Monte Carlo – it's not just gambling

Recent events have increased interest in the accuracy, reliability, and honesty of financial statements. This attention already has led to new standards and procedures that generally will be helpful to financial statement users. There is no doubt that we have not seen the last of such changes. Unfortunately, but inevitably, the pendulum will likely swing too far thereby planting the seeds for further reform in the future. Nevertheless, the presentation of financial statements now is a central focus of senior management of publicly traded (and many private) companies.

Financial Accounting
At its most fundamental level, financial statements aim to represent the current state of the enterprise. They provide critical information to interested parties who rely upon them to make decisions such as buying or selling stocks and securities, and extending credit.

For many reasons, companies prefer strong financial statements depicting an enterprise with a solid balance sheet, steady earnings, and attractive cash flows. Among the advantages solid companies enjoy are access to capital, access to inexpensive capital, and strong stock prices. The preference for strong financial statements creates an incentive to include income and exclude expense in the income statement with a concomitantly similar balance sheet effect. Whether income or expense should be included in the income statement generally is clear-cut. In some cases, however, the answer is not obvious. To illustrate the difficulties, consider an enterprise facing a lawsuit that has some but not overwhelmingly clear merit. Since the outcome of the lawsuit is unknown, the enterprise faces a liability that may, but is not certain to arise. Should the company win the suit, it would have no payment obligation and therefore have no liability. On the other hand, the company may lose and be required to make a substantial payment. Of course, lawsuits often are settled, and in such case, the payment would fall in a range bounded by no payment and a large payment. What, then, should the company do with respect to including this contingent liability in its financial statements?

Fortunately, the accounting rules provide guidance for the appropriate treatment of contingencies. In general, those rules require a contingency to be expensed in the income statement if the amount can be reasonably estimated and it is “probable” that a liability has been incurred. For this purpose, a loss is probable if it is likely to occur. The accrual is measured by the amount of the loss to be incurred. If the amount of the loss is uncertain but will fall within a range, the most likely outcome in that range should be accrued. If there is no most likely outcome in a range, the minimum should be accrued. Where a loss is not probable, it nonetheless must be disclosed in the financial statements if “reasonably possible”. A loss is reasonably possible if its probability is less than probable but more than “slight.”

In summary, a contingent liability should be recognized in the income statement when the amount can be reasonably estimated and is likely to occur. If at least one of these conditions is not met, an expense need not be recognized but it must be disclosed unless the probability of being incurred is slight.

Tax Contingencies
Tax law is inherently complex. The thousands of pages constituting the Internal Revenue Code and the associated Treasury Regulations attest to this complexity. Moreover, thousands of additional pronouncements are issued annually by the Internal Revenue Service and federal courts. These many authorities are complicated in themselves, but their complexity is exacerbated by their interaction with one another and the rapidity of change. Consequently, even tax professionals often feel uncertain about correct answers in developing areas of the law. Non-tax professionals, of course, are at an even greater disadvantage in understanding tax rules.

Given this uncertainty, it is hardly surprising that those responsible for a company's tax accounts often face difficult choices. One early decision that must be taken by a company's tax executive is how to treat transactions not having clear-cut tax answers. The results of such decision, of course, will be reflected on the enterprise's tax returns. Related financial statement decisions that must be made involve deciding upon the appropriate entries to the tax liability accounts and generally follow the tax return treatment of the transaction. To illustrate, assume a U.S. corporation licenses technology to a foreign subsidiary. Further assume that the license calls for a royalty of 5 percent of sales. Finally, assume that the U.S. corporation has a number of licenses to third parties with royalty rates ranging from 4 to 15 percent. The applicable U.S. tax rules generally require that the royalty charged to a wholly owned subsidiary to be at “arm's length,” that is to say, the charge that an unrelated party would bear.

The tax executive responsible for the company's income tax return may very well conclude that since some third-party licenses call for royalties of 5 percent, the company tax return can be filed on that basis. The tax executive may be concerned, however, that the IRS will challenge the 5-percent royalty and require a greater charge. Since tax audits generally lag tax return filings by at least a couple of years, the company may be required to wait some time before it learns whether the IRS agrees that 5 percent is the appropriate royalty rate.

Before knowing the result of an IRS review of the royalty rate, the company must prepare its financial statements. In the usual case, the company would accrue federal and state income tax on the royalty income received by the licensor and record a tax benefit in the subsidiary for the 5-percent expense. The company, however, must face the issue whether the IRS will contest the 5 percent as inadequate and, if so, must predict the amount of the IRS adjustment. Thus, it must decide whether an adjustment is probable and reasonably estimable. If so, the company must record additional tax contingency in its financial statements. If not, it still must determine whether to disclose the contingency based upon financial accounting principles.

The process normally employed for making these assessments depends on the view of the tax executive. Typically, the executive recommends to senior financial management how to account for this contingency. Absent unusual circumstances, this recommendation will be followed, primarily because taxes are too complex and arcane for non-tax professionals to challenge the recommendation. Thus, the tax executive often wields significant influence over the shape of the financial statements.

How does the tax executive decide whether a contingency should be recorded? Typically, the decision will be a function of the executive's assessment of the risk of being challenged by the IRS and, if so, prevailing during the IRS audit (and beyond). The assessment normally is based upon a review of the status of the applicable law and discussions with internal and external professionals. After the requisite review, the tax executive decides whether the IRS has reasonable grounds for an adjustment and, if so, whether the IRS will ultimately prevail, totally or partially. A total victory for the IRS would occur upon the company's conceding the matter at some stage in the long administrative process or losing a court case. A partial IRS victory represents a compromise reached between the parties at any stage of the contest.

The company's external auditors are responsible for certifying the correctness of the financial statements. While most knowledgeable people understand that the auditors do not guarantee that the financial statements are free from error, recent publicity surrounding Enron, Global Crossing, WorldCom, and other companies has heightened the auditors' sensitivity to ensuring the best audit possible. Consequently, auditors today are even more thorough than in the past. Among the areas receiving greater attention are tax accounts for which greater documentation is now required.

Refining the Analysis
A superior process to determine tax contingencies would supplant today's often highly subjective and relatively crude process and replace it with one more objective and analytical. Technology that facilitates this transformation is available today in the form of Monte Carlo simulation software. Monte Carlo conjures up images of aristocratic men and women playing baccarat in evening clothes. The name of this technology, in fact, does derive from the world of casinos because it operates by running many “trials” in a way similar to playing game after game at the gambling tables.

Reduced to its rudiments, Monte Carlo technology allows the user to repeatedly simulate the results of an activity with an uncertain outcome much like a gambler rolling dice over and over. The end result of Monte Carlo simulations is a range of possible outcomes including the one that is most likely. Applied to taxation, Monte Carlo technology enables the tax executive to simulate the results of IRS examination of one or many issues, based upon a virtually infinite number of audits of those issues. Through Monte Carlo technology, the tax executive can create the virtual equivalent of many IRS audits of the same issues and the attendant results of those audits. Much like the movie “Groundhog Day,” the tax executive can model IRS examination after examination with the essential difference being that the movie always ended the same way whereas Monte Carlo software will produce many alternative outcomes.

One good approach to using Monte Carlo technology is to identify and interview “experts” in the area of interest. In the royalty case above, one might identify a number of professionals who have practical experience with structuring technology agreements and others expert in handling IRS audits of technology agreements. These experts would be asked to identify the range of possible outcomes upon audit. Setting a range is important to the effective use of Monte Carlo technology. For example, experts might be asked singly or in a group to define with a confidence level of 90 percent the highest and lowest level of royalty that may result after an IRS audit. In addition, the experts would be asked their opinion of the most likely outcome. Experts in our case may predict, with 90- percent confidence, that the royalty rate will be no less than 4 percent and no more than 8 percent, with 5 percent the most likely outcome. Then, the software would be run over a number of trials, each of which represents a different audit. The output would include a probability distribution that would show not only the most likely outcome but also the mean of all outcomes. With this data, the tax executive would be well positioned to support not only the methodology used but also the results achieved.

Monte Carlo software is capable of handling almost an unlimited number of variables, thereby enabling all audit issues to be included in the calculation. Furthermore, the software allows variables to be correlated to each other. Thus, if royalty income were to be increased, the attendant effect on the foreign tax credit limitation could be calculated automatically. A number of Monte Carlo software programs are commercially available.

Monte Carlo technology promises a series of benefits for tax executives. Notwithstanding its name, the software does not facilitate or encourage “gaming” of the tax system. Indeed, it enables a more disciplined and rigorous approach to issue identification and analysis. Thus, Monte Carlo facilitates the development of expert opinion thereby ensuring a more complete and reasoned view of the issues as well as potentially surfacing new and different angles. In addition, it provides a more objective view of IRS audit outcomes. It also produces an objective basis for resolving questions about the need to provide for liability contingencies. Finally, it provides a useful methodology for demonstrating to the external auditors that the company's tax positions are well considered and properly accounted for in the financial statements.

While Monte Carlo simulation represents a powerful technology with many potential benefits, companies should consider a number of factors beyond the scope of this article including attorney/ accountant privilege before embarking on this rich and robust journey.

Applied to taxation, Monte Carlo technology enables the tax executive to simulate the results of IRS examination of one or many issues, based upon a virtually infinite number of audits of those issues.

BRUCE H. BARNETT is Chief Financial Officer of Renessen LLC, a joint venture of Cargill, Incorporated and Monsanto Company. He previously served as Vice President-Taxes for Cargill. A former member of Tax Executives Institute's Minnesota Chapter, Mr. Barnett has served as chair of the Institute's Federal Tax Committee. He holds both J.D. and LL.M. (Taxation) degrees from New York University School of Law, and has also worked for a national public accounting firm.

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