IPT Tax Symposium White Paper Property Taxes

“The Property Tax Function and the Sarbanes-Oxley Act of 2002”

By
Shane Moncrief, Director, Deloitte Tax LLP**, and
Joseph P. Wilson, Associate, Deloitte Tax LLP**

[Authors drafted White Paper for Property Tax Symposium in Texas 2005]
[Published by thhttp://mediae Institute of Professionals in Taxation at www.ipt.org]

Introduction

The purpose of this paper is to describe the relationship between the Sarbanes-Oxley Act of 2002 (Act)[1] and the property tax function of the reporting company.  The Act created heightened requirements for the reporting company and auditor that could directly affect the management and processes of the property tax function.  The following describes the relevant portions of the Act, the relationship between the audit and property tax functions, issues resulting from the need to comply, and ways to streamline responsibilities associated with the property tax function as it relates to the Act.

Introduction to heightened requirements of the Sarbanes-Oxley Act of 2002

Sections 404[2] and 302[3] of the Act make CEOs and CFOs explicitly responsible for establishing, evaluating and monitoring the effectiveness of internal controls over financial reporting and disclosure.  Most public companies will, at a minimum, have to tailor and document existing processes in order to comply with the Act’s provisions.  Though only SEC registrants are legally obligated to comply, private companies may elect to adopt certain components in order to improve business operations.  Many companies are addressing the internal control requirements of Sections 404 and 302 in tandem to minimize the compliance burden.

Scope of Section 404

Section 404 requires the CEO and CFO to annually state their responsibility for establishing and maintaining an adequate internal control structure and procedures for financial reporting.[4]  Further, the CEO and CFO must annually conduct an assessment of the effectiveness of the company’s internal control and procedures for financial reporting.  Also, the external auditor must issue a report attesting to management’s assertion on the effectiveness of internal control and attesting to the effectiveness of the company’s internal control over financial reporting.  An overall purpose of internal control over financial reporting is to foster the preparation of reliable financial statements.[5]  Therefore, a central purpose of the assessment of internal control over financial reporting is to identify material weaknesses that have more than a remote likelihood of leading to a material misstatement of the financial statements.[6]

Scope of Section 302

Section 302 introduces the concept of disclosure controls and procedures.  The disclosure controls and procedures are defined to help ensure that information required to be disclosed in SEC filings is recorded, processed, summarized, and reported completely and accurately and within the time periods specified by the SEC.  The CEO and CFO are required to personally certify, quarterly and annually, that they are responsible for disclosure controls and procedures and have designed controls to provide reasonable assurance that material information is known to them.[7]  Further, they must certify that they performed an evaluation of the design and effectiveness of disclosure controls and have presented in the filing both their conclusions and any significant changes to disclosure controls.[8]  Also, they must certify that they have disclosed to the audit committee and independent auditors any significant control deficiencies and acts of fraud.[9]

Concern for Internal Control Evaluation Specific to Property Taxation

Property taxes are reported on the reporting company’s balance sheet as accrued expenses or accrued liabilities and are reported as operating expenses in the reporting company’s income statement.  A significant overestimate or underestimate of the property tax accrual results in a misstatement of the balance sheet and the income statement.

A property tax misstatement in the financial statements may be material especially if the company has a capital intensive business.  There are various inherent risks associated with property taxes that consequently may result in misstated financial statements.  For example, a property tax misstatement may be caused by a tax authority’s issuance of duplicate tax bills to a lessor and lessee with respect to a single leased property and the subsequent payment of tax by both parties.  Also, a misstatement may result from a company’s: (1) payment of an erroneous property tax assessment, (2) accidental failure to pay a property tax assessment, or (3) preparation and filing of inaccurate property tax returns due to changes in the law or clerical errors.  Property taxes vary by locality, which can further complicate the process.  Also, using a previous year’s property tax bill amount may not be an accurate estimate of the current year’s liability that is accruing.  Thus, evaluation of the internal controls over the property tax function is necessary in order to manage these inherent risks.

The internal control requirements of Section 404, and heightened certification requirements of Section 302, are intended to reduce the risk of material financial statement misstatements, including risks related to improperly reported property taxes. Because property taxes may be material to the financial reporting of a filing company, companies should document the design and implementation and test the operating effectiveness of internal controls related to the property tax function.

Role of the Independent Auditor

Section 404 requires the reporting company to include in its annual report a statement of management’s responsibility for establishing and maintaining internal control over financial reporting, as well as an assessment of the effectiveness of the internal control structure.[10]  If the company is subject to the requirements of Section 404, the registered public accounting firm that issues an audit report on the company’s annual financial statements also issues two internal control opinions attesting to management’s assessment of internal control over financial reporting and the effectiveness of that internal control in accordance with standards set by the Public Company Accountancy Oversight Board (PCAOB).[11]  Under the “Top-down Approach,” the auditor focuses on the company-level controls and the significant accounts, which lead the auditor to significant processes and later individual controls at the process, transaction, or application level.[12]

The risk and potential that the property tax function could have a material impact on the financial statements determines whether it is a significant account and the level of auditor scrutiny.  Therefore, if property taxes may be material to the financial statements, internal controls for property taxes must be designed, implemented, and documented, as well as operated effectively, to provide a basis for evaluation by management and the auditor.

Streamlining Property Taxation under the Sarbanes-Oxley Act of 2002

The property tax function generally consists of four sub-processes:

  • management,
  • reporting,
  • planning, and
  • appeals,
  • each of which potentially needs internal controls.  An initial understanding of whether controls need to be improved or streamlined can be achieved by first identifying and documenting existing internal controls.  Management is then in a better position to assess how to improve the overall process.A company should consider several things before creating new internal controls.  First, it may be cost effective and efficient to address the control requirements of Sections 404 and 302 in tandem to minimize the compliance burden.  Second, although only SEC filers are obligated to comply, private companies might also elect to comply if the company is considering going public or because it may improve business operations. Third, the company needs to evaluate whether it makes economic sense to simply tailor and document existing processes rather then create all new processes.One suggested framework for internal control design and evaluation is the Committee of Sponsoring Organizations’ Internal Control-Integrated Framework (COSO).12  COSO defines internal control as a process effected by a company’s board of directors, management, and other personnel that drives business success by efficiency of operations, reliability of financial reporting, and compliance with applicable laws and regulations.13  For example, using the COSO approach, the following property tax control methods, combined with periodic testing, might be appropriate to reduce the risk associated with financial misstatements and noncompliance under the Act.
    Keep a formal plan for updates and changes to tax-specific technology applications and systems.

    First, ascertain whether property tax technologies are included in the corporate technology policy.  Confirm that the tax function regularly assesses and evaluates the needs of property tax technology.  Also, assess the procedures for updating custom-built property tax software and for determining that spreadsheet models are checked and modified annually to reflect changes in property tax authority.  Current technology and processes to keep current with changes in the law are effective controls to facilitate accurate information.

    Maintain updated documentation of the source data and automated and manual procedures for preparing and filing property tax returns.

    First, confirm that the tax function maintains updated flowcharts and narratives that detail the property tax return preparation and filing process.  Assess the completeness and accuracy of the property tax return process documentation, then determine the frequency of updates to the property tax return process documentation. Ascertain whether the tax function has access to timely financial source data for planning and compliance purposes.  Also, confirm that documentation exists for each category of property tax return or form filing prepared for the property tax function.  These steps will help ensure the accuracy and reliability of the property tax returns.

    Establish formal communication procedures between the property tax function and operations, accounting, finance, legal, treasury, human resource, sales, research, and other functions to help ensure the collection of complete and accurate source data. 

    First, confirm that standard procedures exist for drafting and submitting information requests and review samples of information requests for recurring items.  Then confirm that procedures exist to determine that costs relating to fixed asset construction or acquisition are properly capitalized by assessing the procedure for capitalizing costs related to fixed assets, and confirm the correct treatment of costs.  Tax personnel should communicate with source data providers to promote the tax awareness necessary to provide timely and complete data.  Procedures must exist for obtaining source data on a separate legal entity basis.  There should also be a process for verifying the completeness and accuracy of source data received and for the finance function to notify the property tax function of changes in the general ledger accounts.  Also, procedures should exist to track and document asset transfers between entities and/or localities. Following these few steps will facilitate effective and efficient communication between departments allowing for more accurate financial reporting of property tax data.

    Use of a tax bill calendar.

    Tax bill calendars track when tax statements are received and mailed.  Using a tax bill calendar, the property tax group can contact the proper authority to obtain non-received bills in order to determine that the source data used for the property tax accrual is accurate and complete. Similarly, the tax group should compare the property value on the tax statement to the data in a master tax file.  Any inconsistency should be timely communicated to the accounting department to allow for an accrual adjustment.  The property tax manager should review and approve all requests for accrual adjusting journal entries and communicate any errors and the corrections necessary for approval of such entries.  Then the tax manager should submit the adjustment accrual requests to the accounting department to avoid erroneous and unauthorized journal entries.

    The methods discussed above are only a few of the tools the property tax function of a reporting company might adopt in order to operate efficiently, effectively and in compliance with financial reporting requirements such as those imposed under the Act.

    *Shane Moncrief, Director, Deloitte Tax LLP, Atlanta, GA, (404) 460-3442 smoncrief@deloitte.com

    **Joseph Wilson, Managing Shareholder at Wilson Tax Law Group, APLC (949) 397-2292 jwilson@wilsontaxlaw.com 

    This article does not constitute tax, legal or other advice from Deloitte Tax LLP, which assumes no responsibility with respect to assessing or advising the reader as to tax, legal, or other consequences arising from the reader’s particular situation.

     About Deloitte
    Deloitte refers to one or more of Deloitte Touche Tohmatsu, a Swiss Verein, its member firms and their respective subsidiaries and affiliates. As a Swiss Verein (association), neither Deloitte Touche Tohmatsu nor any of its member firms has any liability for each other’s acts or omissions. Each of the member firms is a separate and independent legal entity operating under the names “Deloitte,” “Deloitte & Touche,” “Deloitte Touche Tohmatsu,” or other related names. Services are provided by the member firms or their subsidiaries or affiliates and not by the Deloitte Touche Tohmatsu Verein.

    Deloitte & Touche USA LLP is the U.S. member firm of Deloitte Touche Tohmatsu. In the U.S., services are provided by the subsidiaries of Deloitte & Touche USA LLP (Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP, and their subsidiaries), and not by Deloitte & Touche USA LLP.

    [1]              P.L. No. 107-204.

    [2]              15 U.S.C. 7262.

    [3]              15 U.S.C. 7241.

    [4]              15 U.S.C. 7262.

    [5]              SEC Staff Statement on Management’s Report on Internal Control Over Financial Reporting, May 16, 2005.

    [6]              Id.

    [7]              15 U.S.C. 7241.

    [8]              Id.

    [9]              Id.

    [10]            SEC Staff Statement on Management’s Report on Internal Control Over Financial Reporting, May 16, 2005.

    [11]             Id.

    [12]            PCAOB Release 2005-009, May 16, 2005.

    12             COSO refers to The Committee of Sponsoring Organizations of the Treadway Commission’s publication, Internal Control – Integrated Framework (the “COSO Report”). Paragraph 49 of Auditing Standard No. 2 and the COSO Report describe these components.

    13             Id.

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