Contingent Liabilities and Wayfair: The Impact on SUT and Audit Teams
Many businesses are still not compliant with sales and use tax (SUT) nexus obligations created by the 2018 South Dakota v. Wayfair decision. What does that mean to your firm? Your client’s non-compliance may put your audit team in a tricky situation when performing routine audits. This post will explain everything you need to know about contingent liabilities and how they relate to SUT compliance, financial reporting, and your audit team’s legal accountability.
The Value of Audits
Audits are the most significant business driver for most accounting firms, with federal income tax management and filing coming in at a close second. Audits offer businesses of every size a layer of protection by having an impartial third party affirm the integrity of a company's books and records. Equal owners of a company may run an audit to ensure no financial “funny business” is going on. Also, investors considering backing a business or evaluating a potential merger may request an audit during due diligence to assess a company's risk profile.
How SUT Ties Into Audit Analysis
When assessing risk, auditors analyze various things, including debts and tax compliance. While SUT compliance has always been a little murky, complexity peaked when the 2018 South Dakota v. Wayfair decision introduced the concept of economic nexus and created a mechanism to tax remote sellers with interstate or international sales. As a result, businesses' liability risk related to SUT compliance increased dramatically.
States also use audits, but in their case, the audit determines how much unpaid tax money they can recoup from a business that's non-compliant with nexus obligations. During the audit, a state-appointed auditor digs into the business's books and will calculate how the business owes the state in the form of unpaid taxes, penalty fees, and interest charges. When a company receives an audit notice from a state, they have an opportunity to seek representation from an accounting firm to defend the business and help them settle the dispute.
Now, let’s talk about how contingent liabilities tie into financial reporting and audits - and how they can impact your firm.
Contingent Liability: Defined and Explained
A contingent liability is an often overlooked, easily misunderstood possible business expense or debt that is 1) associated with a future event and 2) is contingent on whether or not the event occurs. Lawsuits, future warranty claims – and in the case of economic nexus compliance – unpaid taxes are all excellent examples of potential contingent liabilities.
Auditors are responsible for notating contingent liabilities that meet specific criteria in financial reports and business audit footnotes. The United States Financial Accounting Standards Board, or FASB, wrote specific criteria for how to assess and disclose contingent liabilities.
To determine if a liability must be disclosed, auditors must first determine the materiality – or the significance – of the impact it would have on the business. They must also define the likelihood, or odds, of it happening.
A possible expense is only considered 'material' if it will significantly impact a company's finances. This is determined by an auditor using their best judgment and is typically based on a “materiality threshold” which is stated as a general percentage of a specific financial statement line item – for example, a specific percentage of the company’s annual recurring revenue.
Risks that are deemed to be “non-material” don't need to be disclosed. However, auditors are responsible for notating contingent liabilities that meet specific criteria in financial reports and business audit footnotes. The United States Financial Accounting Standards Board, or FASB, created specific criteria for assessing and disclosing such liabilities.
If a contingent liability is deemed material, it’s time to assess the odds of it occurring.
If a contingent liability is deemed material, the affected company and auditor must determine the likelihood of the liability in question being realized by selecting a category that best defines a business's 'chance of loss.'
The three likelihood categories include:
- Remote (pretty unlikely)
Companies and auditors should choose this option if there’s only a very slight chance the contingent event will occur – for example, if they’re tied up in a frivolous lawsuit that’s likely to dissolve without any major impact on the company. If a liability is determined to be remote, it doesn’t have to be disclosed in financial statements. However, it’s typically a good idea to report it to provide a safety net if the event occurs.
- Reasonably Possible (could go either way)
If the future event in question is less than likely, the company is still not required to make an entry in its accounting records - however, the nature of the event must be disclosed in the footnotes of financial statements. The disclosure should also include the most probable loss amount – or a range if a specific amount is indeterminable.
- Probable (will most likely happen)
When a contingent liability is probable, and the amount of the liability can be estimated using Generally Accepted Accounting Principles (GAAP), a specific accounting journal entry is advised. If an amount cannot be estimated, a footnote is acceptable. Auditors disclosing probable contingent liabilities should make sure debits for legal expenses and credits for accrued liabilities are accounted for.
Auditors should use their best judgment in determining the likelihood of a contingent liability occurring. Given that the outcome of such an event can significantly impact a company's profitability, accurately reporting these liabilities is a big responsibility. And when it comes to sales and use taxes, many businesses are currently facing contingent liabilities in the form of unpaid taxes.
Who’s Responsible for Keeping Businesses Complaint
With the first big wave of post-Wayfair audits making the rounds and most businesses still stumbling through what compliance means to their books - audit teams have a substantially higher contingent liability risk. This is especially true right now since so many business owners and leaders are unaware of their sales tax obligations.
In an ideal world, every business owner with consistent sales would hire an accountant right out of the gate. It's much easier to maintain squeaky clean books when clients are proactive about it from the offset. Mitigating issues before any state contacts a business can result in massive cost savings. In a best-case scenario, the firm gets to know the client's business inside and out, issues are identified early, and the firm uses voluntary disclosure agreements and other bargaining tools to help the business become compliant in the least painful way possible.
Unfortunately, many business owners fall victim to not knowing what they don’t know – especially when it comes to taxes. As a result, company leaders often turn to accounting firms for help once they’ve already gotten themselves into a non-compliance pickle. Often, firms are brought into the picture once the state has already issued an audit request, which unfortunately limits the business's options in how to respond to any monetary burdens they’re facing due to non-compliance.
Empower Your Firm and Protect Your Clients
Ideally, firms have SUT compliance experts on staff who can inform audit teams and work together to ask the right questions and educate clients about potential non-compliance risks. But even with in-house experts, bandwidth is limited, and ever-evolving SUT legislation is difficult to keep up with. Also, while some firms have great collaboration between audit teams and specialized tax experts, others are more siloed.
Let LumaTax HelpFirms that enlist the help of smart software that offers nexus analysis designed to simplify risk assessment are in a much better position to effectively support clients by offering proactive SUT advisory and compliance services. Backed with the right data and insights, SUT and audit teams can accurately identify non-compliance risks, inform clients of their options, and swear to audit results with confidence.
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