspects of the transactions without jeopardizing the company's status or creating a road map for the IRS.

We are client advocates. When there is a problem, we can help you work it out.

Melvin J. Van de Ven, CPA, CVA is a partner in the certified public accounting firm of Schott & Van de Ven in Cape Girardeau. He can be reached by email at mvandeven@schottvandeven.com.