FIN 48 will require corporations to indicate in their financial statements which of their tax positions may be challenged on audit.

The Financial Accounting Standards Board has been concerned that corporations lack objective rules for reporting tax benefits and potential exposure to additional taxes in their financial statements. The board issued an interpretation — called FIN 48 — of its rules in this area on July 13.

FIN 48 will require a company’s tax department to evaluate every position the company has taken on a return using a two-step process. The first step is to assess whether benefits shown on the return can be booked. Only tax positions that are more likely than not to be upheld on audit can be booked. Tax positions that pass muster under this test must then be further evaluated and a probability assigned to their being upheld on audit. Tax benefits that are less than certain cannot be fully booked. The portion considered an unrecognized tax benefit will show up in most cases as a potential tax liability.

If over time, as a company’s assessment of risk changes, then a later adjustment will have to be made to the amount of benefit booked.

The new rules take effect in corporate fiscal years starting after December 15, 2006. Thus, companies that use the calendar year for financial reporting will have to comply starting in 2007. However, Staff Accounting Bulletin 74 will require public companies to disclose the expected financial impact of FIN 48 as early as the Form 10-Q filed with the US Securities and Exchange Commission for the second quarter of 2006.

Critics charge that FIN 48 will provide a roadmap to the IRS about where to probe on audit.

It may also force companies to ask for more outside tax opinions because of concerns about the potential exposure under US securities laws for misstatements on financial reports. As shown in the Enron and other recent trials, the penalties can be severe.

Keith Martin