FIN 48: Required Reading for Income Tax Compliance
By Manuel E. Pravia, CPA

Since the issuance of FAS 109, "Accounting for Income Taxes," in 1992, there have been a variety of inconsistent practices with respect to the recognition of income tax items in financial statements. As a result, FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes: An Interpretation of FASB Statement No. 109” (FIN 48) was issued in June 2006. By identifying their tax positions and by understanding the implications of FIN 48, companies can reduce accounting errors and ensure appropriate tax benefits are realized.

FIN 48 requires that each material “tax position” be evaluated to determine whether all, part, or none, of its related tax benefit should be recognized for US accounting purposes. Generally, a “tax position” arises with every decision made, or expected to be made, in the income tax compliance process. Some examples of tax positions include: a deduction in determining taxable income; an exclusion from, or reduction of, taxable income; a decision not to file a tax return in a particular state; or a shift of income between jurisdictions (e.g., transfer pricing).

In principle, the validity of a tax position is a matter of tax law. However, in some cases, the law is subject to interpretation, and the sustainability of a position upon examination is not assured. Prior to FIN 48, there was inconsistency in the criteria used to quantify the economic benefits of tax positions. The Interpretation now provides specific guidance for the recognition and measurement of tax positions taken or expected to be taken in a tax return that directly or indirectly affect amounts reported in financial statements.

FIN 48 utilizes a two-step approach for evaluating tax positions: recognition and measurement. Recognition occurs when an enterprise concludes that a tax position is more likely than not (greater than 50% likelihood) to be sustained upon examination based solely on its technical merits. If a tax position is to be recognized, the tax benefit is measured as the largest amount of benefit that is more likely than not to be realized upon effective settlement. The adjustment to the benefit previously recorded in the financial statements (i.e., the result of derecognition or measurement at less than 100% benefit) is to be disclosed in the financial statement footnotes as an unrecognized tax benefit.

Interest and penalties relating to the unrecognized tax benefit should be accrued as required by the applicable tax law. A company may elect to classify these as either income tax expense or interest expense (interest) and other expense (penalties), instead of being included in the provision for income tax.

The necessary adjustment (including accrued interest and penalties) should be recorded directly to the beginning balance of retained earnings in the period of adoption and reported as a change in accounting principle. Once adopted, any changes to recognition, derecognition, or measurement will be recognized in the entity's operational results in the period in which the change occurs.

It should be noted that FIN 48 does not affect the applicable guidance to tax positions that relate to business combinations. Furthermore, the Interpretation only applies to income tax positions, and the accounting for other types of tax (payroll, sales, etc.) is unchanged. Lastly, like all accounting principles, the provisions of FIN 48 are not required to be applied to immaterial items.

FIN 48 was scheduled to be implemented for years beginning after December 15, 2006. On November 7, 2007 the Financial Accounting Standards Board delayed the effective date of the implementation of FIN 48 for non-public entities by one year. Therefore, the rules will apply to 2008 financial statements for most non-public entities. In anticipation of implementing FIN 48, all tax positions should be identified, documented and assessed for potential impact to the company's financial statements. In the years following implementation, the documentation will have to be updated for any new tax positions and changes in the assessment of each position's benefit.