Auditing the tax provision: AU-C 540 estimates and AU-C 620 tax specialists

• Assess inherent risk for tax estimates using the AU-C 540 risk factors
• Choose among the three AU-C 540 testing approaches for each tax estimate
• Decide when a tax professional is an auditor's specialist and apply AU-C 620
• Apply AU-C 9500 to tax accrual documentation and reliance on outside tax opinions

The provision is a set of estimates

Valuation allowances, uncertain tax positions, the interim effective rate and state apportionment are accounting estimates, so AU-C 540 applies. Current tax is more mechanical but still depends on judgments about deductibility.

Risk assessment under AU-C 540

AU-C 540 requires an understanding of how management identifies the need for estimates, the methods, assumptions and data it uses, how it applies specialized skills, and the controls over the process. The standard also requires a review of the outcome of prior-period estimates, such as last year's provision against the filed return and prior uncertain positions against settlements. The retrospective review guide covers how.

AU-C 540 requires the auditor to consider the degree of estimation uncertainty and the degree to which complexity, subjectivity or other inherent risk factors affect method, assumptions, data and the point estimate. A valuation allowance resting on a five-year forecast of a loss-making company is high on subjectivity and uncertainty. A deferred tax rollforward for a profitable domestic company is low. The auditor then decides whether any risk is significant and, if so, to identify the controls that address it and evaluate their design and implementation.

Responses

AU-C 540 requires one or more of three approaches:

1. Events up to the report date, such as a return filed or an audit settled after year end.
2. Testing how management made the estimate: evaluate the method, significant assumptions and data. The standard also asks, when applicable, whether management has the intent to carry out specific courses of action and the ability to do so. That is the test for tax-planning strategies and for indefinite reinvestment of foreign earnings.
3. Developing an auditor's point estimate or range, for example the auditor's own measurement of an uncertain position.

Tax professionals as specialists

AU-C 620 applies to an individual with expertise in a field other than accounting or auditing. The application guidance in AU-C 620 draws the line for taxes: expertise in applying methods of accounting for deferred income tax is accounting expertise, while a specialist in taxation law has expertise in another field and is a specialist under AU-C 620. Analysis of complex or unusual tax compliance issues is a typical example. A firm's own tax partner or staff can be an auditor's internal specialist.

When a specialist is used, the auditor:

• Evaluates competence, capabilities and objectivity
• Obtains enough understanding of the field to set scope and evaluate the work
• Agrees, in writing when appropriate, on scope, roles, communication and confidentiality
• Evaluates the findings, significant assumptions and methods, and the relevance, completeness and accuracy of significant source data

The auditor keeps sole responsibility for the opinion. See the AU-C 620 guide.

AU-C 9500: tax accrual interpretation

The AU-C 9500 interpretation on the effect of an inability to obtain audit evidence relating to income tax accruals adds three points:

• If the entity lacks documentation of its tax accrual and denies access to the people who made the judgments, the auditor may be unable to obtain sufficient appropriate evidence. That is a scope limitation that can lead to a qualified opinion or a disclaimer.
• Audit documentation includes the significant elements of the entity's tax contingency analysis, including a rollforward of material changes, support for the rate reconciliation, intraperiod allocation, valuation allowances and indefinite reversal plans.
• An opinion from the entity's legal or tax counsel does not, alone, provide sufficient appropriate evidence. The auditor cannot accept a third party's tax analysis without applying the auditor's own tax expertise and knowledge of the business.

Putting it in the program

The income taxes audit program sequences these steps. Get written representations under AU-C 580 on tax positions and planning intent.

Planning the provision audit for Granite Peak Outdoor, Inc.