We want to follow up today on our previous post about critical audit matters (CAMs), to take a closer look at one particular set of CAMs: uncertain tax items.
You might have noticed that tax-related items accounted for a significant portion of the CAMs we’ve seen so far in 2020 annual reports. We found 13 CAMs related to uncertain tax positions, plus another three related to unrecognized tax benefits. Taken together, that’s nearly 20 percent of the 85 CAMs we identified in total.
Well, exactly what are those tax positions? What’s the nature of the uncertainty, and what makes these disclosures qualify as critical audit matters?
Let’s first remember what a critical audit matter is. As dictated by accounting regulators, all CAMs have two parts:
In that case, you can see how various corporate tax issues might qualify as critical audit matters. Plenty of tax disclosures can be quite large and therefore material to the financial statements. And given the complexity of modern tax law in the United States and around the world, uncertain tax disclosures will almost always meet the second criteria, too: especially challenging, subjective judgment on the part of the auditor.
One example of this is Pepsico ($PEP), which reported $1.6 billion in reserves the company is salting away for unrecognized future tax benefits. That is, Pepsico might get that $1.6 billion sometime in the future, if certain disputes with tax regulators go the company’s way — but if not, Pepsico will have the cash to cover taxes due.
Pepsico’s auditor, KPMG, still flagged the issue as a CAM. In its auditor’s report (where audit firms disclose CAMs), KPMG had this to say:
The Company establishes reserves if it believes that certain positions taken in its tax returns are subject to challenge and the Company likely will not succeed, even though the Company believes the tax return position is supportable under the tax law. The Company adjusts these reserves, as well as the related interest, in light of new information, such as the progress of a tax examination, new tax law, relevant court rulings or tax authority settlements.
We identified the evaluation of the Company’s unrecognized tax benefits as a critical audit matter because the application of tax law and interpretation of a tax authority’s settlement history is complex and involves subjective judgment. Such judgments impact both the timing and amount of the reserves that are recognized, including judgments about re-measuring liabilities for positions taken in prior years’ tax returns in light of new information.
What does Pepsico itself have to say about unrecognized tax benefits? You can find that using the Interactive Disclosures tool and pulling up the firm’s tax disclosures. For example, in the 10-K Pepsico filed on Feb. 11, the company mentioned a $364 million gain in 2018 from a tax dispute with Russia that was resolved in Pepsico’s favor. The company also disclosed this table, below, showing how its tax reserves changed over the course of the year.
If you’re feeling ambitious, you can also use our Multi-Company Page and search for “unrecognized tax benefits” in the Standardized Metrics search field on the left side of the page. Then you could, say, identify all firms in the S&P 500 where unrecognized tax benefits were a material amount of money; and next search the auditor reports for those firms to see if any have unrecognized tax benefits as a CAM.
A close cousin of unrecognized tax benefits are uncertain tax positions. They’re conceptually similar — firms reporting a tax item as a potential payment or benefit — but uncertain tax positions encompass a wider range of tax items, including potential losses that might not materialize.
Amazon.com ($AMZN) is a good example of what we mean here. The company reported this table of tax contingencies in its annual report from Feb. 3:
Even for Amazon, $2.8 billion in uncertain tax positions is a material amount of money. And sure enough, we see that the company’s auditor, Ernst & Young, flagged this as a CAM.
The Company is subject to income taxes in the U.S. and numerous foreign jurisdictions and, as discussed in Note 9 of the consolidated financial statements, during the ordinary course of business, there are many tax positions for which the ultimate tax determination is uncertain. As a result, significant judgment is required in evaluating the Company’s tax positions and determining its provision for income taxes. The Company uses significant judgment in (1) determining whether a tax position’s technical merits are more likely than not to be sustained and (2) measuring the amount of tax benefit that qualifies for recognition. As of December 31, 2020, the Company accrued liabilities of $2.8 billion for various tax contingencies.
Auditing the measurement of the Company’s tax contingencies was challenging because the evaluation of whether a tax position is more likely than not to be sustained and the measurement of the benefit of various tax positions can be complex, involves significant judgment, and is based on interpretations of tax laws and legal rulings.
Companies can be a bit more liberal in how they tag uncertain tax positions, so you might need to search the XBRL tag field on the Multi-Company page for this disclosure. Try “LiabilityForUncertainTaxPositionsCurrent” or “LiabilityForUncertainTaxPositionsNonCurrent,” and that should get you the results you’re looking for.
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